S-1/A 1 ds1a.htm AMENDMENT NO. 4 TO FORM S-1 Amendment No. 4 to Form S-1
Table of Contents

As filed with the Securities and Exchange Commission on May 3, 2010

Registration No. 333-163905

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Amendment No. 4 to

Form S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

ReachLocal, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware   7311   20-0498783

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

  (I.R.S. Employer
Identification No.)

21700 Oxnard Street, Suite 1600

Woodland Hills, California 91367

(818) 274-0260

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

 

 

Zorik Gordon

President and Chief Executive Officer

ReachLocal, Inc.

21700 Oxnard Street, Suite 1600

Woodland Hills, California 91367

(818) 274-0260

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

Copies to:

 

Christopher L. Kaufman, Esq.

Bradley A. Helms, Esq.

Latham & Watkins LLP

355 South Grand Avenue

Los Angeles, California 90071-1560

(213) 485-1234

  

Adam F. Wergeles, Esq.

ReachLocal, Inc.

21700 Oxnard Street, Suite 1600 Woodland Hills, California 91367

(818) 274-0260

  

Julia K. Cowles, Esq.

Martin A. Wellington, Esq.

Davis Polk & Wardwell LLP

1600 El Camino Real

Menlo Park, California 94025

(650) 752-2000

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after this Registration Statement becomes effective.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

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. (Check one):

 

Large accelerated filer  ¨

   Accelerated filer  ¨    Non-accelerated filer  x    Smaller reporting company  ¨
   (Do not check if a smaller reporting company)   

 

 

CALCULATION OF REGISTRATION FEE

 

 

Title of Each Class of

Securities To Be Registered

   Amount
to be
Registered(1)
   Proposed
Maximum Aggregate
Offering Price
per Share(2)
   Proposed
Maximum
Aggregate
Offering Price(2)
   Amount of
Registration
Fee(3)

Common Stock, par value $0.00001 per share

   4,791,667    $ 19.00    $ 91,041,673    $ 6,491.27
 
(1) Includes 625,000 shares that the underwriters have the option to purchase to cover overallotments, if any.
(2) Estimated solely for the purpose of calculating the registration fee pursuant to Rule 457(o) under the Securities Act of 1933, as amended.
(3) A filing fee of $7,130 was previously paid in connection with the initial filing of this Registration Statement on December 22, 2009. The filing fee of $6,491.27 is being offset by the $7,130 payment previously made.

 

 

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the registration statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

 


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The information in this prospectus is not complete and may be changed. We and the selling stockholders may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

SUBJECT TO COMPLETION, DATED MAY 3, 2010

Preliminary Prospectus

4,166,667 shares

LOGO

 

 

Common Stock

 

 

This is the initial public offering of shares of common stock of ReachLocal, Inc. Prior to this offering, there has been no public market for our common stock. We are offering 3,316,103 shares and the selling stockholders identified in this prospectus are offering 850,564 shares of our common stock. We will not receive any proceeds from the sale of shares to be offered by the selling stockholders. The initial public offering price of our common stock is expected to be between $17.00 and $19.00 per share.

We have applied to list our common stock on The Nasdaq Global Market under the symbol “RLOC.”

Investing in our common stock involves a high degree of risk. See “Risk Factors” beginning on page 11.

 

     Per share    Total

Initial public offering price

   $                 $             

Underwriting discounts and commissions

   $                 $             

Proceeds to ReachLocal, before expenses

   $                 $             

Proceeds to selling stockholders, before expenses

   $                 $             

The underwriters have an option to purchase a maximum of 625,000 additional shares of common stock from us at the public offering price, less the underwriting discounts and commissions, to cover over-allotment of shares, if any. The underwriters can exercise this option at any time within 30 days from the date of this prospectus.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

The underwriters expect to deliver the shares of common stock to purchasers on                     , 2010.

 

J.P. Morgan     BofA Merrill Lynch

 

 

 

  Citi  

 

 

 

Piper Jaffray   Needham & Company, LLC   Gleacher & Company

                    , 2010


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LOGO


Table of Contents

TABLE OF CONTENTS

 

     Page

Prospectus Summary

   1

Risk Factors

   11

Forward-Looking Statements

   30

Use of Proceeds

   31

Dividend Policy

   31

Capitalization

   32

Dilution

   33

Selected Consolidated Financial and Other Data

   35

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   39

Business

   66

Management

   78

Executive Compensation

   86

Certain Relationships and Related Party Transactions

   118

Principal and Selling Stockholders

   122

Description of Capital Stock

   124

Shares Eligible for Future Sale

   129

Material United States Federal Income Tax Consequences to Non-U.S. Holders of Our Common Stock

   131

Underwriting

   135

Legal Matters

   140

Experts

   140

Where You Can Find More Information

   140

Index to Consolidated Financial Statements

   F-1

 

 

You should rely only on the information contained in this prospectus or contained in any free writing prospectus filed with the Securities and Exchange Commission. Neither we, nor the underwriters, have authorized anyone to provide you with additional information or information different from that contained in this prospectus or in any free writing prospectus filed with the Securities and Exchange Commission. We are offering to sell, and seeking offers to buy, our common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of our common stock.

Unless the context requires otherwise, the words “we,” “us,” “our,” “Company” and “ReachLocal” refer to ReachLocal, Inc. and its subsidiaries taken as a whole. For purposes of this prospectus, the term “stockholders” shall refer to the holders of our common stock.

Until             , 2010, U.S. federal securities laws may require all dealers that effect transactions in our common stock, whether or not participating in this offering, to deliver a prospectus. This is in addition to the dealers’ obligation to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions.

 

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PROSPECTUS SUMMARY

This summary highlights the information contained elsewhere in this prospectus and is qualified in its entirety by the more detailed information and financial statements included elsewhere in this prospectus. Because this is only a summary, it does not contain all of the information that may be important to you. For a more complete understanding of the information that you may consider important in making your investment decision, we encourage you to read this entire prospectus. Among the other information in this prospectus, you should carefully consider the information set forth under the heading “Risk Factors” and in our consolidated financial statements and accompanying notes included elsewhere in this prospectus.

ReachLocal Overview

Our mission is to help small and medium-sized businesses, or SMBs, acquire, maintain and retain customers via the Internet. We offer a comprehensive suite of online marketing and reporting solutions, including search engine marketing, display advertising, remarketing and online marketing analytics, each targeted to the SMB market. We deliver these solutions to SMBs through a combination of our proprietary RL Platform and our direct, “feet-on-the-street” sales force of Internet Marketing Consultants, or IMCs, and select third-party agencies and resellers.

We use our RL Platform to create advertising campaigns for SMBs to target potential customers in their geographic area, optimize those campaigns in real time and track tangible results. Through a single Internet advertising budget, we enable our clients to reach local customers across all the major search engines and leading general interest and vertically focused online publishers. Based in or near the cities in which our clients operate, our IMCs establish a direct consultative relationship with our clients and, empowered by the RL Platform, work with the clients to achieve their marketing objectives.

At March 31, 2010, we managed 19,700 Active Campaigns across 15,700 Active Advertisers, a substantial majority of which we calculate spend from $500 to $3,000 per month with us. Our clients include SMBs in a number of industry verticals, such as home repair and improvement, automobile sales and repair, medical and health services, legal services and retail and personal services. Since inception, we have delivered to our SMB clients more than 330 million geographically targeted clicks and 25 million phone calls. We employ 569 IMCs in North America, Australia and the United Kingdom and work with over 350 third-party agencies and resellers that use the RL Platform to serve their SMB clients. We intend to expand our IMC sales force both in existing and new markets.

We generate revenue by providing online advertising solutions for our clients through our ReachSearch, ReachDisplay, Remarketing, TotalTrack® and other products and services. We reported $203.1 million in revenue in 2009 and $146.7 million in revenue in 2008, an increase of 38.5%, as well as a $6.0 million loss from operations in 2009 and a $7.0 million loss from operations in 2008. We also reported $63.6 million in revenue in the three months ended March 31, 2010, an increase of 48.9% as compared to the same period in 2009, as well as a $2.9 million loss from operations.

Industry Overview

The Local SMB Advertising Market

SMBs serving local markets represent significant economic activity, control substantial purchasing power and address the needs of hundreds of millions of consumers. These SMBs include businesses such as lawyers, physicians, car dealers, dentists, plumbers, florists and local operations of national chains. According to Borrell Associates, there were more than 15 million businesses with less than 50 employees in the United States in 2008, of which more than three million spent an average of $1,200 per month on advertising. Borrell Associates estimates total local advertising spend for U.S. SMBs in 2008 at $60.5 billion.

An SMB’s owner and operator is also typically its chief marketing officer because the business is too small to justify hiring dedicated marketing personnel. Companies that operate traditional offline media formats, such as

 

 

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the yellow pages, newspapers, radio stations and direct mail publishers, adapted to the limited amount of time and effort that SMB owners and operators are normally able to devote to advertising and marketing by developing products, distribution and service delivery models that greatly simplified the marketing process for SMBs. These traditional offline media companies deployed direct local sales forces that walked into the SMB’s place of business for a face-to-face meeting, presented a media package that gave the SMB broad customer reach through a single advertising purchase, assisted in the creation of the media advertisement for the SMB and ultimately asked the SMB to do little more than write a check.

The Digitization of Local Advertising

Over the past decade, the local advertising market for SMBs and other local businesses has undergone rapid and fundamental changes. The delivery and consumption of local advertising, like all media, is becoming increasingly fragmented and digitized. Many consumers who used to search for a local business in the yellow pages are now going online and searching on Google, checking reviews on Yelp and Citysearch and asking their friends for their opinions through Facebook and Twitter. Similarly, many consumers who used to read the newspaper are now accessing the news through news sites, portals and blogs. According to a TMP Directional Marketing and comScore Local Search Usage Study, consumers used online sources for 64% of local business searches, and of these consumers, 46% contacted the business owner over the phone and 37% visited the business’s physical location following their online search. This consumer-led digital transformation has profoundly disrupted the ways that businesses of all sizes need to acquire, maintain and retain their customers.

To keep pace with this transformation, we believe that SMBs need to follow their customers and move an increasing portion of their marketing efforts and spend online. According to Veronis Suhler Stevenson, the amount of money spent on local advertising in the U.S. through traditional media sources, which include yellow pages, newspapers, TV, radio, magazines and out-of-home media as well as their associated online platforms, is forecast to decline from $101.5 billion in 2007 to $73.6 billion in 2011. Over the same period, spend for all local online advertising in the U.S. is projected to grow from $8.7 billion to $15.9 billion, according to Borrell Associates.

The Local Challenge

The growth of local online advertising spend has, however, significantly lagged the increase in online media consumption. According to Forrester Research, 50% of weekly media consumption among U.S. adults is done via the Internet. However, according to Borrell Associates, SMBs spend only 11% of their advertising budgets online. We believe that this lag is the result of two significant challenges:

 

   

The Product Challenge. For owners and operators of SMBs, building an efficient and effective online marketing presence is a significant challenge, especially given the highly fragmented landscape of digital media publishers. While it is possible for an SMB to purchase search and display media online through various self-service advertising platforms, we believe that these online advertising products and services do not address the fundamental needs and business realities of the SMB advertiser, which include a lack of time, resources, expertise and ability to track meaningful results, such as phone calls, from the campaign. Even if SMBs could overcome these challenges, the opportunity cost of the hours spent analyzing and optimizing online marketing campaigns would be disproportionate to the level of their advertising budgets.

 

   

The Distribution Challenge. Selling advertising to SMBs is difficult. The SMB market is fragmented, and owners and operators are busy running their businesses and have little time to consider new marketing options. Offline media companies addressed this problem for their offline products and services by developing dedicated local sales forces. We believe that offline media companies — even those with online products and services — have not effectively refocused their existing sales forces to sell online media. In contrast, online media publishers have generally not made the investment in a dedicated local sales force to sell to SMBs.

 

 

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The ReachLocal Solution

We combine advanced, publisher-agnostic technology and an experienced, digitally sophisticated direct sales force to provide SMBs with a single, easy-to-use and cost-effective solution to acquire, maintain and retain customers using digital media. Our target market is SMBs that spend at least $5,000 per year on advertising.

The Product Solution: the RL Platform

We have built a technology platform that addresses the needs of the SMB and re-creates with online media the simplicity, breadth of customer reach and effectiveness to which SMBs are accustomed with offline media.

 

   

One Check: The Internet Budget. Through the simplicity of a single Internet advertising budget, the RL Platform allows us to connect SMBs to multiple online publishers, including major search engines, an extensive network of local search and directory sites, as well as leading general interest and vertically focused publishers and display advertising networks.

 

   

Do It for Me: End-to-End Execution. Through our proprietary RL Platform, we execute all aspects of an SMB’s search engine marketing and online display advertising campaigns, including account setup with each of the online publishers, ad creation, keyword provisioning, bid management, budget optimization and online and offline event tracking.

 

   

Do It Better Than I Can: Efficient and Optimized Buying. The RL Platform runs a set of proprietary algorithms multiple times a day to evaluate each publisher and each keyword, and dynamically shifts spend to continually optimize and improve the performance of our SMBs’ campaigns. We have run tens of thousands of online marketing campaigns for SMBs, and this scale and experience in purchasing online advertising from publishers allows us to make more efficient and effective purchasing decisions on behalf of our clients.

 

   

Prove It: Calls, not Just Clicks. We employ a proprietary reverse proxy technology that automatically tracks campaign-generated activity, such as phone calls, e-mails and site navigation, without requiring the SMB to alter its website or maintain a separate website.

Each of our products and services includes, through a single budget, access to multiple publishers, some of which are not available to SMBs, as well as access to our proprietary optimization and tracking technologies that dynamically adjust the publishers to which we allocate clients’ media spend in order to meet their performance objectives. For these reasons, while we rely on third-party publishers for the substantial majority of the media we purchase on behalf of our clients, we are not simply a reseller of media; rather, we market our products and services as a complete package of media optimized for the client using our RL Platform.

Our comprehensive suite of SMB-focused online marketing and reporting products include:

 

   

ReachSearch. Our search engine marketing product, ReachSearch, places our clients’ advertisements prominently among the search results on leading search engines such as Google, Yahoo! and Microsoft, as well as our extensive network of local search and directory sites, called the ReachLocal Search Network.

 

   

ReachDisplay. Our display advertising product, ReachDisplay, broadcasts an SMB’s message to a specific target online audience. We offer more than 20 different display advertising products across a wide variety of publishing partners, including Yahoo!/Right Media, Google, Collective Media, Facebook, Fox Interactive Media, and Kelley Blue Book.

 

   

Remarketing. Our remarketing product allows us to target consumers who have previously visited a specific SMB’s website through a ReachSearch or ReachDisplay campaign.

 

   

TotalTrack. Powered by our proprietary reverse proxy technology, our TotalTrack product allows our clients to see exactly how much online and offline activity, including phone calls, is generated by their online advertising campaigns.

 

 

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The Distribution Solution: Internet Marketing Consultants

We have built a direct sales force of IMCs that re-creates the way SMBs traditionally purchased offline advertising products and services. Our IMCs sell our products and services directly to our SMB clients through an in-person, consultative sales process. Our IMCs are trained to explain the benefits of a digitally focused marketing strategy to SMB owners and operators who are generally preoccupied with operating and managing their businesses. Our largest operating expense has been our investment in the hiring, training and ongoing support of our IMCs while they develop a portfolio of SMB clients. Our IMC development program divides IMCs into two groups: Underclassmen, which consists of IMCs during their first 12 months of employment; and Upperclassmen, which consists of IMCs with more than 12 months of employment. Increasing the number of our IMCs has been the principal engine for our growth. In particular, our growth is driven by the increase in the number of Upperclassmen, who are significantly more productive than our Underclassmen. Our recruitment, training and performance system is designed with the objective of increasing the number of our Upperclassmen over time and increasing the percentage of Underclassmen who become Upperclassmen.

At March 31, 2010, we employed 472 IMCs in North America and an additional 97 IMCs internationally, of which 227 were Upperclassmen. The principal characteristics of our IMCs include the following:

 

   

Internet-Focused and Trained. Our IMCs are 100% focused on selling Internet-based advertising products and services.

 

   

Locally Based. Our 569 IMCs are located in 37 markets in North America, Australia and the United Kingdom where their clients are based, enabling them to provide the personal connection that is necessary for the IMC to develop and maintain a relationship with our clients.

 

   

Consultative. Our IMCs are trained to consult with, educate and guide SMBs through the opportunities arising from and mechanics of purchasing online advertising.

In addition, we have a separate sales channel targeting national brands with operations in multiple local markets and select third-party agencies and resellers.

We believe that the ReachLocal solution, a combination of technology and human capital, gives our SMB clients access to technology and media that they could not access by themselves, and we show that it works in ways they understand. We allow the SMB to write a single check while we do the rest.

Our Strategy

We believe that we are in the early stages of a large and long-term business opportunity presented by the shift of local marketing budgets from traditional media formats to digital media formats. Our strategy for pursuing this opportunity includes the following key components:

 

   

Continue Investment in Growing our IMC Sales Force. We intend to continue to increase the size of our IMC sales force and the geographic footprint of our operations. We expect domestic and international expansion of our IMC sales force in both existing and new markets to be a key driver of growth for our business.

 

   

Increase IMC Productivity. We intend to continue to invest in our service delivery model to provide our IMCs with additional capacity to manage and acquire more advertisers.

 

   

Expand Media Offerings. We intend to continue expanding the number of media options available to our SMB clients. Through the launch of the RL Media Xchange, we have developed a platform that enables us more easily to connect our SMB advertisers to a broader array of online publishers and, in the future, to reach customers through new formats such as mobile and video. Our plan is to be able to fulfill, track and optimize an SMB’s entire digital media plan, regardless of media property or format.

 

 

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Develop Complementary Products and Services in Adjacent Digital Marketing Segments. Our current products and services target our clients’ needs to acquire customers through online media buying. We believe that there will be continued movement towards digital platforms in other segments of an SMB’s marketing activities, such as digital presence, reputation management and customer retention. To address these and other needs, we plan to continue investing in the internal development or potential acquisition of products and services in these adjacent segments. For example, with the technology acquired through the SMB:LIVE acquisition, as discussed below, we are in the process of developing a digital presence and reputation management solution for SMBs.

Recent Developments

On February 22, 2010, we acquired all of the issued and outstanding common stock of SMB:LIVE Corporation, or SMB:LIVE, for consideration of up to approximately $8.5 million in cash and stock. On the closing date, we paid $2.8 million in cash. The balance of the purchase price, or the Deferred Consideration, is estimated to total up to $5.7 million and will be payable based upon the achievement of certain milestones tied to employee retention objectives in three installments, with 25% payable February 2011, 25% payable August 2011 and 50% payable February 2012. Approximately $4.7 million of the Deferred Consideration will be payable in shares of our common stock, based on the price per share of our common stock in this offering, and approximately $1.0 million will be payable in cash.

With the technology acquired through the SMB:LIVE acquisition, we are developing a digital presence and reputation management solution designed to enable an SMB to publish multi-media content from a single interface to a business profile page hosted by us as well as to local directory sites, search engines and social media sites, including Twitter and Facebook. In addition, we will provide automated monitoring of local review sites, social media sites, and local blogs for references to the SMB or comments related to the SMB’s business to provide an SMB with feedback, alerts and analytics to assist it in managing its online reputation.

Corporate Information

We were incorporated in the State of Delaware in August 2003. Our principal executive offices are located at 21700 Oxnard Street, Suite 1600, Woodland Hills, California 91367, and our telephone number is (818) 274-0260. We maintain a number of websites, including www.reachlocal.com. The information on, or accessible through, our websites does not constitute part of, and is not incorporated into, this prospectus.

ReachLocal® , ReachSearch, ReachDisplay, TotalTrack, the ReachLocal logo and other trademarks or service marks of ReachLocal appearing in this prospectus are the property of ReachLocal. All other service marks, trademarks and trade names referred to in this prospectus are the property of their respective holders.

Industry Data

Some of the industry and market data contained in this prospectus are based on independent industry publications or other publicly available information, while other information is based on our internal sources. Although we believe that each source is reliable as of its respective date, the information contained in such sources has not been independently verified, and neither the underwriters nor we can assure you as to the accuracy or completeness of this information. As a result, you should be aware that the industry and market industry data contained in this prospectus, and beliefs and estimates based on such data, may not be reliable.

 

 

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The Offering

 

Common stock offered:

  

By us

   3,316,103 shares

By the selling stockholders

   850,564 shares

Total

   4,166,667 shares

Underwriters’ option to purchase additional shares

   625,000 shares

Common stock to be outstanding after this offering

   27,138,285 shares, or 27,763,285 shares if the underwriters exercise their option to purchase additional shares in full.

Use of proceeds

  

We estimate that the net proceeds from the sale of shares by us in the offering (based on an assumed offering price of $18.00 per share, the mid-point of the estimated price range shown on the cover page of this prospectus), after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us, will be $43.9 million. We will not receive any of the proceeds from the sale of shares by the selling stockholders.

 

We anticipate that we will use the net proceeds of this offering to fund working capital and for general corporate purposes. We will also use the net proceeds of this offering to fulfill a deferred payment obligation of $6.1 million in connection with our acquisition in September 2009 of the approximately 53% of our Australian operations that we did not already own. We may also use a portion of the net proceeds to acquire, invest in, or obtain rights to, complementary technologies, products, services or businesses. See “Use of Proceeds” for additional information.

Risk factors

   See “Risk Factors” and the other information included in this prospectus for a discussion of factors you should consider carefully before investing in shares of our common stock.

Proposed Nasdaq symbol

   RLOC

The number of shares of common stock to be outstanding after this offering is based on 23,822,182 shares outstanding as of March 31, 2010 and excludes:

 

   

5,173,693 shares of common stock issuable upon the exercise of outstanding options to purchase our common stock at a weighted average exercise price of $8.27 per share;

 

   

76,137 shares of common stock issuable upon the exercise of a warrant with an exercise price of approximately $9.23 per share;

 

 

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15,000 shares of common stock issuable upon the exercise of a warrant with an exercise price of approximately $10.91 per share; and

 

   

2,285,634 shares of common stock reserved for future issuance under our stock-based compensation plans, including 185,634 shares reserved for issuance under our existing stock option plan and an additional 2,100,000 shares of common stock reserved for future issuance under our amended and restated stock plan, which was approved by our stockholders on April 23, 2010 in connection with this offering, of which approximately 1,400,000 shares are expected to be granted in the form of stock options and restricted stock units to our employees, including options to purchase 480,000 shares to be granted to our named executive officers (in the respective amounts set forth on page 97 of this prospectus), immediately following the pricing of this offering at an exercise price equal to the initial public offering price.

Unless otherwise indicated, this prospectus reflects and assumes the following:

 

   

no exercise by the underwriters of their option to purchase up to 625,000 additional shares of our common stock from us;

 

   

the automatic conversion of all of our outstanding preferred stock into an aggregate of 16,712,120 shares of common stock upon completion of this offering; and

 

   

the filing of our amended and restated certificate of incorporation and the adoption of our amended and restated bylaws immediately prior to the effectiveness of the offering.

 

 

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Summary Consolidated Financial and Other Data

The following tables summarize financial and other data regarding our business. You should read the following summary financial data in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this prospectus.

We derived the consolidated statements of operations data for the three years ended December 31, 2007, 2008 and 2009, from our audited consolidated financial statements included elsewhere in this prospectus. We derived the unaudited consolidated statement of operations data for the three months ended March 31, 2009 and 2010, as well as unaudited consolidated balance sheet data as of March 31, 2010, from our unaudited interim consolidated financial statements included elsewhere in this prospectus. The as-adjusted balance sheet data reflects the balance sheet data at March 31, 2010 as adjusted to reflect our receipt of the net proceeds from the sale by us in this offering of 3,316,103 shares of common stock at an assumed public offering price of $18.00 per share, the mid-point of the estimated price range on the cover page of this prospectus, after deducting estimated underwriting discounts and commissions, estimated offering expenses payable by us and payment of our deferred purchase price obligation in connection with the ReachLocal Australia acquisition. The unaudited interim consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and, in the opinion of our management, reflect all adjustments necessary for the fair presentation of the financial information set forth in those statements. Our historical results are not necessarily indicative of results to be expected in any future period.

 

    Year Ended December 31,     Three Months Ended
March 31,
 
    2007     2008     2009     2009     2010  
                      (Unaudited)  

Consolidated Statements of Operations:

         
(in thousands, except per share data)                              

Revenue

  $   68,356      $ 146,687      $ 203,117      $ 42,735      $ 63,626   

Cost of revenue (1)

    39,262        77,496        112,218        23,823        34,839   

Operating expenses:

         

Selling and marketing (1)

    24,435        61,054        76,175        17,080        23,940   

Product and technology (1)

    1,911        2,938        5,167        974        2,344   

General and administrative (1)

    5,804        12,128        15,534        3,057        5,385   
                                       

Total operating expenses

    32,150        76,120        96,876        21,111        31,669   
                                       

Loss from operations

    (3,056     (6,929     (5,977     (2,199     (2,882

Gain on acquisition of ReachLocal Australia

                  16,223                 

Equity in losses of ReachLocal Australia

    (250     (813                     

Other income (expense), net

    669        889        (7     9        (10
                                       

Income (loss) before provision for income taxes

    (2,637     (6,853     10,239        (2,190     (2,892

Provision (benefit) for income taxes

    11        145        217        67        (638
                                       

Net income (loss)

    (2,648     (6,998     10,022        (2,257     (2,254

Undistributed income attributable to preferred stockholders

                  8,638                 
                                       

Net income (loss) available to common stockholders

  $ (2,648   $ (6,998   $ 1,384      $ (2,257   $ (2,254
                                       

Pro forma net income per share (unaudited)(2):

         

Basic

      $ 0.44        $ (0.10
                     

Diluted

      $ 0.41        $ (0.10
                     

Pro forma weighted average shares outstanding used in calculating net income per share (unaudited)(2):

         

Basic

        22,995          23,680   

Diluted

        24,613          23,680   

 

 

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(1) Stock-based compensation, net of capitalization, and depreciation and amortization included in the above line items (in thousands):

 

     Year Ended December 31,    Three Months Ended
March 31,
     2007    2008    2009    2009    2010
                    (Unaudited)

Stock-based compensation:

              

Cost of revenue

   $ 18    $ 34    $ 86    $ 10    $ 91

Selling and marketing

     94      338      566      69      181

Product and technology

     16      73      164      17      264

General and administrative

     278      1,366      2,145      447      549
                                  
   $    406    $ 1,811    $    2,961    $ 543    $ 1,085
                                  

 

     Year Ended December 31,    Three Months Ended
March 31,
     2007    2008    2009    2009    2010
                    (Unaudited)

Depreciation and amortization:

              

Cost of revenue

   $ 83    $ 186    $ 261    $ 63    $ 72

Selling and marketing

     205      596      892      196      245

Product and technology

     603      916      1,765      355      670

General and administrative

     49      154      430      56      247
                                  
   $    940    $ 1,852    $    3,348    $ 670    $ 1,234
                                  

 

(2) See Note 2 to our consolidated financial statements for an explanation of the method used to calculate pro forma basic and diluted net income per share of common stock.

 

     March 31, 2010
     Actual     As adjusted (3)
    

(Unaudited)

Consolidated Balance Sheet Data:

    

(in thousands)

    

Cash and cash equivalents

   $   32,786      $ 78,610

Working capital

     (13,712     41,800

Total assets

     101,531        142,818

Total liabilities

     60,218        51,593

Total stockholders’ equity

     41,313        91,225

 

(3) A $1.00 increase (decrease) in the assumed initial public offering price of $18.00 per share would increase (decrease) cash and cash equivalents, working capital, total assets and total stockholders’ equity by approximately $3.1 million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting underwriter discounts and commissions and estimated offering expenses payable by us.

 

 

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     Year Ended December 31,    Three Months Ended
March 31,
 
     2007     2008     2009    2009     2010  

Other Financial Data:

           

(in thousands)

           

Net cash provided by operating activities

   $ 7,421      $ 12,062      $ 14,308    $ 3,012      $ 2,529   

Capital Expenditures (unaudited) (4)

     2,479        5,152        5,805      892        1,777   

Non-GAAP Financial Measures (unaudited):

           

(in thousands)

           

Adjusted EBITDA (5)

     (1,710     (3,266     1,393      (986     (228

Underclassmen Expense (6)

     10,043        27,886        26,824      6,892        7,806   

 

     December 31,    March 31,
     2007    2008    2009    2009    2010

Other Operational Data:

              

Number of IMCs:

              

Upperclassmen

   16    80    235    108    227

Underclassmen

   152    337    280    277    342
                        

Total

   168    417    515    385    569
                        

Active Advertisers (7)

   7,400    11,600    14,700    12,400    15,700

Active Campaigns (8)

     8,900    13,500      18,600    14,900    19,700

 

(4) Represents purchases of property and equipment and the amount of software development costs capitalized, in aggregate, excluding stock-based compensation and the acquisition of ReachLocal Australia in September 2009 (see Note 4 to the consolidated financial statements).
(5) We define Adjusted EBITDA as net income (loss) before interest, income taxes, depreciation and amortization expenses and excluding, when applicable, non-cash stock-based compensation, the effects of accounting for business combinations and amounts included in other non-operating income or expense. See Note 4 to “Selected Consolidated Financial and Other Data” for more information and for a reconciliation of Adjusted EBITDA to our loss from operations calculated in accordance with U.S. generally accepted accounting principles.
(6) For the definition of Underclassmen Expense, see Note 5 to “Selected Consolidated Financial and Other Data.”
(7) For the definition of Active Advertisers, see Note 6 to “Selected Consolidated Financial and Other Data.”
(8) For the definition of Active Campaigns, see Note 7 to “Selected Consolidated Financial and Other Data.”

 

 

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RISK FACTORS

Before deciding to invest in our common stock, you should carefully consider each of the following risk factors and all of the other information set forth in this prospectus. The following risks and the risks described elsewhere in this prospectus, including in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” could materially harm our business, financial condition, future results and cash flow. If that occurs, the trading price of our common stock could decline, and you could lose all or part of your investment. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business.

Risks Related to Our Business

We are an early stage company in an emerging market with an unproven business model and a limited operating history, which makes it difficult to evaluate our current business and future prospects and may increase the risk of your investment.

We have only a limited operating history, and our current business and future prospects are difficult to evaluate. We commenced operations in late 2004. We have developed a strategy for taking advantage of what we believe is a shift of local marketing budgets from traditional media formats to digital media formats, but we cannot assure you that our strategy will not fail or prove less successful than other approaches. You must consider our business and prospects in light of the risks and difficulties we encounter as an early stage company in the new and rapidly evolving online marketing industry. These risks and difficulties include:

 

   

our new and unproven business model;

 

   

maintaining the effectiveness of our RL Platform, and adapting our technology to new market opportunities and challenges;

 

   

our limited number of product offerings and risks associated with developing and selling new product offerings;

 

   

continuing to attract new SMB clients, many of whom have not previously advertised online and may not understand the value to their businesses of our products and services; and

 

   

effectively managing rapid growth in our sales force, personnel and operations.

Failing to successfully address these challenges or others could significantly harm our business, financial condition, results of operations and liquidity.

We have incurred significant operating losses in the past and may incur significant operating losses in the future.

As of March 31, 2010, we have an accumulated deficit of approximately $7.2 million, and we expect to incur net operating losses for the foreseeable future. We expect our operating expenses to increase in the future as we expand our operations. Our business strategy contemplates hiring significant numbers of additional IMCs, both in new and existing markets, as well as making substantial investments in our RL Platform and the development and launch of new products and services, each of which will require significant expenditures. In addition, as a public company, we will incur significant additional legal, accounting and other expenses that we did not incur as a private company. If our revenue does not grow to offset these increased expenses, we will not be profitable. We also expect that a variety of factors, including increased competition and the maturation of our business, will cause our revenue growth rate to decline in the future, and we cannot assure you that our revenue will continue to grow or will not decline. As a result, you should not consider our historical revenue growth as indicative of our future performance. Furthermore, if our operating expenses exceed our expectations, our financial performance will be adversely affected.

 

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We purchase most of our media from Google, and our business could be adversely affected if Google takes actions that are adverse to our interests. Similar actions from Yahoo!, Microsoft and other media providers could adversely affect our business to a lesser degree.

Nearly all of our cost of revenue is for the purchase of media, and a substantial majority of the media we purchase is from Google. According to comScore, Google accounts for more than 65% of all U.S. searches conducted for the month ended March 31, 2010, and Google’s share in foreign markets is often significantly higher. As a result, we expect that our business will depend upon media purchases from Google for the foreseeable future. This dependence makes us vulnerable to actions that Google may take to change the manner in which it sells AdWords, as described below, or conducts its business on a number of levels:

 

   

Google Can Choose to Change the Terms and Conditions Upon Which it Does Business with Us. Google can act unilaterally to change the terms and conditions for our purchase of media, and Google has done so in the past. For example, effective December 31, 2008, Google terminated a publisher rebate provided as part of its North American Authorized AdWords Reseller program, which was the primary reason that our cost of revenue as a percentage of revenue increased from 52.8% in 2008 to 55.2% in 2009. In addition, in January 2010, Google advised us that changes were being made to the program terms, which would require program participants to make certain disclosures to their customers concerning their purchases of media from Google. We concluded that the benefits of the program in North America were outweighed by these additional requirements and, effective March 30, 2010, in North America we have elected to purchase Google media on Google’s standard terms and conditions. Under Google’s standard terms and conditions, Google may continue to impose additional obligations on companies like us unilaterally. For example, in March and April 2010, we learned, through meetings with Google, that Google was contemplating requiring companies such as ours to disclose to its customers a range of information, which might effectively include point-of-sale and ongoing disclosures regarding the percentage of media allocated to Google, the cost to us of the media and, accordingly, our fees associated with the purchase of Google media, as well as potentially instituting new pricing policies on the resale of Google clicks. Based on discussions with Google, we believe that Google could require these or similar disclosures or policies as early as mid-2010. Although we cannot at this time accurately assess the degree to which Google’s imposition of these kinds of requirements and pricing policies would adversely affect our business, new requirements could lead to increased competition, changes in the way we price our services to our clients, and disruption of our customer relationships. Any future changes by Google to the terms and conditions upon which we purchase media could materially and adversely affect our business.

 

   

Competitive Risk. Google offers its products directly to SMBs through an online self-service option. Google enjoys substantial competitive advantages over us, such as substantially greater financial, technical and other resources. In addition, Google has recently launched products, such as their Google Local Business Ads, that are targeted directly at SMBs, and has yet to make them available to third-parties. While we cannot assess at this time the effect of Google’s offering such products directly to SMBs, the prices charged by Google for direct service will be lower than the prices we will be able to charge for the same media.

 

   

Technology Risk. Our RL Platform interacts with Google through publicly available application programming interfaces, or APIs. If Google were to discontinue the availability of all or a portion of these APIs to us, we may have to change our technology, incur additional costs or discontinue certain products or services that we currently offer our clients. Any of these changes could adversely affect our ability to provide effective online marketing and reporting solutions to our clients. In addition, Google may decide to alter the amount it charges us for the right to use its APIs, which would decrease our gross margin absent any change in our pricing to our customers.

 

   

Editorial Control. Google closely monitors the experience of end-users, and from time-to-time its editorial personnel request that companies alter their services based on Google’s determination that aspects of such services could adversely affect the end-user experience. For example, each of our media products includes TotalTrack, a tracking service powered by our proprietary reverse proxy technology. If Google were to determine that the tracking URLs utilized by our TotalTrack service

 

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adversely affects the end-user’s experience, Google could require us to alter or suspend the way we implement our tracking solutions. Such a change would significantly decrease our ability to optimize our clients’ advertising campaigns and limit our ability to provide the level of campaign performance reporting that we currently provide to our clients.

 

   

International Risk. In connection with our operations in the United Kingdom, Google requires us to allocate a specific percentage of our aggregate search engine media purchases to Google in order for us to qualify for preferential access, rebates or other financial incentives. If Google were to increase the percentage required or impose other requirements, our business in the United Kingdom could be adversely affected.

In addition, any new developments or rumors of developments regarding Google’s business practices that affect the local online advertising industry may create perceptions with our customers or investors that our ability to compete has been impaired.

With the exception of the international risk enumerated above, the above risks also apply to other publishers from whom we purchase media, including Yahoo! and Microsoft. Similar actions from those publishers would also have adverse effects on our operating results, the impact of which we believe would most likely be in proportion to their market share relative to Google’s.

We purchase a significant majority of our media from Google, Yahoo! and Microsoft in an auction marketplace. If we are unable to purchase media from any one of these companies, if prices for media significantly increase or if the manner in which the media is sold changes, our business could be adversely affected.

Our success depends on our ability to purchase media from Google, Yahoo!, and Microsoft at reasonable prices so that we can provide our clients with a reasonable return on the advertising expenditures they make through us. We generally purchase this media in an auction marketplace. Increased competition or other factors may cause the cost of the media that we purchase from Google, Yahoo! and Microsoft to rise. In particular, if our expectation that local SMB advertising will increasingly migrate to the Internet is correct, the marketing budget available to bid in these auctions will increase and the price of media may increase substantially. An increase in the cost of media in these marketplaces without a corresponding increase in our media buying efficiency could result in an increase in our cost of revenue as a percentage of revenue even if our business expands. In addition, such an increase could result in an increase in the prices we must charge our clients or a decrease in our ability to fulfill our clients’ service expectations. Furthermore, the Internet search companies that operate these media marketplaces may change the operating rules or bidding procedures in ways that decrease the effectiveness of the technology that we use to optimize our purchases or otherwise prevent us from purchasing media at reasonable prices or at all. Any change in our ability to provide effective online marketing campaigns to our clients may adversely affect our ability to attract and retain clients.

Failure to adequately recruit, train and retain our Internet Marketing Consultants would impede our growth and could harm our business, operating results and financial condition.

Our ability to maintain or grow revenue and achieve profitability will depend, in large part, on increasing the size of our direct sales force of IMCs. We divide our IMCs into two groups: Underclassmen, who are IMCs during their first 12 months of employment, and Upperclassmen, who are IMCs with more than 12 months of employment. Generally, Upperclassmen are more productive than Underclassmen and generate revenue in excess of direct and allocable costs, while Underclassmen do not. Accordingly, we rely on the success of our Upperclassmen to fund our investment in Underclassmen. As we attempt to achieve larger scale in our business, if our Upperclassmen are not as successful as we anticipate, or if our Underclassmen do not successfully develop into productive Upperclassmen, our ability to grow revenue will suffer, our costs may increase and we may not ever become profitable. We assume a certain level of attrition when we hire new Underclassmen. We base that assumption on our historical experience and future expectations, and our assumptions may prove wrong. If our IMC attrition is greater than anticipated, our business will be harmed. In addition, as more companies seek to capitalize on the shift to online media, competition for knowledgeable and qualified online media sales personnel will increase. Moreover, employees that we hire from our competitors have in the past and may in the future be

 

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subject to claims of breach of noncompetition and nonsolicitation obligations owed to their former employers, which could impact our ability to attract and hire high-quality candidates and potentially subject us to litigation. If we are unable to effectively recruit, train and retain IMCs, we may not be able to grow our sales force, our revenue may suffer or our costs may increase.

The market in which we participate is intensely competitive, and if we do not compete effectively, our operating results could be harmed.

The market for online marketing solutions is intensely competitive and rapidly changing, and with the emergence of new technologies and market entrants, we expect competition to intensify in the future.

Our competitors include:

 

   

Internet Marketing Providers. We compete with large Internet marketing providers such as Google, Yahoo! and Microsoft. These providers typically offer their products and services through disparate, online-only, self-service platforms.

 

   

Traditional, Offline Media Companies. We compete with traditional yellow page, newspaper, television and radio companies that, in many cases, have large, direct sales forces.

 

   

Other Technology-Focused, SMB Marketing Providers. We also compete with emerging technology companies focused on the SMB market.

Many of our current and potential competitors enjoy substantial competitive advantages, such as greater name recognition, longer operating histories, substantially greater financial, technical and other resources and, in some cases, the ability to combine their online marketing products with traditional offline media such as newspapers or yellow pages. These companies may use these advantages to offer products similar to ours at a lower price, develop different products to compete with our current solutions and respond more quickly and effectively than we can to new or changing opportunities, technologies, standards or client requirements. In particular, if major Internet search companies such as Google, Yahoo! and Microsoft decide to devote greater resources to develop and market online advertising offerings directly to SMBs, greater numbers of our clients and potential clients may choose to purchase online advertising services directly from these competitors, particularly if and as the ease of their self-service models increases. In addition, many of our current and potential competitors have established marketing relationships with and access to larger client bases. As the market for local online advertising increases, we expect new competitors, business models and solutions to emerge, some of which may be superior to ours. We also believe that the marketplace for online media is more transparent than other media marketplaces. Our competitors may use information available to them to price their products at a discount to the prices that we currently offer. Even if our online marketing and reporting solutions are more effective than those offered by our competitors, potential clients might adopt competitive products and services in lieu of purchasing our solutions. For all of these reasons, we may not be able to compete successfully against our current and potential competitors.

We depend on key personnel to operate our business, and if we are unable to retain our current personnel or hire additional personnel, our ability to develop and successfully market our business could be harmed.

We believe that our future success is highly dependent on the contributions of our executive officers, as well as our ability to attract and retain highly skilled managerial, sales, technical and finance personnel. Qualified individuals are in high demand, and we may incur significant costs to attract them. All of our U.S. officers and other U.S. employees are at-will employees, which means they may terminate their employment relationship with us at any time, and their knowledge of our business and industry would be extremely difficult to replace. If we are unable to attract and retain our executive officers and key employees, our business, operating results and financial condition will be harmed. In addition, our management team has a long history of working together, and we believe that our key executives have developed highly successful and effective working relationships. If one or more of these individuals leave, we may not be able to fully integrate new executives or replicate the current dynamic, and our operations could suffer.

 

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Volatility or lack of performance in our stock price may also affect our ability to attract and retain our key employees. Our executive officers have become, or will soon become, vested in a substantial amount of stock or stock options. Employees may be more likely to leave us if the shares they own or the shares underlying their options have significantly appreciated in value relative to the original purchase prices of the shares or the exercise prices of the options, or if the exercise prices of the options that they hold are significantly above the market price of our common stock.

The impact of worldwide economic conditions, including the resulting effect on advertising budgets, may adversely affect our business, operating results and financial condition.

Our performance is subject to worldwide economic conditions and their impact on levels of advertising. We believe that the current recession has adversely affected our business. For example, we responded to the recession by reducing the number of IMCs we hired, which resulted in a decline in our Upperclassmen headcount in the first quarter of 2010, and which may adversely affect revenue growth in 2010. We also believe that the recession adversely impacted IMC productivity and contributed to a decrease in our National Brands, Agencies and Resellers revenue in the same period. To the extent that the current economic recession continues, or worldwide economic conditions materially deteriorate, our existing and potential clients may no longer consider investment in our online marketing solutions a necessity, or may elect to reduce advertising budgets. Historically, economic downturns have resulted in overall reductions in advertising spending. In particular, online marketing advertising solutions may be viewed by some of our existing and potential clients as a lower priority and may be among the first expenditures reduced as a result of unfavorable economic conditions. These developments could have an adverse effect on our business, operating results and financial condition.

If we fail to increase the number of our clients or retain existing clients, our revenue and our business will be harmed.

Our ability to grow our business depends in large part on maintaining and expanding our client base. To do so, we must convince prospective clients of the benefits of our RL Platform and existing clients of the continuing value of our products and services. The online marketing industry is new and rapidly evolving, and many prospective clients may not be familiar with the benefits of online marketing. These businesses may generally favor using more traditional methods of local advertising, such as newspapers or print yellow pages directories. We cannot assure you that we will be successful in maintaining or expanding our client base.

SMB marketing and advertising campaigns are often sporadic and difficult to predict, as they may be driven by seasonal promotions or business dynamics, evolving product and service offerings, available budgets and other factors. Some SMBs advertise only periodically, such as to promote sales or special offers. Because we need to address these business considerations of our clients, we do not require clients to enter into long-term obligations to purchase our products and services. Many do not renew their campaigns, and some cancel. We must continually add new clients both to replace clients who choose not to renew their advertising campaigns and to grow our business beyond our current client base. A client’s decision not to renew may be based on a number of factors, including dissatisfaction with our products and services, inability to continue operations and spending levels or because their campaigns were event-driven or otherwise intentionally limited in scope or duration. If our clients increasingly fail to fulfill their contracts or increasingly do not renew their advertising campaigns with us, or if we are unable to attract new clients in numbers greater than the number of clients that we lose, our client base will decrease and our business, financial condition and operating results will be adversely affected.

A significant portion of our revenue is generated by our national brands, agencies and resellers. If we are not able to maintain relationships with one or more of them, our sales may suffer and our revenue may decline.

We distribute our products and services through a separate sales force for national brands with operations in multiple local markets, as well as select third-party agencies and resellers. Because these national brands, agencies and resellers generally represent an aggregated group of SMB clients, if our relationship with one or more of these persons or companies were restricted or terminated, our sales would decrease and our revenue would be adversely affected, potentially materially. In addition, our strategy of distributing our products and

 

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services to our clients through our Direct Local channel and through our National Brands, Agencies and Resellers channel may result in distribution channel conflicts. Our direct local sales efforts may compete with our third- party agency and resellers and, to the extent different third-party agencies and resellers target the same clients, they may also come into conflict with each other. While we have certain policies in place to address these potential conflicts, there can be no assurance that these channel conflicts will not materially adversely affect our relationship with existing third-party agencies and resellers or adversely affect our ability to attract new third-party agencies and resellers. In the event that any of our relationships with existing third-party agencies and resellers are terminated or we are unable to attract new third-party agencies and resellers as a result of these distribution channel conflicts, our sales may suffer and our revenue may decline.

If SMBs increasingly opt to perform advertising tasks on their own, their demand for our products and services would decrease, negatively affecting our revenue.

Large Internet marketing providers such as Google, Yahoo! and Microsoft offer online advertising products and services through self-service platforms. As SMBs become more familiar with and experienced in interacting online, they may prefer to actively manage their own Internet presence and their demand for our products and services may decrease. We cannot predict the evolving experiences and preferences of SMBs, which may become more fully integrated into digitized modes of commerce and communication, and cannot assure you that we can develop our products and services in a manner that will suit their needs and expectations faster or more effectively than our competitors, or at all. If we are not able to do so, our results of operations would suffer.

Our future success depends in part on our ability to effectively develop and sell additional products, services and features.

We invest in the development of new products and services with the expectation that we will be able to effectively offer them to our clients. For example, we have recently begun to offer ReachDisplay to our existing Direct Local clients in North America. In addition, we plan to develop or potentially acquire products and services that address new segments of an SMB’s marketing activities, such as digital presence, reputation management and customer retention. As part of this strategy, in connection with our acquisition of SMB:LIVE, we are developing a suite of digital presence and reputation management products for SMBs, which we plan to launch in the third quarter of 2010. Our future revenue depends in part on our ability to sell these products and services, as well as additional features and enhancements to our existing offerings, to our clients. Our ability to develop and launch new products on our expected timelines, or at all, is subject to numerous risks and uncertainties, such as the difficulties of designing complex software products, achieving desired functionality and integrating the new products with our existing technology.

The sale of new or additional features, products and services, the value or utility of which may be different from our current products and services or less easily understood by our clients, may require increasingly sophisticated and costly sales efforts and increased operating expenses, as well as additional training of our IMCs and education for our SMB clients. New product launches require the investment of resources in advance of any revenue generation. If new products fail to achieve market acceptance, we may never realize a return on this investment. If these efforts are not successful, our business may suffer. Further, many SMBs have modest advertising budgets. Accordingly, we cannot assure you that the successful introduction of new products or services will not adversely affect sales of our current products and services or that our SMB clients will increase their aggregate spending as a result of the introduction of new products and services.

We currently receive rebates and other financial incentives from media publishers. In most circumstances, these rebates and financial incentives can be terminated by the applicable media publisher, or made subject to burdensome conditions, upon little or no notice.

We receive rebates or incentives from Yahoo!, Microsoft and other publishers and, in the United Kingdom and Australia, from Google. Publisher rebates, as percentage of revenue, for the years ended 2007, 2008 and 2009 and for the three months ended March 31, 2010, were 1.7%, 4.1%, 1.2% and 1.9%, respectively. These rebate programs are subject to change or cancellation with little notice, have been cancelled in the past and may

 

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be coupled with burdensome operational requirements. As discussed in an earlier risk factor, Google has, in the past, unilaterally and with limited notice, changed or eliminated its rebate programs. Yahoo!, Microsoft and other publishers may similarly make such unilateral changes, and there are no guarantees that we would be able to defray the effects of the losses of those rebates.

We expect a number of factors to cause our operating results to fluctuate on a quarterly and annual basis, which may make it difficult to predict our future performance.

Our revenue and operating results could vary significantly from quarter-to-quarter and year to year because of a variety of factors, many of which are outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful. In addition to other risk factors discussed in this section, factors that may contribute to the variability of our quarterly and annual results include:

 

   

unilateral actions taken by Google or other media providers;

 

   

seasonal variations in advertising budgets and media pricing;

 

   

seasonal variations in IMC hiring;

 

   

the rate at which SMBs migrate their advertising spending online;

 

   

the timing and stage of product and technology development;

 

   

the impact of worldwide economic conditions on our revenue and expenses;

 

   

our ability to accurately forecast revenue and appropriately plan our expenses;

 

   

the attraction and retention of qualified employees and key personnel;

 

   

the effectiveness of our internal controls;

 

   

our ability to effectively manage our growth;

 

   

the timing of and our ability to enter new markets and manage expansion in new markets;

 

   

our ability to successfully manage any future acquisitions of businesses, solutions or technologies;

 

   

interruptions in service and any related impact on our reputation;

 

   

the impact of fluctuations in currency exchange rates;

 

   

the effects of natural or man-made catastrophic events; and

 

   

changes in government regulation affecting our business.

As a result of these and other factors, the results of any prior quarterly or annual periods should not be relied upon as indications of our future operating performance. In addition, our operating results may not meet the expectations of investors.

We may be unsuccessful in managing or growing our international operations, which could harm our business, operating results and financial condition.

We currently have international sales operations in Australia, the United Kingdom and Canada, and campaign support services in India. Revenue from international operations outside North America accounted for 6.7% and 15.3% of total revenue in 2009 and the three months ended March 31, 2010, respectively. Over the long term, we intend to expand our international operations to new markets and countries. We may incur losses or otherwise fail to enter new markets successfully.

Our ability to operate internationally involves various risks, including the need to invest significant resources, the possibility that returns on such investments will not be achieved in the near future and competitive environments with which we are unfamiliar. Our international operations may not prove to be successful in certain or any markets. In addition, we have incurred and expect to continue to incur significant expenses as we

 

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attempt to establish our presence in particular international markets. Our current and any future international expansion plans will require management attention and resources and may be unsuccessful. Our initial focus in international operations has been in English-speaking countries. We have no experience in modifying our technology and selling our solutions in non-English speaking international markets. Furthermore, in many international markets, we would not be the first entrant, and there may exist greater competition with stronger brand recognition than we have faced in our current markets. Different privacy, censorship and liability standards and regulations and different intellectual property laws in foreign countries may cause our business and operating results to suffer.

Our international operations may also fail to succeed due to other risks inherent in foreign operations, including:

 

   

difficulties or delays in developing a network of clients in one or more international markets;

 

   

legal, political or systemic restrictions on the ability of U.S. companies to market products and services or otherwise do business in foreign countries;

 

   

international intellectual property laws that may be insufficient to protect our intellectual property or permit us to successfully defend ourselves or our intellectual property in international lawsuits;

 

   

difficulties in staffing and managing foreign operations;

 

   

greater difficulty in accounts receivable collection;

 

   

currency fluctuations or a weakening U.S. dollar, which can increase costs of international expansion;

 

   

potential adverse tax consequences;

 

   

lack of infrastructure to adequately conduct electronic commerce transactions; and

 

   

price controls or other restrictions on foreign currency.

As a result of these obstacles, we may find it impossible or prohibitively expensive to continue or expand our international operations, which could harm our business, operating results and financial condition.

Growth may place significant demands on our management and our infrastructure.

We have experienced substantial growth in our business. This growth has placed and may continue to place significant demands on our management and our operational and financial infrastructure. As our operations grow in size, scope and complexity, we will need to improve and upgrade our systems and infrastructure to offer an increasing number of clients enhanced solutions, features and functionality. The expansion of our systems and infrastructure will require us to commit substantial financial, operational and technical resources in advance of an increase in the volume of business, with no assurance that the volume of business will increase. Continued growth could also strain our ability to maintain reliable service levels for our clients, develop and improve our operational, financial and management controls, enhance our reporting systems and procedures and recruit, train and retain highly skilled personnel. Managing our growth will require significant expenditures and allocation of valuable management resources. If we fail to maintain the necessary level of discipline and efficiency in our organization as it grows, our business, operating results and financial condition would be harmed.

Our independent registered public accounting firm reported to us that, at December 31, 2009, we had significant deficiencies in our internal controls.

Our independent registered public accounting firm reported to us that, at December 31, 2009, we had significant deficiencies in our internal controls with respect to our processes for calculating the costs to be capitalized for internally developed software and our method of performing the consolidation process for our financial reports. Under standards established by the Public Company Accounting Oversight Board, or PCAOB, a “significant deficiency” is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is important enough to merit attention by those responsible for oversight of the registrant’s

 

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financial reporting. A significant deficiency is less severe than a “material weakness,” which the PCAOB defines as a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis.

The significant deficiency with respect to the calculation of capitalized software development costs pertains to our lack of contemporaneous documentation of how each project meets the criteria for capitalization and the frequency of collection of estimates used to quantify the costs to be capitalized. We are in the process of remediating this significant deficiency by establishing additional control systems to assure that such contemporaneous documentation is prepared and the frequency of collections is increased. The significant deficiency relating to our consolidation process pertains to our use of multiple spreadsheets and a manual process to effect the consolidation. We have begun the process of remediating this significant deficiency by implementing additional systems to automate a significant portion of the consolidation and reporting process. We are in the process of designing and implementing an Oracle Hyperion financial reporting system that will streamline the financial reporting process and standardize our chart of accounts and financial reporting templates across all of our subsidiaries. As of March 31, 2010 the system has been implemented and continues to be developed and tested.

Our remediation efforts may not, however, enable us to remedy the significant deficiencies or avoid material weaknesses or other significant deficiencies in the future. In addition, these significant deficiencies, any material weaknesses and any other significant deficiencies will need to be addressed as part of the evaluation of our internal controls over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and may impair our ability to comply with Section 404, which will first be applicable to us with respect to our Annual Report on Form 10-K to be filed in 2012.

Our ability to deliver reporting and tracking solutions to our clients depends upon the quality, availability, policies and prices of third-party call tracking providers, website hosting companies and domain registrars.

We rely on third parties to provide our call tracking and recording services. In certain geographies, we rely on a single call tracking provider. In the event the provider were to terminate our relationship or stop providing these services, our ability to provide our tracking services could be impaired. We may not be able to find an alternative provider in time to avoid a disruption of our services or at all, and we cannot be certain that such provider’s services would be compatible with our products without significant modifications or cost, if at all. Our proxy servers, which underlie key elements of our tracking services, require the use of various domains and IP address blocks. If domain registrars, website hosting companies or Internet service providers determined that our use of such domains and IP blocks were in violation of their terms of service or internet policies, such companies could elect to block our traffic. For example, several website hosting companies have blocked traffic from our reverse proxy servers for a group of our SMB clients, resulting in our inability to provide our full tracking services to those clients. Our ability to address or mitigate these risks may be limited. The failure of all or part of our tracking services could result in a loss of clients and associated revenue and could harm our results of operations.

We rely on bandwidth providers, data centers and other third parties for key aspects of the process of providing online marketing solutions to our clients, and any failure or interruption in the services provided by these third parties could harm our ability to operate our business and damage our reputation.

We rely on third-party vendors, including data center, Internet infrastructure and bandwidth providers. Any disruption in the services provided by these third-party providers or any failure of these third-party providers to handle current or higher volumes of use could significantly harm our business. Any financial or other difficulties our providers face may have negative effects on our business, the nature and extent of which we cannot predict. We exercise little control over these third-party vendors, which increases our vulnerability to problems with the services they provide. We have experienced and expect to continue to experience interruptions and delays in service and availability for such elements. Any errors, failures, interruptions or delays experienced in connection with these third-party technologies and information services could negatively impact our relationship with our clients and adversely affect our brand and our business and could expose us to liabilities to third parties.

 

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Client complaints or negative publicity about our customer service or other business practices could adversely affect our reputation and brand.

Client complaints or negative publicity about our technology, personnel or customer service could severely diminish confidence in and the use of our products and services. Effective customer service requires significant personnel expense, and this expense, if not managed properly, could significantly impact our operating results. Moreover, failure to provide our clients with high-quality customer experiences for any reason could substantially harm our reputation and our brand and adversely affect our efforts to develop as a trusted provider of online marketing and reporting solutions for the SMB market.

Rapid technological changes may render our online marketing and reporting solutions obsolete or decrease the attractiveness of our solutions to our clients.

To remain competitive, we must continue to enhance and improve the functionality and features of our RL Platform. The Internet, access to the Internet and the online marketing and advertising industry are rapidly changing. Our competitors are constantly developing new products and services in online marketing and advertising. As a result, we must continue to invest significant resources in order to enhance our existing products and services and introduce new products and services that clients can easily and effectively use. If competitors introduce new solutions embodying new technologies, or if new industry practices emerge, our existing technology may become obsolete. Our future success will depend on our ability to:

 

   

enhance our existing solutions;

 

   

develop new solutions and technologies that address the increasingly sophisticated and varied needs of our prospective clients; and

 

   

respond to technological advances and emerging industry practices on a cost-effective and timely basis.

Developing our online marketing and reporting solutions and the underlying technology entail significant technical and business risks. We may use new technologies ineffectively, or we may fail to adapt our RL Platform and network infrastructure to client requirements or emerging industry practices. If we face material delays in introducing new or enhanced solutions, our clients may forego the use of our solutions in favor of those of our competitors.

Future acquisitions could disrupt our business and harm our financial condition and operating results.

Our success will depend, in part, on our ability to expand our offerings and markets and grow our business in response to changing technologies, client demands and competitive pressures. In some circumstances, such as our acquisition of SMB:LIVE, we may determine to do so through the acquisition of complementary businesses, solutions or technologies rather than through internal development. The identification of suitable acquisition candidates can be difficult, time-consuming and costly, and we may not be able to successfully complete identified acquisitions. Furthermore, even if we successfully complete an acquisition, we may not be able to successfully assimilate and integrate the business, technologies, solutions, personnel or operations of the company that we acquired, particularly if key personnel of an acquired company decide not to work for us. In addition, we may borrow to complete an acquisition, which would increase our costs, or issue equity securities, which would dilute our stockholders’ ownership and could adversely affect the price of our common stock. We have grown organically, rather than through acquisitions. As a result, we have little experience in identifying and executing acquisition opportunities. Acquisitions may also involve the entry into geographic or business markets in which we have little or no prior experience. Consequently, we may not achieve anticipated benefits of the acquisitions which could harm our operating results.

We may require additional capital to respond to business opportunities, challenges, acquisitions or unforeseen circumstances. If capital is not available to us, our business, operating results and financial condition may be harmed.

We may require additional capital to operate or expand our business. In addition, some of the product development initiatives we have in the early stages of development, such as digital presence, reputation

 

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management and customer retention, may require substantial additional capital resources before they begin to generate revenue. Additional funds may not be available when we need them, on terms that are acceptable to us, or at all. Any debt financing secured by us in the future could involve restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. If we do not have funds available to enhance our solutions, maintain the competitiveness of our technology or pursue business opportunities, we may not be able to service our existing clients or acquire new clients, which could have an adverse effect on our business, operating results and financial condition.

Our business is subject to the risks of earthquakes, fires, floods and other natural catastrophic events and to interruption by man-made problems such as computer viruses or terrorism.

Our systems and operations are vulnerable to damage or interruption from earthquakes, fires, floods, power losses, telecommunications failures, terrorist attacks, acts of war, human errors, break-ins and similar events. For example, a significant natural disaster, such as an earthquake, fire or flood, could have a material adverse impact on our business, operating results and financial condition, and our insurance coverage will likely be insufficient to compensate us for losses that may occur. Our servers may also be vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering with our computer systems, which could lead to interruptions, delays, loss of critical data or the unauthorized disclosure of confidential intellectual property or client data. We may not have sufficient protection or recovery plans in certain circumstances, such as natural disasters affecting the Los Angeles area, and our business interruption insurance may be insufficient to compensate us for losses that may occur. As we rely heavily on our servers, computer and communications systems and the Internet to conduct our business and provide high quality customer service, such disruptions could negatively impact our ability to run our business, which could have an adverse affect on our operating results and financial condition.

If our security measures are breached and unauthorized access is obtained to a client’s data, our service may be perceived as not being secure and clients may curtail or stop using our service.

Our service involves the storage and transmission of clients’ proprietary information, such as credit card and bank account numbers, and security breaches could expose us to a risk of loss of this information, litigation and possible liability. Our payment services may be susceptible to credit card and other payment fraud schemes, including unauthorized use of credit cards, debit cards or bank account information, identity theft or merchant fraud.

For example, in April 2010 we experienced a security breach of our Australian platform, which resulted in disruption of advertising campaigns. The breach also required bringing the Australian platform offline for approximately thirty-six hours, which resulted in limitations on customer reporting and delayed implementation of a few new campaigns. While the disruption did not result in any compromise of customer credit card or our internal human resources information, we cannot assure that future breaches will not occur nor that any such breaches will not compromise commercially sensitive data.

If our security measures are breached in the future as a result of third-party action, employee error, malfeasance or otherwise, and as a result, someone obtains unauthorized access to our clients’ data, our reputation will be damaged, our business may suffer and we could incur significant liability. Because techniques used to obtain unauthorized access or to sabotage systems change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. If an actual or perceived breach of our security occurs, the market perception of the effectiveness of our security measures could be harmed and we could lose sales and clients.

We are subject to a number of risks related to credit card payments we accept. If we fail to be in compliance with applicable credit card rules and regulations, we may incur additional fees, fines and ultimately the revocation of the right to use the credit card company, which would have a material adverse effect on our business, financial condition or results of operations.

In 2009, approximately 64% of our clients’ campaigns were paid for using a credit card or debit card. For credit and debit card payments, we pay interchange and other fees, which may increase over time and raise our

 

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operating expenses and adversely affect our net income. We are also subject to payment card association operating rules, certification requirements and rules governing electronic funds transfers, which could change or be reinterpreted to make it difficult or impossible for us to comply. We believe we are compliant with the Payment Card Industry Data Security Standard, which incorporates Visa’s Cardholder Information Security Program and MasterCard’s Site Data Protection standard. However, there is no guarantee that we will maintain such compliance or that compliance will prevent illegal or improper use of our payment system. If we fail to comply with these rules or requirements, we may be subject to fines and higher transaction fees and lose our ability to accept credit and debit card payments from our clients. A failure to adequately control fraudulent credit card transactions would result in significantly higher credit card-related costs and could have a material adverse effect on our business, financial condition or results of operations.

Our revenue may be negatively affected if we are required to charge sales tax or other transaction taxes on all or a portion of our past and future sales to customers located in jurisdictions where we are currently not collecting and reporting tax.

We generally do not charge, collect or have imposed upon us sales or other transaction taxes related to the products and services we sell, except for certain corporate level taxes and transaction level taxes outside of the United States. However, many states, local jurisdictions or one or more countries may seek to impose sales or other transaction tax obligations on us in the future. A successful assertion by any state, local jurisdiction or country in which we do business that we should be collecting sales or other transaction taxes on the sale of our products or services could result in substantial tax liabilities related to past sales, create increased administrative burdens or costs, discourage clients from purchasing products or services from us, decrease our ability to compete or otherwise substantially harm our business and results of operations. The imposition of new laws requiring the collection of sales or other transaction taxes on the sale of our products or services could create increased administrative burdens or costs, discourage clients from purchasing products or services from us, decrease our ability to compete or otherwise substantially harm our business and results of operations.

Failure to adequately protect our intellectual property could substantially harm our business and operating results.

Because our business is heavily dependent on our intellectual property, including our proprietary technology, the protection of our intellectual property rights is crucial to the success of our business. We rely on a combination of intellectual property rights, including trade secrets, patent applications, copyrights and trademarks, as well as contractual restrictions, to safeguard our intellectual property. These afford only limited protection. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our online marketing and reporting solutions, technology, software and functionality or obtain and use information that we consider proprietary. Moreover, policing our proprietary rights is difficult and may not always be effective. In particular, because we sell our solutions internationally, we may need to enforce our rights under the laws of countries that do not protect proprietary rights to as great an extent as do the laws of the United States.

Our proprietary technology is not currently protected by any issued patents, and policing our rights to such technology may be hindered if we are unable to obtain any patents. In addition, the type and extent of patent claims that may be issued to us in the future is uncertain, and any patents that are issued may not contain claims that permit us to stop competitors from using similar technology. In light of the costs of obtaining patent protection, at times we may choose not to protect certain innovations that later on prove to be highly important. To the extent that the various technologies underlying any patent applications are determined to be business methods, the law around these types of patents is rapidly developing, and pending changes may impact our ability to protect our technology and proprietary use thereof through patents.

We have registered ReachLocal and other trademarks as trademarks in the United States and in certain other countries. Some of our trade names are not eligible to receive trademark protection. Also, trademark protection may not be available, or sought by us, in every country in which our technology and products are available online. Competitors may adopt service names similar to ours, or purchase our trademarks and confusingly similar

 

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terms as keywords in Internet search engine advertising programs, thereby impeding our ability to build brand identity and possibly leading to client confusion. In addition, there could be potential trade name or trademark infringement claims brought by owners of other registered trademarks or trademarks that incorporate variations of the term ReachLocal or our other trademarks.

Litigation or proceedings before the U.S. Patent and Trademark Office or other governmental authorities and administrative bodies in the United States and abroad may be necessary in the future to enforce our intellectual property rights, to protect our patent rights, trade secrets and domain names and to determine the validity and scope of the proprietary rights of others. Our efforts to enforce or protect our proprietary rights may be ineffective and could result in substantial costs and diversion of resources and could substantially harm our operating results.

Confidentiality agreements with employees and others may not adequately prevent disclosure of trade secrets and other proprietary information.

In order to protect our proprietary technology and processes, we rely in part on confidentiality agreements with our employees, licensees, independent contractors and other advisors. These agreements may not effectively prevent disclosure of confidential information and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. In addition, others may independently discover trade secrets and proprietary information, and in such cases we could not assert any trade secret rights against such parties. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position.

Assertions by third parties of infringement by us of their intellectual property rights could result in significant costs and substantially harm our business and operating results.

Companies in the Internet, technology and media industries own large numbers of patents, copyrights, trademarks and trade secrets and frequently litigate or threaten litigation based on allegations of infringement or other violations of intellectual property rights. Other parties have asserted, and may in the future assert, that we have infringed their intellectual property rights. Such litigation may involve patent holding companies or other adverse patent owners who have no relevant product revenue, and therefore our own issued and pending patents may provide little or no deterrence. In addition, we have been and could in the future become involved in disputes over the use of keywords by our clients, to the extent such clients’ competitors allege the use of such keywords on our RL platform violates such competitors’ trademark rights. We cannot predict whether assertions of third-party intellectual property rights or claims arising from such assertions will substantially harm our business and operating results. If we are forced to defend against any infringement claims, whether they are with or without merit or are determined in our favor, we may face costly litigation and diversion of technical and management personnel. Furthermore, an adverse outcome of a dispute may require us to pay damages, potentially including treble damages and attorneys’ fees, if we are found to have willfully infringed a party’s patent or copyright rights; cease making, licensing or using solutions that are alleged to incorporate the intellectual property of others; expend additional development resources to redesign our solutions; and enter into potentially unfavorable royalty or license agreements in order to obtain the right to use necessary technologies. Royalty or licensing agreements, if required, may be unavailable on terms acceptable to us, or at all. Over time, we expect that we will increasingly be subject to infringement claims as the number of competitors in our industry segment grows or as our presence and visibility within the industry increases.

We could lose clients if we or our media partners fail to detect click-through or other fraud on advertisements in a manner that is acceptable to our clients.

We are exposed to the risk of fraudulent clicks or actions on our third-party publishers’ websites. We may lose clients, or in the future we may have to refund revenue that our clients have paid to us and that was later attributed to, or suspected to be caused by, click-through fraud. Click-through fraud occurs when an individual clicks on an ad displayed on a website or an automated system is used to create such clicks with little to no intent

 

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of viewing the underlying content. If fraudulent clicks are not detected, the affected clients may become dissatisfied with our campaigns, which in turn may lead to loss of clients and the related revenue.

If the technology that we currently use to target the delivery of online advertisements is restricted or becomes subject to regulation, our expenses could increase and we could lose clients.

Websites typically place small files of non-personalized information, commonly known as cookies, on an Internet user’s hard drive. For example, our remarketing product uses cookies for its remarketing capabilities, which involves showing a consumer an ad for the website of an advertiser that the consumer has previously visited. Most currently available Internet browsers allow Internet users to modify their browser settings to prevent cookies from being stored on their hard drive, and some users currently do so. Internet users can also delete cookies from their hard drives at any time. Some Internet commentators and privacy advocates have suggested limiting or eliminating the use of cookies, and legislation has been introduced in some jurisdictions to regulate the use of cookie technology. In Europe, we and our clients are bound by a number of obligations in relation to the use of cookies. The restrictive nature of these obligations may increase significantly in the future, following recent amendments to the governing European Union directive, which may require users to provide consent to the use of cookies. If any new regulations and directives require us to alter the ways in which we use cookies, our ability to provide our products and services to our clients would be impaired.

Some of our services may utilize “open source” software, and any failure to comply with the terms of one or more of these open source licenses could negatively affect our business.

Some of our services may utilize software licensed by its authors or other third parties under so-called “open source” licenses, including, but not limited to, the GNU General Public License and the GNU Lesser General Public License. Some of those licenses may require that we make available source code for modifications or derivative works we create using the open source software, that we provide notices with our products and that we license any modifications or derivative works under an open source license or rights of further use to third parties. If we combine our proprietary software with open source software, we could be required to release the source code of our proprietary software. Although we take steps to ensure that our software engineers properly isolate our proprietary software they design from open source software components, we may not control the product development efforts of our engineers and we cannot be certain that they have not inappropriately incorporated open source software into our proprietary technologies. If an author or other third party that distributes open source software were to obtain a judgment against us based on allegations that we had not complied with the terms of any applicable open source license, we could be subject to liability for copyright infringement damages and breach of contract. In addition, we could be enjoined from selling our services that contained the open source software and required to make the source code for the open source software available, to grant third parties certain rights of further use of our software or to remove the open source software from our services, which could disrupt our distribution and sale of some of our services.

We could be subject to legal claims, government enforcement actions and damage to our reputation and held liable for our or our clients’ failure to comply with federal, state and foreign laws, regulations or policies governing consumer privacy, which could materially harm our business.

Recent growing public concern regarding privacy and the collection, distribution and use of information about Internet users has led to increased federal, state and foreign scrutiny and legislative and regulatory activity concerning data collection and use practices. The United States Congress currently has pending legislation regarding privacy and data security measures. The European Union’s directives addressing data privacy and electronic communications limit both our ability to use electronic communications in relation to Internet users, and our ability to collect and use information regarding these Internet users. These restrictions in relation to targeted advertising may become significantly more onerous in the future following the introduction of an amendment to the Privacy and Electronic Communications Directive, which may require a material change in our and our clients’ use of certain common technologies (including cookies) used to track and target Internet advertising. Our Australia operations currently are subject to privacy and data security measures under privacy laws. These may be amended in 2011 to provide for greater powers to the regulator and more extensive penalties

 

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for breaches. Our failure to comply with these or other federal, state or foreign laws could result in liability and materially harm our business.

In addition to government activity, privacy advocacy groups and the technology and direct marketing industries are considering various new, additional or different self-regulatory standards. This focus, and any legislation, regulations or standards promulgated, may impact us adversely. Governments, trade associations and industry self-regulatory groups may enact more burdensome laws, regulations and guidelines, including consumer privacy laws, affecting our clients and us (such as the proposed amendments to the European Union’s directives mentioned above). Since many of the proposed laws or regulations are just being developed, and a consensus on privacy and data usage has not been reached, we cannot yet determine the impact these proposed laws or regulations may have on our business. However, if the gathering of profiling information were to be curtailed, Internet advertising would be less effective, which would reduce demand for Internet advertising and harm our business.

Our clients are also subject to various federal, state and foreign laws concerning the collection and use of information regarding individuals, including the Children’s Online Privacy Protection Act, the Federal Drivers Privacy Protection Act of 1994, the privacy provisions of the Gramm-Leach-Bliley Act, the Federal CAN-SPAM Act of 2003, the Data Protection Directive and the Privacy and Electronic Communications Directive in Europe and the Privacy Act 1988 in Australia. The European Union’s directives are implemented differently in each European Union member state and our clients will therefore be subject to the local implementing laws in their relevant member state. We cannot assure you that our clients are currently in compliance, or will remain in compliance, with these laws and their own privacy policies. We may be held liable if our clients use our online marketing and reporting solutions in a manner that is not in compliance with these laws or their own stated privacy policies.

Government regulation of the Internet is evolving, and unfavorable changes could substantially harm our business and operating results.

We are subject to general business regulations and laws as well as regulations and laws specifically governing the Internet. Existing and future laws and regulations may impede the growth of the Internet or other online services. These regulations and laws may cover taxation, tariffs, user privacy, data protection, pricing, content, copyrights, distribution, electronic contracts and other communications, consumer protection, broadband residential Internet access and the characteristics and quality of services. It is not clear how existing laws governing issues such as property ownership, sales and other taxes, libel and personal privacy apply to the Internet. Unfavorable resolution of these issues may substantially harm our business and operating results.

In addition, the Federal Trade Commission, or the FTC, has recently issued its report on Self-Regulatory Principles for Online Behavioral Advertising which promotes principles designed to encourage meaningful self-regulation with regard to online behavioral advertising within the industry. As evidenced by such report, the FTC maintains its support of self-regulation within the industry, however its message strongly encourages that industry participants come up with more meaningful and rigorous self-regulation or invite legislation by states, Congress or a more regulatory approach by the FTC. Such legislation or increased regulatory approach by the FTC may adversely affect our ability to grow our remarketing and ReachDisplay products. Other laws and regulations have been adopted and may be adopted in the future, and may address issues such as user privacy, spyware, “do not email” lists, pricing, intellectual property ownership and infringement, copyright, trademark, trade secret, export of encryption technology, click-fraud, acceptable content, search terms, lead generation, behavioral targeting, taxation and quality of products and services. This legislation could hinder growth in the use of the Internet generally and adversely affect our business. Moreover, it could decrease the acceptance of the Internet as a communications, commercial and advertising medium.

 

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Risks Related to Owning Our Common Stock

An active, liquid and orderly market for our common stock may not develop or be sustained, and the trading price of our common stock is likely to be volatile.

Prior to this offering, there has been no public market for shares of our common stock. An active trading market for our common stock may not develop or be sustained, which could depress the market price of our common stock and could affect your ability to sell your shares. The initial public offering price will be determined through negotiations between us and the representatives of the underwriters and may bear no relationship to the price at which our common stock will trade following the completion of this offering. The trading price of our common stock following this offering is likely to be highly volatile and could be subject to wide fluctuations in response to various factors, some of which are beyond our control. In addition to the factors discussed in this “Risk Factors” section and elsewhere in this prospectus, these factors include:

 

   

our operating performance and the operating performance of similar companies;

 

   

the overall performance of the equity markets;

 

   

the number of shares of our common stock publicly owned and available for trading;

 

   

threatened or actual litigation;

 

   

changes in laws or regulations relating to our solutions;

 

   

any major change in our board of directors or management;

 

   

publication of research reports about us or our industry or changes in recommendations or withdrawal of research coverage by securities analysts;

 

   

large volumes of sales of our shares of common stock by existing stockholders; and

 

   

general political and economic conditions.

In addition, the stock market in general, and the market for Internet-related companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These fluctuations may be even more pronounced in the trading market for our stock shortly following this offering. Securities class action litigation has often been instituted against companies following periods of volatility in the overall market and in the market price of a company’s securities. This litigation, if instituted against us, could result in very substantial costs, divert our management’s attention and resources and harm our business, operating results and financial condition. In addition, the recent distress in the financial markets has also resulted in extreme volatility in security prices.

Sales of substantial amounts of our common stock in the public markets, or the perception that they might occur, could reduce the price that our common stock might otherwise attain and may dilute your voting power and your ownership interest in us.

After the completion of the offering, we will have 27,138,285 outstanding shares of common stock (27,763,285 shares of common stock if the underwriters exercise in full their option to purchase additional shares). This number is comprised of all the shares of our common stock that we are selling in this offering, which may be resold immediately in the public market. Subject to certain exceptions described under the caption “Underwriters,” we and all of our directors and officers and certain of our stockholders, warrant and option holders have agreed not to offer, sell or agree to sell, directly or indirectly, any shares of common stock without the permission of the underwriters for a period of 180 days from the date of this prospectus. When this period expires, we and our locked-up security holders will be able to sell our shares in the public market. Sales of a substantial number of such shares upon expiration, or early release, of the lock-up (or the perception that such sales may occur) could cause our share price to fall.

Sales of substantial amounts of our common stock in the public market following our initial public offering, or the perception that such sales could occur, could adversely affect the market price of our common stock and may make it more difficult for you to sell your common stock at a time and price that you deem appropriate.

 

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We also may issue our shares of common stock from time to time as consideration for future acquisitions and investments. If any such acquisition or investment is significant, the number of shares that we may issue may in turn be significant. In addition, we may also grant registration rights covering those shares in connection with any such acquisitions and investments.

Investors purchasing common stock in this offering will experience immediate and substantial dilution.

The assumed initial public offering price of our common stock is substantially higher than the net tangible book value per outstanding share of our common stock immediately after this offering. As a result, you will pay a price per share that substantially exceeds the book value of our tangible assets after subtracting our liabilities. Purchasers of our common stock in this offering will incur immediate and substantial dilution of $16.05 per share in the net tangible book value of our common stock from the assumed initial public offering price of $18.00 per share, which is the mid-point of the estimated range set forth on the cover of this prospectus. The exercise of outstanding options to purchase our common stock may result in further dilution.

As a result of becoming a public company, we will be obligated to develop and maintain proper and effective internal controls over financial reporting and will be subject to other requirements that will be burdensome and costly. We may not complete our analysis of our internal controls over financial reporting in a timely manner, or these internal controls may not be determined to be effective, which may adversely affect investor confidence in our company and, as a result, the value of our common stock.

We will be required, pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404), to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting for the first fiscal year beginning after the effective date of this offering. This assessment will need to include disclosure of any material weaknesses identified by our management in our internal control over financial reporting, as well as a statement that our auditors have issued an attestation report on our management’s assessment of our internal controls.

We are just beginning the costly and challenging process of compiling the system and processing documentation before we perform the evaluation needed to comply with Section 404. We may not be able to complete our evaluation, testing and any required remediation in a timely fashion. During the evaluation and testing process, if we identify one or more material weaknesses in our internal control over financial reporting, we will be unable to assert that our internal control is effective. If we are unable to assert that our internal control over financial reporting is effective, or if our auditors are unable to attest that our management’s report is fairly stated or they are unable to express an opinion on the effectiveness of our internal control, we could lose investor confidence in the accuracy and completeness of our financial reports, which would have a material adverse effect on the price of our common stock. Failure to comply with the new rules might make it more difficult for us to obtain certain types of insurance, including director and officer liability insurance, and we might be forced to accept reduced policy limits and coverage and/or incur substantially higher costs to obtain the same or similar coverage. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, on committees of our board of directors, or as executive officers.

If securities or industry analysts do not publish research or publish inaccurate or unfavorable research about our business, our stock price and trading volume could decline.

The trading market for our common stock will depend in part on the research and reports that securities or industry analysts publish about us or our business. Securities and industry analysts do not currently, and may never, publish research on our company. If no securities or industry analysts commence coverage of our company, the trading price for our stock would likely be negatively impacted. In the event securities or industry analysts initiate coverage, if one or more of the analysts who cover us downgrade our stock or publish inaccurate or unfavorable research about our business, our stock price would likely decline. If one or more of these analysts cease coverage of our company or fail to publish reports on us regularly, demand for our stock could decrease, which might cause our stock price and trading volume to decline.

 

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Our management will have broad discretion over the use of the proceeds we receive in this offering and might not apply the proceeds in ways that increase the value of your investment.

Our management will generally have broad discretion to use the net proceeds to us from this offering, and you will be relying on the judgment of our management regarding the application of these proceeds. Our management might not apply the net proceeds from this offering in ways that increase the value of your investment. We expect that we will use the net proceeds of this offering to fund development of our products and services and for general corporate purposes, including working capital, selling and marketing activities, general and administrative matters and capital expenditures. We will also use the net proceeds of this offering to fulfill a deferred payment obligation of $6.1 million in connection with our acquisition in September 2009 of the approximately 53% of our Australian operations that we did not already own, and may use up to $1.0 million to fulfill a deferred cash payment obligation in connection with our acquisition of SMB:LIVE, which is payable in three installments through February 2012. We may also use a portion of the net proceeds for the acquisition of businesses, solutions and technologies that we believe are complementary to our own. We have not otherwise allocated the net proceeds from this offering for any specific purposes. Until we use the net proceeds to us from this offering, we plan to invest them, and these investments may not yield a favorable rate of return. If we do not invest or apply the net proceeds from this offering in ways that enhance stockholder value, we may fail to achieve expected financial results, which could cause our stock price to decline.

Investment funds managed by VantagePoint Venture Partners will own a substantial amount of our stock after this offering, and will have significant influence over our business.

After this offering, we anticipate that investment funds managed by VantagePoint Venture Partners, one of our early venture capital investors, will beneficially own approximately 46.39% of our outstanding common stock, assuming no exercise of the underwriters’ option to purchase additional shares of our common stock in this offering from us. As a result, VantagePoint will have significant influence over the outcome of matters submitted to our stockholders for approval, including the election of directors. VantagePoint’s significant ownership also could affect the market price of our common stock by, for example, delaying, deferring or preventing a change in corporate control, impeding a merger, consolidation, takeover or other business combination involving us, or discouraging a potential acquiror from making a tender offer or otherwise attempting to obtain control of us. In addition, prior to the consummation of this offering, the investment funds managed by VantagePoint had the right to appoint two members of our board of directors. After the consummation of this offering, Alan Salzman and Jason Whitt, both of whom are affiliated with VantagePoint, will be members of our board of directors, with Mr. Salzman acting as Chairman of our board of directors. If Messrs. Salzman and Whitt cast votes in a similar manner, those two votes could substantially influence the decisions of our board of directors.

Certain provisions in our charter documents and Delaware law could discourage takeover attempts and lead to management entrenchment.

Our certificate of incorporation and bylaws contain provisions that could have the effect of delaying or preventing changes in control or changes in our management without the consent of our board of directors, including, among other things:

 

   

a classified board of directors with three-year staggered terms, which may delay the ability of stockholders to change the membership of a majority of our board of directors;

 

   

no cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates;

 

   

the ability of our board of directors to determine to issue shares of preferred stock and to determine the price and other terms of those shares, including preferences and voting rights, without stockholder approval, which could be used to significantly dilute the ownership of a hostile acquirer;

 

   

the exclusive right of our board of directors to elect a director to fill a vacancy created by the expansion of our board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors;

 

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a prohibition on stockholder action by written consent, which forces stockholder action to be taken at an annual or special meeting of our stockholders;

 

   

the requirement that a special meeting of stockholders may be called only by the chairman of our board of directors, the Chief Executive Officer, the president (in absence of a Chief Executive Officer) or our board of directors, which may delay the ability of our stockholders to force consideration of a proposal or to take action, including the removal of directors;

 

   

the requirement for the affirmative vote of holders of at least 66 2/3% of the voting power of all of the then outstanding shares of the voting stock, voting together as a single class, to amend the provisions of our certificate of incorporation relating to the issuance of preferred stock and management of our business or our bylaws, which may inhibit the ability of an acquiror from amending our certificate of incorporation or bylaws to facilitate a hostile acquisition;

 

   

the ability of our board of directors, by majority vote, to amend the bylaws, which may allow our board of directors to take additional actions to prevent a hostile acquisition and inhibit the ability of an acquiror from amending the bylaws to facilitate a hostile acquisition; and

 

   

advance notice procedures that stockholders must comply with in order to nominate candidates to our board of directors or to propose matters to be acted upon at a stockholders’ meeting, which may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquiror’s own slate of directors or otherwise attempting to obtain control of us.

We are also subject to certain anti-takeover provisions under Delaware law. Under Delaware law, a corporation may not, in general, engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other things, our board of directors has approved the transaction.

 

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FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements about us and our industry that involve substantial risks and uncertainties. All statements, other than statements of historical facts, included in this prospectus regarding our strategy, future operations, future financial position, future net sales, projected expenses, prospects and plans and objectives of management are forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievement to be materially different from those expressed or implied by the forward-looking statements.

In some cases, you can identify forward-looking statements by terms such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “project,” “will,” “would,” “should,” “could,” “can,” “predict,” “potential,” “continue,” “objective” or the negative of these terms, and similar expressions intended to identify forward-looking statements. However, not all forward-looking statements contain these identifying words. These forward-looking statements reflect our current views about future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Actual events or results could differ materially from those expressed or implied by these forward-looking statements as a result of various factors, including:

 

   

our ability to evaluate our current and future prospects;

 

   

our ability to grow revenue to offset increased expenses;

 

   

our ability to purchase media from Google, Yahoo! and Microsoft;

 

   

our ability to recruit, train and retain our Internet Marketing Consultants;

 

   

competition and competitive factors;

 

   

the impact of worldwide economic conditions, including the resulting effect on advertising budgets;

 

   

our ability to predict our future operating results;

 

   

our ability to expand our operations internationally;

 

   

our ability to keep pace with changes in technology;

 

   

our ability to comply with applicable credit card rules and regulations;

 

   

our ability to protect our intellectual property;

 

   

our ability to comply with government regulation affecting our business, including regulations or policies governing consumer privacy; and

 

   

other risk factors included under “Risk Factors” in this prospectus.

Some of the industry and market data contained in this prospectus are based on independent industry publications or other publicly available information, while other information is based on our internal sources. Although we believe that each source is reliable as of its respective date, the information contained in such sources has not been independently verified, and neither the underwriters nor we can assure you as to the accuracy or completeness of this information. You should read this prospectus and the documents that we reference in this prospectus and have filed as exhibits to the registration statement, of which this prospectus is a part, completely and with the understanding that our actual future results may be materially different from what we expect. We qualify all of our forward-looking statements by these cautionary statements.

 

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USE OF PROCEEDS

We estimate that the net proceeds to us from the sale of the shares of common stock offered by us will be approximately $43.9 million, or approximately $54.4 million if the underwriters’ over-allotment option is exercised in full, based on an assumed initial public offering price of $18.00 per share, the mid-point of the estimated price range set forth on the cover page of this prospectus, and after deducting underwriting discounts and commissions and estimated offering expenses payable by us. We will not receive any of the proceeds from the sale of shares by the selling stockholders.

A $1.00 increase (decrease) in the assumed initial public offering price of $18.00 per share would increase (decrease) the net proceeds to us from this offering by approximately $3.1 million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same.

We anticipate that we will use the net proceeds of this offering to fund working capital and for general corporate purposes. We will also use the net proceeds of this offering to fulfill our deferred payment obligation of $6.1 million in connection with our acquisition of the approximately 53% of our Australian operations that we did not already own in September 2009. We may also use a portion of the net proceeds to acquire, invest in, or obtain rights to, complementary technologies, products, services or businesses. Our management will have broad discretion over the use of the net proceeds in this offering. Pending these uses, we intend to invest the net proceeds of this offering in short-term, investment-grade interest-bearing securities or guaranteed obligations of the U.S. government.

By establishing a public market for our common stock, this offering is also intended to facilitate our future access to public markets.

DIVIDEND POLICY

We have never declared or paid dividends on our capital stock and currently do not anticipate paying any cash dividends after the offering and for the foreseeable future. Instead, we anticipate that all of our earnings on our common stock will be used to provide working capital, to support our operations and to finance the growth and development of our business. Any future determination relating to dividend policy will be made at the discretion of our board of directors and will depend on our future earnings, capital requirements, financial condition, future prospects, applicable Delaware law, which provides that dividends are only payable out of surplus or current net profits, and other factors our board of directors deems relevant.

 

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CAPITALIZATION

The following table shows a summary of our cash, cash equivalents and short-term investments and our capitalization as of March 31, 2010:

 

   

on an actual basis; and

 

   

on a pro forma, as adjusted basis, giving effect to (i) the automatic conversion of all outstanding preferred stock into an aggregate of 16,712,120 shares of common stock upon completion of this offering and (ii) our receipt of the net proceeds from the sale by us in this offering of 3,316,103 shares of common stock at an assumed public offering price of $18.00 per share, the mid-point of the estimated price range shown on the cover page of this prospectus, after deducting estimated underwriting discounts and commissions, estimated offering expenses payable by us and payment of our deferred purchase price obligation in connection with the ReachLocal Australia acquisition.

You should read the following table in conjunction with “Use of Proceeds,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Description of Capital Stock,” and our audited consolidated financial statements and related notes appearing elsewhere in this prospectus.

 

     March 31, 2010  
     Actual     Pro Forma
as Adjusted (1)
 
(in thousands)             

Cash, cash equivalents and short-term investments

   $ 40,838      $ 86,662   
                

Stockholders’ equity:

    

Convertible preferred stock

     4           

Common stock

     1        1   

Receivable from stockholder

     (102     (102

Additional paid-in capital

     48,677        98,714   

Accumulated deficit

     (7,151     (7,272

Accumulated other comprehensive loss

     (116     (116
                

Total stockholders’ equity

   $ 41,313      $ 91,225   
                

Total capitalization

   $ 41,313      $ 91,225   
                

 

(1) A $1.00 increase (decrease) in the assumed initial public offering price of $18.00 per share of our common stock in this offering would increase (decrease) each of cash, cash equivalents and short-term investments, additional paid-in capital, total stockholders’ equity and total capitalization by $3.1 million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same, and after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

The share information in the table above excludes, as of March 31, 2010:

 

   

5,173,693 shares of common stock issuable upon the exercise of outstanding options to purchase our common stock at a weighted average exercise price of $8.27 per share;

 

   

76,137 shares of common stock issuable upon the exercise of a warrant with an exercise price of approximately $9.23 per share;

 

   

15,000 shares of common stock issuable upon the exercise of a warrant with an exercise price of approximately $10.91 per share; and

 

   

2,285,634 shares of common stock reserved for future issuance under our stock-based compensation plans, including 185,634 shares reserved for issuance under our existing stock option plan and an additional 2,100,000 shares of common stock reserved for future issuance under our amended and restated stock plan, which was approved by our stockholders on April 23, 2010 in connection with this offering, of which approximately 1,400,000 shares are expected to be granted in the form of stock options and restricted stock units to our employees, including options to purchase 480,000 shares to be granted to our named executive officers (in the respective amounts set forth on page 97 of this prospectus), immediately following the pricing of this offering at an exercise price equal to the initial public offering price.

 

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DILUTION

If you invest in our common stock, your interest will be diluted to the extent of the difference between the public offering price per share of our common stock and the pro forma as adjusted net tangible book value per share of our common stock immediately after the offering. After giving effect to the automatic conversion of our preferred stock in connection with this offering, our pro forma historical net tangible book value of our common stock as of March 31, 2010 was $3.1 million, or $0.13 per share. Historical net tangible book value per share represents the amount of our total tangible assets reduced by the amount of our total liabilities and divided by the number of shares of our outstanding common stock.

After giving effect to the sale of 4,166,667 shares of common stock in this offering at an initial public offering price of $18.00 per share, after deducting underwriting discounts and commissions and estimated offering expenses payable by us and the payment of our deferred purchase price obligation in connection with the ReachLocal Australia acquisition, our pro forma as adjusted net tangible book value as of March 31, 2010 would have been $53.0 million, or $1.95 per share. This represents an immediate increase in pro forma as adjusted net tangible book value of $1.82 per share to existing stockholders and an immediate dilution of $16.05 per share to new investors purchasing shares in the offering.

The following table illustrates this dilution on a per share basis to new investors:

 

Assumed initial public offering price

      $ 18.00

Pro forma net tangible book value per share as of March 31, 2010

   $ 0.13   

Increase per share attributable to this offering from new investors

     1.82   
         

Pro forma net tangible book value, as adjusted to give effect to this offering

        1.95
         

Dilution per share to new investors in this offering

      $ 16.05
         

Our pro forma as adjusted net tangible book value after the offering, and the dilution to new investors in the offering, will change from the amounts shown above if the underwriters’ over-allotment option is exercised.

A $1.00 increase (decrease) in the assumed initial public offering price of $18.00 per share would increase (decrease) our pro forma as adjusted net tangible book value by $0.11 per share, and increase (decrease) the dilution to new investors by $0.89 per share, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.

The following table sets forth, as of March 31, 2010, on a pro forma as adjusted basis, the differences between existing stockholders and new investors with respect to the total number of shares of common stock purchased from us, the total consideration paid and the average price per share paid before deducting underwriting discounts and commissions and estimated offering expenses payable by us, at an assumed initial public offering price of $18.00 per share of common stock, which is the mid-point of the estimated price range set forth on the cover page of this prospectus:

 

     Total Shares     Total Consideration     Average
Price Per
Share
     Number    Percent     Amount    Percent    
     (in thousands, other than percentages)      

Existing stockholders (1)

   23,822    88   $ 70,987    54   $ 2.98

New stockholders in this offering

   3,316    12        59,690    46        18.00
                          

Total

   27,138    100   $ 130,677    100  
                          

 

(1) Disregards 1,666,418 shares of Series C preferred stock and 1,977,823 shares of common stock issued by us and subsequently repurchased. See “Certain Relationships and Related Party Transactions.”

 

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Sales by the selling stockholders in this offering will cause the number of shares held by existing stockholders to be reduced to 22,971,618 shares, or 84.6% of the total number of shares of our common stock outstanding after this offering. If the underwriters’ over-allotment option is exercised in full, the number of shares held by existing stockholders after this offering would be reduced to 82.7% of the total number of shares of our common stock outstanding after this offering.

The above discussion and tables are based on 23,822,182 shares of common stock issued and outstanding as of March 31, 2010, and exclude:

 

   

5,173,693 shares of common stock issuable upon the exercise of outstanding options to purchase our common stock at a weighted average exercise price of $8.27 per share;

 

   

76,137 shares of common stock issuable upon the exercise of an outstanding warrant at an exercise price of approximately $9.23 per share;

 

   

15,000 shares of common stock issuable upon the exercise of an outstanding warrant with an exercise price of approximately $10.91 per share; and

 

   

2,285,634 shares of common stock reserved for future issuance under our stock-based compensation plans, including 185,634 shares reserved for issuance under our existing stock option plan and an additional 2,100,000 shares of common stock reserved for future issuance under our amended and restated stock plan, which was approved by our stockholders on April 23, 2010 in connection with this offering, of which approximately 1,400,000 shares are expected to be granted in the form of stock options and restricted stock units to our employees, including options to purchase 480,000 shares to be granted to our named executive officers (in the respective amounts set forth on page 97 of this prospectus), immediately following the pricing of this offering at an exercise price equal to the initial public offering price.

To the extent that any outstanding options or warrants are exercised, new investors will experience further dilution.

 

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SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA

The following selected consolidated financial and other data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this prospectus. We derived the consolidated statements of operations data for the three years ended December 31, 2007, 2008 and 2009, as well as the consolidated balance sheet data as of December 31, 2008 and 2009 from our audited consolidated financial statements included elsewhere in this prospectus. We derived the consolidated statements of operations data for the years ended December 31, 2004 and 2005, as well as the consolidated balance sheet data as of December 31, 2005, 2006 and 2007 from our audited consolidated financial statements not included in this prospectus. We derived the unaudited consolidated statements of operations data for the three months ended March 31, 2009 and 2010 and consolidated balance sheet data as of March 31, 2010 from our unaudited interim consolidated financial statements included elsewhere in this prospectus. The unaudited interim consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and, in the opinion of our management, reflect all adjustments necessary for the fair presentation of the financial information set forth in those statements. Our historical results are not necessarily indicative of results to be expected in any future period.

 

    Year Ended December 31,     Three Months Ended
March 31, 2010
 
    2005     2006     2007     2008     2009     2009     2010  
                                  (Unaudited)  

Consolidated Statements of Operations:

  

         
(in thousands, except per share data)                                      

Revenue

  $ 4,426      $ 25,635      $ 68,356      $ 146,687      $ 203,117      $ 42,735      $ 63,626   

Cost of revenue (1)

           4,245               16,702           39,262        77,496        112,218        23,823        34,839   

Operating expenses:

             

Selling and marketing (1)

    1,892        8,062        24,435        61,054        76,175        17,080        23,940   

Product and technology (1)

    465        695        1,911        2,938        5,167        974        2,344   

General and administrative (1)

    952        1,475        5,804        12,128        15,534        3,057        5,385   
                                                       

Total operating expenses

    3,309        10,232        32,150        76,120        96,876        21,111        31,669   
                                                       

Loss from operations

    (3,128     (1,299     (3,056     (6,929     (5,977     (2,199     (2,882

Gain on acquisition of ReachLocal Australia

                                16,223                 

Equity in losses of ReachLocal Australia

                  (250     (813                     

Other income (expense), net

    6        181        669        889        (7     9        (10
                                                       

Income (loss) before provision for income taxes

    (3,122     (1,118     (2,637     (6,853     10,239        (2,190     (2,892

Provision (benefit) for income taxes

    1        9        11        145        217        67        (638
                                                       

Net income (loss)

  $ (3,123   $ (1,127   $ (2,648   $ (6,998   $ 10,022      $ (2,257   $ (2,254
                                                       

Pro forma net income per share (unaudited)(2):

             

Basic

          $ 0.44        $ (0.10
                         

Diluted

          $ 0.41        $ (0.10
                         

Pro forma weighted average shares outstanding used in calculating net income per share (unaudited)(2):

             

Basic

            22,995          23,680   

Diluted

            24,613          23,680   

 

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(1) Stock-based compensation, net of capitalization, and depreciation and amortization included in the above line items (in thousands):

 

    Year Ended December 31,   Three Months Ended
March 31,
    2005   2006   2007   2008   2009   2009   2010
                        (Unaudited)
Stock-based compensation:                            

Cost of revenue

  $ 8   $ 13   $ 18   $ 34   $ 86   $ 10   $ 91

Selling and marketing

    14     45     94     338     566     69     181

Product and technology

    28     27     16     73     164     17     264

General and administrative

    114     150     278     1,366     2,145     447     549
                                         
  $    164   $ 235   $ 406   $ 1,811   $ 2,961   $ 543   $ 1,085
                                         
    Year Ended December 31,   Three Months Ended
March 31,
    2005   2006   2007   2008   2009   2009   2010
                        (Unaudited)
Depreciation and amortization:            

Cost of revenue

  $ 20   $ 40   $ 83   $ 186   $ 261   $ 63   $ 72

Selling and marketing

        21     205     596     892     196     245

Product and technology

    242     397     603     916     1,765     355     670

General and administrative

    14     18     49     154     430     56     247
                                         
  $ 276   $ 476   $ 940   $ 1,852   $ 3,348   $ 670   $ 1,234
                                         

 

(2) See Note 2 to our consolidated financial statements for an explanation of the method used to calculate pro forma basic and diluted net income per share of common stock.

 

    December 31,     March 31,  
    2005   2006   2007   2008   2009     2010  
                      (Unaudited)  
Consolidated Balance Sheet Data:                            
(in thousands)                            

Cash and cash equivalents

  $ 3,337   $ 5,760   $ 8,409   $ 38,820   $ 35,379      $ 32,786   

Working capital

    2,831     5,832     22,913     15,256     (6,714     (13,712

Total assets

    5,004     11,032     38,881     51,124     97,887        101,531   

Total liabilities

    1,286     3,232     12,590     28,610     55,769        60,218   

Total stockholders’ equity

    3,718     7,801     26,291     22,514     42,118        41,313   
            Year Ended December 31,   Three Months
Ended March 31,
 
            2007     2008     2009   2009     2010  
              (Unaudited)   
Other Financial Data:                                    
(in thousands)                                    

Net cash provided by operating activities

  $ 7,421      $ 12,062      $ 14,308   $ 3,012      $ 2,529   

Capital Expenditures (unaudited) (3)

    2,479        5,152        5,805     892        1,777   

Non-GAAP Financial Measures (unaudited):

           

Adjusted EBITDA (4)

    (1,710     (3,266     1,393     (986     (228

Underclassmen Expense (5)

    10,043        27,886        26,824     6,892        7,806   

 

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      December 31,    March 31,
     2007    2008    2009    2009    2010

Other Operational Data:

              

Number of IMCs:

              

Upperclassmen

   16    80    235    108    227

Underclassmen

   152    337    280    277    342
                        

Total

   168    417    515    385    569
                        

Active Advertisers (6)

     7,400    11,600    14,700    12,400    15,700

Active Campaigns (7)

   8,900    13,500    18,600    14,900    19,700

 

(3) Represents purchases of property and equipment and the amount of software development costs capitalized, in aggregate, excluding stock-based compensation and the acquisition of ReachLocal Australia in September 2009 (see Note 4 to our consolidated financial statements).
(4) We include Adjusted EBITDA in this prospectus because (i) it is a key basis upon which our management assesses our operating performance; (ii) it may be a factor in the evaluation of the performance of our management in determining compensation; (iii) we use it, in conjunction with GAAP measures such as revenue and income (loss) from operations, for operational decision-making purposes; and (iv) we believe it is one of the primary metrics investors use in evaluating Internet marketing companies. We define Adjusted EBITDA as net income (loss) before interest, income taxes, depreciation and amortization expenses, excluding, when applicable, stock-based compensation, the effects of accounting for business combinations and amounts included in other non-operating income or expense.

 

     Our management believes that Adjusted EBITDA permits an assessment of our operating performance, in addition to our performance based on our GAAP results, that is useful in assessing the progress of the business. By excluding (i) the effects of accounting for business combinations and associated acquisition and integration costs, which obscure the measurable performance of the business operations; (ii) depreciation and amortization and other non-operating income and expense, each of which may vary from period to period without any correlation to underlying operating performance; and (iii) stock-based compensation, which is a non-cash expense, we believe that we are able to gain a fuller view of the operating performance of the business. We provide information relating to our Adjusted EBITDA so that investors have the same data that we employ in assessing our overall operations. We believe that trends in our Adjusted EBITDA are a valuable indicator of operating performance on a consolidated basis and of our ability to produce operating cash flow to fund working capital needs, capital expenditures and investments in Underclassmen.

 

     In addition, we believe Adjusted EBITDA and similar measures are widely used by investors, securities analysts, ratings agencies and other interested parties in our industry as a measure of financial performance and debt-service capabilities. Our use of Adjusted EBITDA has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:

 

   

Adjusted EBITDA does not reflect our cash expenditures for capital equipment or other contractual commitments;

 

   

Although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect capital expenditure requirements for such replacements;

 

   

Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs;

 

   

Adjusted EBITDA does not consider the potentially dilutive impact of issuing equity-based compensation to our management team and employees;

 

   

Adjusted EBITDA does not reflect the potentially significant interest expense or the cash requirements necessary to service interest or principal payments on indebtedness we may incur in the future;

 

   

Adjusted EBITDA does not reflect income and expense items that relate to our financing and investing activities, any of which could significantly affect our results of operations or be a significant use of cash;

 

   

Adjusted EBITDA does not reflect certain tax payments that may represent a reduction in cash available to us; and

 

   

Other companies, including companies in our industry, calculate Adjusted EBITDA measures differently, which reduces their usefulness as a comparative measure.

 

     Adjusted EBITDA is not intended to replace operating income (loss), net income (loss) and other measures of financial performance reported in accordance with GAAP. Rather, Adjusted EBITDA is a measure of operating performance that you may consider in addition to those measures. Because of these limitations, Adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results, including cash flows provided by operating activities, and using total Adjusted EBITDA as a supplemental financial measure.

 

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The following table presents a reconciliation of Adjusted EBITDA to our loss from operations for each of the periods indicated:

 

     Year Ended December 31,     Three Months Ended
March 31,
 
     2007     2008     2009     2009     2010  
(in thousands)                   

Loss from operations

   $ (3,056   $ (6,929   $ (5,977   $ (2,199   $ (2,882

Add:

          

Depreciation and amortization

     940        1,852        3,348        670        1,234   

Stock-based compensation, net

     406        1,811        2,961        543        1,085   

Acquisition and integration costs

                   389       

  
   
335
  

Amortization of step-down in deferred revenue on acquisition of ReachLocal Australia, net of tax

                   672       

  
   

  
                                        

Adjusted EBITDA

   $ (1,710   $ (3,266   $ 1,393      $ (986   $ (228
                                        

 

(5) Underclassmen Expense is a number we calculate to approximate our investment in Underclassmen and is comprised of the selling and marketing expenses we allocate to Underclassmen during a reporting period. The amount includes the direct salaries and allocated benefits of the Underclassmen (excluding commissions), training and sales organization expenses including depreciation allocated based on relative headcount and marketing expenses allocated based on relative revenue. While we believe that Underclassmen Expense provides useful information regarding our approximated investment in Underclassmen, the methodology we use to arrive at our estimated Underclassmen Expense was developed internally by the company, is not a concept or method recognized by GAAP and other companies may use different methodologies to calculate or approximate measures similar to Underclassmen Expense. Accordingly, our calculation of Underclassmen Expense may not be comparable to similar measures used by other companies.
(6) Active Advertisers is a number we calculate to approximate the number of clients directly served through our Direct Local channel as well as clients served through our National Brands, Agencies and Resellers channel. We calculate Active Advertisers by adjusting the number of Active Campaigns to combine clients with more than one Active Campaign as a single Active Advertiser. Clients with more than one location are generally reflected as multiple Active Advertisers. Because this number includes clients served through the National Brands, Agencies and Resellers channel, Active Advertisers includes entities with which we do not have a direct client relationship. Numbers are rounded to the nearest hundred.
(7) Active Campaigns is a number we calculate to approximate the number of individual products or services we are managing under contract for Active Advertisers. For example, if we were performing both ReachSearch and ReachDisplay campaigns for a client, we consider that two Active Campaigns. Similarly, if a client purchased ReachSearch campaigns for two different products or purposes, we consider that two Active Campaigns. Numbers are rounded to the nearest hundred.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion of our financial condition and results of operations in conjunction with the financial statements and the notes thereto included elsewhere in this prospectus. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this prospectus, particularly in the “Risk Factors.”

Overview

Our mission is to help small and medium-sized businesses, or SMBs, acquire, maintain and retain customers via the Internet. We offer a comprehensive suite of online marketing and reporting solutions, including search engine marketing, display advertising, remarketing and online marketing analytics, each targeted to the SMB market. We deliver these solutions to SMBs through a combination of our proprietary RL Platform and our direct, “feet-on-the-street” sales force of Internet Marketing Consultants, or IMCs, and select third-party agencies and resellers.

We use our RL Platform to create advertising campaigns for SMBs to target potential customers in their geographic area, optimize those campaigns in real time and track tangible results. Through a single Internet advertising budget, we enable our clients to reach local customers across all the major search engines and leading general interest and vertically focused online publishers. Based in or near the cities in which our clients operate, our IMCs establish a direct consultative relationship with our clients and, empowered by the RL Platform, work with the clients to achieve their marketing objectives.

We generate revenue by providing online advertising solutions for our clients through our search engine marketing product, ReachSearch, our display advertising product, ReachDisplay, our remarketing product and our campaign performance tracking product, TotalTrack. We sell our ReachSearch, ReachDisplay and remarketing products based on a package pricing model in which our clients commit to a fixed fee that includes the media; the optimization, reporting and tracking technologies of the RL Platform; and the personnel dedicated to support and manage their campaigns. While we do not commit to a specific set of results, we work with our clients to meet their marketing objectives. For our ReachSearch product, we believe clients evaluate performance based on the number and quality of leads (phone, email and other) received. For our ReachDisplay and remarketing products, we believe clients focus on the numbers of customers reached and the accuracy of targeting achieved through the campaign. Each of our products includes, through a single budget, access to multiple publishers, some of which are not directly available to SMBs, as well as access to our proprietary optimization and tracking technologies that dynamically adjust the publishers to which we allocate clients’ media spend in order to meet their performance objectives. For these reasons, while we rely on third-party publishers for the substantial majority of the media we purchase on behalf of our clients, we are not simply a reseller of media; rather, we market our products as a complete package of media optimized for the client.

Nearly all of our cost of revenue is for the purchase of media and nearly all of the media we purchase is from Google, Yahoo! and Microsoft. A substantial majority of the media we purchase is from Google. We generally purchase this media in an auction marketplace. We believe that our technology enables us to purchase this media efficiently and, as a result, allows us to fulfill our clients’ expected level of performance. However, an increase in the cost of media in these marketplaces without a corresponding increase in our media buying efficiency could result in an increase in our cost of revenue as a percentage of revenue even if our business expands. In addition, such an increase could result in an increase in the prices we must charge our clients or a decrease in our ability to fulfill our clients’ service expectations at the existing package price. While we enter into rebate and incentive programs with some publishers, these incentive programs are subject to change or cancellation with little notice, and, on occasion, these incentives have been cancelled, reduced or have required us to comply with rules that reduce the benefit of the incentives from what we previously received. For example, effective December 31, 2008, Google terminated a publisher rebate provided as part of its North American

 

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Authorized AdWords Reseller program, which was the primary reason that our cost of revenue as a percentage of revenue increased from 52.8% in 2008 to 55.2% in 2009. In addition, in March 2010, we learned that Google was contemplating requiring companies such as ours to disclose to its customers a range of information, which might effectively include our fees associated with the purchase of Google media. For further information, see “Risk Factors—We purchase most of our media from Google, and our business could be adversely affected if Google takes actions that are adverse to our interests.”

We first offered our products and services solely through third-party agencies and resellers that, in turn, offered them to their end advertiser clients. In 2007, we began to allocate resources to focus on sales to national or regional businesses with multiple locations, such as franchisors, which we refer to as national brands. Because the sale to agencies, resellers and national brands involves negotiations with businesses that generally represent an aggregated group of SMB advertisers, we group them together as our National Brands, Agencies and Resellers channel. In 2006, we made the strategic decision to invest in creating a direct local sales force and began selling our products and services through our IMCs. We refer to sales through our IMCs as our Direct Local channel. Sales in the Direct Local channel accounted for 70% of our revenue in 2009 and 74% of our revenue for the three months ended March 31, 2010. Our ongoing investment in increasing the number of our IMCs has been the principal engine for our growth, and it is our largest operating expense.

In December 2006, we entered our first market outside of North America through a joint venture in Australia. On September 11, 2009, we acquired the remaining interest in our Australian joint venture. In connection with the ReachLocal Australia acquisition, we recognized a non-cash gain of $16.2 million and will pay $6.1 million in deferred cash compensation upon the closing of this offering. We now own all our international operations and currently operate in Australia, the United Kingdom and Canada. At March 31, 2010, 97 of our 569 total IMCs were located outside of North America.

On February 22, 2010, we acquired SMB:LIVE for consideration of up to approximately $8.5 million in cash and stock. On the closing date, we paid $2.8 million in cash. The balance of the purchase price, or the Deferred Consideration, of up to $5.7 million will be payable based upon the achievement of certain employee retention milestones through February 2012. Approximately $4.7 million of the Deferred Consideration will be payable in shares of our common stock, based on the price per share of our common stock in this offering, and approximately $1.0 million will be payable in cash. As the Deferred Consideration is contingent upon retention objectives with regard to the acquired employees, we will recognize such amounts as compensation expense over the period in which the Deferred Consideration may be earned.

We were formed in 2003 and remained a development-stage company until the end of 2004. Prior to 2007, we financed our operations and capital expenditures through private sales of preferred stock. Since 2007, we have financed our operations, our expansion of our IMC sales force and the extension of our Direct Local channel into new territories through cash provided by operations. Deferred revenue arising from prepayment by the great majority of our clients and vendor trade financing are major components of our cash flow from operations. Although we expect that cash flow from operations, existing cash balances and proceeds from our initial public offering will be sufficient to continue funding our expansion activities, these investments, including investments in developing new products and services for our clients, could require us to seek additional equity or debt financing, and that financing may not be available on terms favorable to us or at all. In addition, expansion in the number of IMCs and rapid expansion of new products and services for our clients could require significant capital and entail non-capitalized expenses that could diminish our income from operations.

Business Model, Operating Metrics and Trends

Our Direct Local channel has grown rapidly. As a percentage of revenue, Direct Local revenue has increased from 31% in 2007 to 74% in the three months ended March 31, 2010. Growth in Direct Local revenue is primarily driven by the growth in the number of IMCs and increases in IMC productivity, particularly those IMCs with more than 12 months of employment, who we refer to as Upperclassmen.

Typically, each month we hire one to two classes of 20-30 IMCs, with the hiring weighted towards the first ten months of the year. We refer to IMCs with 12 months or less of experience as Underclassmen. With each new

 

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class of Underclassmen, we track how they are performing relative to a standard level of revenue growth and other performance metrics for each month after their training. Understanding the performance of past and current Underclassmen allows us to adjust our investment in additional Underclassmen in the event we detect significant changes in their productivity.

We believe the key factors that affect the productivity of our IMCs are:

 

   

Macroeconomic Conditions. Macroeconomic conditions directly impact the amount of money SMBs allocate to market their business. We believe that, commencing in mid-2008, IMC productivity was significantly impacted by the economic recession as some of our SMB clients were forced to close or temporarily suspend their operations, while others curtailed their marketing expenditures in light of a contraction in consumer spending. IMC productivity has, therefore, declined from the levels we observed in 2007 and the first two quarters of 2008. For this reason, in January 2009, we temporarily ceased hiring IMCs in North America. We began to observe some growth in IMC productivity starting in March 2009, and we resumed hiring IMCs at the end of March 2009 at a more modest level than in 2008.

 

   

Number of Products. We believe that expanding our comprehensive suite of online marketing and reporting products and services will allow us to generate more revenue from each SMB relationship. Prior to 2009, we primarily offered a single product, ReachSearch. As a result of product and technology investments commencing in 2008, we launched ReachDisplay and our remarketing product in 2009. In addition, we are currently investing in the development of our digital presence and reputation management product based on the technology acquired in connection with the SMB:LIVE acquisition. While new products and technology require investment by us without any assurance of, and prior to recognition of, additional revenue, our strategy remains to increase the number of products our IMCs have to sell. Should some of these investments not achieve client acceptance or economic results, we may be required to reduce the value of the capitalized costs, if any, associated with such products and services and realize a reduction in net income.

 

   

IMC Capacity. We continually endeavor to enhance the productivity of our IMCs. Our business model therefore contemplates additional investments in technology and support personnel to assist our IMCs in managing and maintaining existing clients in order to increase their capacity to acquire new clients. For example, we are investing in a centralized campaign performance organization in Shreveport, Louisiana that, in tandem with our existing customer support team, we expect will assume many of the day-to-day campaign management obligations of our IMCs. These investments are intended to increase IMC productivity, but the benefits of these investments, if any, will trail their expense. These additional costs will be borne through increased cost of revenue as well as product and technology expense.

 

   

Client Tenure. One of the most time-consuming activities for our IMCs is the process of prospecting, arranging a time to visit and obtaining the first order for our products and services from a new client. A key factor in IMC productivity is therefore the success of our efforts to continue to sell our products and services to existing clients, which requires significantly less of an IMC’s time. We believe that a measure of the success of these efforts is the percentage of our revenue generated by sales to clients with different tenures. For this purpose, we divide our clients into three groups:

 

   

Trial Period Clients. We characterize a client’s initial four months as the “trial period” because the most common term for a new client’s first agreement is four months, and we believe that four months is the shortest period in which performance of an advertising campaign can be fully assessed. Trial period clients represented 49%, 42% and 32% of our revenue for 2007, 2008 and 2009, respectively.

 

   

First-Year Post-Trial Clients. We characterize a client that continues to advertise through us after its four-month trial period and for up to one year after its trial period as a First-Year Post-Trial Client. First-Year Post-Trial Clients represented 40%, 42% and 43% of our revenue for 2007, 2008 and 2009, respectively.

 

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Long-Term Clients. We characterize clients that continue to advertise through us for more than one year after their trial period as Long-Term Clients. Long-Term Clients represented 11%, 16% and 25% of our revenue for 2007, 2008 and 2009, respectively.

We regularly review a number of other financial and operating metrics to evaluate our business, determine the allocation of resources and make decisions regarding business strategies. The following table shows certain key operating metrics for the years ended December 31, 2007, 2008 and 2009 and the three months ended March 31, 2009 and 2010:

 

     Year Ended December 31,    Three Months Ended
March 31,
     2007    2008    2009    2009    2010

Number of IMCs (at period end):

              

Upperclassmen

     16      80      235      108      227

Underclassmen

     152      337      280      277      342
                                  

Total

     168      417      515      385      569
                                  

Underclassmen Expense (in thousands) (1)

   $ 10,043    $ 27,886    $ 26,824    $ 6,892    $ 7,806

Active Advertisers (at period end) (2)

     7,400      11,600      14,700      12,400      15,700

Active Campaigns (at period end) (3)

     8,900      13,500      18,600      14,900      19,700

 

(1) For the definition of Underclassmen Expense, see Note 5 to “Selected Consolidated Financial and Other Data.”
(2) For the definition of Active Advertisers, see Note 6 to “Selected Consolidated Financial and Other Data.”
(3) For the definition of Active Campaigns, see Note 7 to “Selected Consolidated Financial and Other Data.”

Number of IMCs

Our ongoing investment in increasing the number of our IMCs has been the principal engine for our growth. In particular, our growth is driven by the increase in the number of Upperclassmen, who are significantly more productive than our Underclassmen. As such, we believe that our ability to grow our business is highly dependent on our ability to grow the number of our Upperclassmen. Beyond our hiring practices, which determine the number of IMCs to be hired as well as the rate at which we hire them, the increase in the number of Upperclassmen depends primarily on the productivity of Underclassmen, as the majority of Underclassmen attrition has been involuntary and is based on performance relative to a standard level of revenue growth and other performance metrics determined by us. We do not expect all Underclassmen to become Upperclassmen, and our investment decisions anticipate the cost of attrition. The performance of past and current IMCs allows us to adjust our investment model in the event there are significant changes in macroeconomic or competitive conditions.

Due to the economic recession, we temporarily ceased hiring IMCs in North America during the first quarter of 2009 and have hired IMCs at a slower rate than in prior periods beginning at the end of March 2009. As a result, the number of our Upperclassmen declined in the first quarter of 2010 and will grow at a slower rate in 2010 than in 2009. In connection with our acquisition on September 11, 2009 of the portion of ReachLocal Australia that we did not previously own, we added 45 Underclassmen and 17 Upperclassmen. At March 31, 2010, we had 38 Underclassmen and 25 Upperclassmen from ReachLocal Australia.

Underclassmen Expense

Underclassmen do not in the aggregate make a positive contribution to operating income. Our largest operating expenses include the hiring, training and retention of Underclassmen in support of our goal of developing more Upperclassmen.

Underclassmen Expense is a number we calculate to approximate our investment in Underclassmen and is comprised of the selling and marketing expenses we allocate to Underclassmen during a reporting period. The

 

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amount includes the direct salaries and allocated benefits of the Underclassmen (excluding commissions), training and sales organization expenses, including depreciation, allocated based on relative headcount and marketing expenses allocated based on relative revenue. While we believe that Underclassmen Expense provides useful information regarding our approximated investment in Underclassmen, the methodology we use to arrive at our estimated Underclassmen Expense was developed internally by the company, is not a concept or method recognized by GAAP and other companies may use different methodologies to calculate or approximate measures similar to Underclassmen Expense. Accordingly, our calculation of Underclassmen Expense may not be comparable to similar measures used by other companies.

We determine the amount to invest in Underclassmen Expense based on our objectives for development of the business and the key factors affecting IMC productivity described above.

The decrease in Underclassmen Expense from 2008 to 2009 reflects our decision in the beginning of 2009 to refrain from hiring Underclassmen in North America until the end of March 2009 and is net of a $1.2 million increase in Underclassmen Expense attributable to our acquisition in September 2009 of the portion of ReachLocal Australia that we did not previously own. The increase in Underclassmen Expense in the three months ended March 31, 2010 as compared to the preceding year period was primarily attributable to the inclusion of 38 Underclassmen from ReachLocal Australia and our decision to recommence hiring in the second quarter of 2009.

Active Advertisers and Active Campaigns

We track the number of Active Advertisers and Active Campaigns to evaluate the growth, scale and diversification of our business. We also use these metrics to determine the needs and capacity of our sales forces, our support organization and other personnel and resources.

Active Advertisers and Active Campaigns increased by 900 Active Advertisers and 1,200 Active Campaigns as a result of our acquisition of the portion of ReachLocal Australia that we did not already own on September 11, 2009.

Basis of Presentation

Sources of Revenue

We derive our revenue principally from the provision and sale of online advertising to our clients. Revenue includes the sale of our ReachSearch, ReachDisplay and remarketing products based on a package pricing model in which our clients commit to a fixed fee that includes the media, the optimization, reporting and tracking technologies of the RL Platform, and the personnel dedicated to support and manage their campaigns; the sale of our TotalTrack product; and set-up, management and service fees associated with these products and other services. We distribute our products and services directly through our sales force of IMCs, who are focused on serving SMBs in their local markets through an in-person, consultative process, which we refer to as our Direct Local channel, as well as a separate sales force targeting our National Brands, Agencies and Resellers channel. The sales cycle for sales to SMBs ranges from one day to over a month. Sales to our National Brands, Agencies and Resellers clients generally require several months.

We typically enter into agreements to provide advertising campaigns for the delivery of our ReachSearch and ReachDisplay products. Each agreement fixes the price per approximately 30-day campaign cycle, which includes all charges for the included technology and media services, management and other fees. Our Direct Local clients generally prepay for services either by credit card, check or electronic debit prior to the commencement of each campaign cycle. We record these prepayments as deferred revenue and only record revenue for income statement purposes as we purchase media and perform other services on behalf of clients. Generally, when at least 85% of requisite purchases and other services have occurred and an additional campaign cycle remains under the agreement, we make an additional billing or automatic collection for the next campaign cycle.

 

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Our National Brands, Agencies and Resellers clients enter into agreements of various lengths or that are indefinite. Our National Brands, Agencies and Resellers clients either pay in a manner similar to Direct Local clients or are extended credit privileges with payment generally due in 30 to 60 days. There were $3.4 million of related accounts receivables at March 31, 2010.

Cost of Revenue

Cost of revenue consists primarily of costs of online media acquired from third-party publishers. Cost of revenue also includes third-party telephone and information services costs, data center and third-party hosting costs, credit card processing fees and other direct costs.

In addition, cost of revenue includes our costs to initiate, operate and manage our clients’ campaigns, other than costs associated with our sales force, which are reflected as selling and marketing expenses. These costs include salaries, benefits, bonuses and stock-based compensation for the related staff and allocated overhead such as depreciation expense, rent and utilities, as well as an allocable portion of our technical operations costs.

Operating Expenses

Selling and Marketing. Selling and marketing expenses consist primarily of personnel and related expenses for our selling and marketing staff, including salaries and wages, commissions, benefits, bonuses and stock-based compensation; travel and business costs; training, recruitment, marketing and promotional events; advertising; other brand building and product marketing expenses; and occupancy, technology and other direct overhead costs. A portion of the compensation for IMCs, sales management and other employees in the sales organization is based on commissions.

Product and Technology. Product and technology expenses consist primarily of personnel and related expenses for our product development and technology staff, including salaries, benefits, bonuses and stock-based compensation, and the cost of certain third-party service providers and other expenses, including occupancy, technology and other direct overhead costs. Technology operations costs, including related personnel and third-party costs, are included in product and technology expenses.

We capitalize a portion of costs for software development and, accordingly, include amortization of those costs as product and technology expenses as the RL Platform addresses all aspects of our activities, including supporting the IMC selling and consultation process, online publisher integration, efficiencies and optimization, providing insight to our clients into the results and effects of their online advertising campaigns and supporting all of the financial and other back-office functions of our business.

Following the acquisition of SMB:LIVE on February 22, 2010, product and technology expenses also include the amortization of the technology obtained in the acquisition and the expenses related to the deferred payment obligations for that acquisition related to product and technology personnel.

General and Administrative. General and administrative expenses consist primarily of personnel and related expenses for executive, legal, finance, human resources and corporate communications, including wages, benefits, bonuses and stock-based compensation, professional fees, insurance premiums and other expenses, including occupancy, technology and other direct overhead, certain costs in preparation to become a public company and other corporate expenses. During 2009, we strengthened our management and corporate infrastructure, particularly in our finance department, and implemented financial reporting, compliance and other infrastructure in preparation for becoming a public company.

Critical Accounting Policies and Estimates

The preparation of our consolidated financial statements in conformity with U.S. generally accepted accounting principles, or GAAP, requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses. We continually evaluate our estimates, judgments

 

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and assumptions based on available information and experience. Because the use of estimates is inherent in the financial reporting process, actual results could differ from those estimates. Certain of our accounting policies require higher degrees of judgment than others in their application. These include the following:

Revenue Recognition

We recognize revenue for our services when all of the following criteria are satisfied:

 

   

persuasive evidence of an arrangement exists;

 

   

services have been performed;

 

   

the selling price is fixed or determinable; and

 

   

collectability is reasonably assured.

Generally, we recognize revenue as the cost for the third-party media is incurred, which is upon delivery of the advertising on behalf of our clients. We recognize revenue for our ReachSearch product as clicks are recorded on sponsored links on the various search engines and for our ReachDisplay product when the display advertisements record impressions or as otherwise provided in our agreement with the applicable publisher. We recognize revenue when we charge set-up, management or other fees on a straight line basis over the term of the related campaign contract or the completion of any obligation for services, if shorter. When we receive advance payments from our clients, we record these amounts as deferred revenue until the revenue is recognized. When we extend credit, we record a receivable when the revenue is recognized.

Our Direct Local clients, which represented 74% of revenue for the three months ended March 31, 2010, generally prepay for services either by credit card, check or electronic debit prior to the commencement of each approximately 30-day cycle of a campaign.

When we sell through agencies, we either receive payment in advance of services or in some cases we extend credit. We pay each agency an agreed-upon commission based on the revenue we earn or cash we receive. Some agency clients who have been extended credit may offset the amount otherwise due to us by any commissions they have earned. We follow the guidance of “Revenue Recognition in Financial Statements” in accordance with ASC Topic 605-45, Revenue Recognition—Principle Agent Consideration, in determining whether it is appropriate to record the gross amount of campaign revenue or the net amount earned after commissions. As we are the primary party obligated in the arrangement, subject to the credit risk and with discretion over both price and media, we recognize the gross amount of such sales as revenue and any commissions are recognized as a selling and marketing expense.

We also have a small number of resellers that integrate our product offerings and services, including ReachSearch, ReachDisplay, remarketing and TotalTrack, into their product offerings. In each case, the resellers integrate with our RL Platform through a custom API. Resellers are responsible for the price and specifications of the integrated product offered to their clients. Resellers pay us in arrears, net of commissions and other adjustments. We recognize revenue generated under reseller agreements net of the agreed-upon commissions and other adjustments earned or retained by the reseller, as we believe that the reseller has retained sufficient control and bears sufficient risks to be considered the primary obligor in those arrangements.

When we offer future incentives to our clients in exchange for minimum annual commitments, we estimate the amount of the future incentives that will be earned by our clients and defer a portion of the otherwise recognizable revenue. Our estimate is based upon a statistical analysis of previous campaigns for which such incentives were offered. Should a client not meet its minimum annual commitment and therefore no longer qualify for the incentive, we recognize the revenue previously deferred related to the estimated incentive. Our estimates are based upon historical actual results and unexpected changes in client purchasing patterns could render our estimates inaccurate.

 

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Stock-based Compensation

We account for stock-based compensation in accordance with Accounting Standards Codification Topic 718, Compensation—Stock Compensation, or ASC Topic 718. ASC Topic 718 requires compensation expense related to stock-based transactions, including employee stock options, to be measured and recognized in the financial statements based on fair value. On January 1, 2006, we implemented the attribution method under ASC Topic 718 that requires companies to reduce current stock-based compensation expenses by the effect of anticipated forfeitures. Prior to January 1, 2006, reduction in stock-based compensation expense for forfeitures was recorded in the period in which the award was forfeited. We estimate forfeitures based upon our historical experience, which has resulted in a small expected forfeiture rate.

Under ASC Topic 718, the fair value of each award is estimated on the date of the grant and amortized over the requisite service period.

We use the Black-Scholes option pricing model to estimate the fair value of stock-based payment awards on the date of grant. Determining the fair value of stock-based awards at the grant date under this model requires judgment, including estimating our value per share of common stock, volatility, expected term and risk-free interest rate. The assumptions used in calculating the fair value of stock-based awards represent our best estimates based on management judgment and subjective future expectations. These estimates involve inherent uncertainties. If any of the assumptions used in the Black-Scholes model significantly changes, stock-based compensation for future awards may differ materially from the awards granted previously.

The fair values of the common stock underlying stock options granted in 2009 were estimated by our board of directors, which intended all options granted to be exercisable at a price per share not less than the per share fair market value of our common stock underlying those options on the date of grant. In the absence of a public trading market, our board of directors considered numerous objective and subjective factors to determine its best estimate of the fair market value of our common stock as of the date of each option grant, including but not limited to, the following factors:

 

   

transactions in our common stock;

 

   

third-party valuations of our common stock;

 

   

the rights, preferences and privileges of our preferred stock relative to the common stock;

 

   

our performance and stage of development; and

 

   

the likelihood of achieving a liquidity event for the shares of common stock underlying these stock options, such as an initial public offering or sale of our company, given prevailing market conditions.

We granted stock options with the following exercise prices during 2009:

 

Option Grant Dates

   Number of Shares
Underlying
Options
   Exercise Price
Per Share
   Estimated Fair
Value Per
Underlying
Share as of
Grant Date
   Intrinsic Value
Per Share  at Date
of Grant
 

April 2009

   767,050    $ 10.91    $ 6.81    $    

August 2009

   274,100    $ 10.91    $ 10.43    $    

October 2009

   282,250    $ 12.30    $ 12.30    $    

We have not granted any stock options since October 2009.

We estimate the fair value of each option award on the date of grant using the Black-Scholes option pricing model. We determined weighted average valuation assumptions as follows:

 

   

Volatility. As we do not have a trading history for our common stock, the expected stock price volatility for our common stock was estimated by taking the median historic price volatility for industry peers based on daily price observations over a period equivalent to the expected term of the

 

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stock option grants. Industry peers consist of several public companies in the technology industry similar in size, stage of life cycle and financial leverage. We did not rely on implied volatilities of traded options in our industry peers’ common stock because the volume of activity was relatively low.

 

   

Expected term. The expected term was estimated using the simplified method allowed under SEC Staff Accounting Bulletin No. 107, Share-Based Payment. We use this method because we do not have adequate historical data to estimate future terms and we are unable to obtain objective, measurable and comparative historical data of comparable companies.

 

   

Risk free interest rate. The risk free interest rate is based on the yields of U.S. Treasury securities with maturities similar to the expected term of the options for each option group.

 

   

Dividend yield. We have never declared or paid any cash dividends and do not presently plan to pay cash dividends in the foreseeable future. Consequently, we used an expected dividend yield of zero.

The following table summarizes the assumptions relating to our stock options granted in 2009:

 

     December 31,
2009
 

Dividend yield

   0

Volatility

   55   

Risk free interest rate

   2.16   

Expected term, in years

   4.73   

In addition, we estimate the forfeiture rate using our historical experience with forfeitures. We review the estimated forfeiture rates each period end and make changes as factors affecting the forfeiture rate calculations and assumptions change.

Using the Black-Scholes option pricing model, we recorded non-cash stock-based compensation expenses related to employee stock options granted of approximately $3.0 million and $1.1 million in 2009 and the three months ended March 31, 2010, respectively, in accordance with the requirements of ASC Topic 718. At March 31, 2010, we had unrecorded compensation costs of $8.5 million related to unvested stock options.

During 2009 and the three months ended March 31, 2010, we obtained quarterly valuations from an independent, third-party valuation expert for purposes of determining fair market value of our common stock at March 31, 2009, June 30, 2009, September 30, 2009, December 31, 2009 and March 31, 2010, as well as determining the fair value of the options granted for financial statement purposes. The valuations all took into account valuation multiples for comparable public companies considered as part of the valuation process, our historical performance and our forecast of expected future performance. The valuations were generally obtained shortly after the conclusion of each quarter, and our board of directors considered the valuations for purposes of determining the fair market value of our common stock and the exercise price for any options granted in the quarter following each valuation date. While other factors were considered in determining the option strike price (as discussed above), at no time were options granted under the fair market value indicated by the third party valuation. The third party valuations estimated that, as of March 31, 2009, June 30, 2009, September 30, 2009, December 31, 2009 and March 31, 2010, the value of a share of our common stock was $6.81, $10.43, $12.30, $13.04 and $14.85, respectively.

The March 2009 valuation was based on the binomial lattice model, an option pricing methodology used by many private companies. The March 2009 valuation reflects the broad market decline in 2008 and early 2009, which had partially recovered by the end of March 2009. As the markets continued to improve during the second quarter of 2009, our management and board initiated steps towards readying our company for an initial public offering of our stock, with a view towards an offering in the first half of 2010. For the June 30, 2009 and later valuations, the probability-weighted expected return method, or P-WERM valuation approach, was adopted as the primary valuation method. The P-WERM methodology requires the consideration of various liquidity scenarios, including an initial public offering and a sale of our company at various valuations, as well as continuing as a standalone company, and takes into account potential timing and the relative probability of each

 

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possible outcome. Management’s assumptions were evaluated using public company data available regarding valuations and other factors in determining the effects of the various outcomes used in the P-WERM valuation analysis. The value of our common stock was then determined using the assumptions discussed above and other factors, including the risk adjusted rate used for discounting the value, continued instability in the public markets and in the overall macroeconomic environment and the impact of liquidity limitations at the time the options were granted.

The substantial increase in value from March 31, 2009 to June 30, 2009 was principally due to a dramatic rebound in the public market performance of our comparable public companies during the quarter. The P-WERM methodology yielded a valuation of $10.43 per share of our common stock on June 30, 2009. The increase in valuation from June 30, 2009 to September 30, 2009 from $10.43 to $12.30 reflected the ongoing improvement of market conditions, but was principally driven by an increase in expected future scale of the company as a result of the acquisition and consolidation of ReachLocal Australia acquired on September 11, 2009. The increases in valuations from September 30, 2009 to December 31, 2009 to March 31, 2010, from $12.30 to $13.04 to $14.85, respectively, principally reflect the estimated reduction in the time to our initial public offering and continued improvement in the valuations of comparable public companies.

Software Development Costs

Costs related to internal-use software are accounted for in accordance with ASC Topic 350-40, Intangibles—Internal Use Software, under which we capitalize our costs to develop software when management has determined the development efforts will result in new or additional functionality or results in new products. Costs incurred prior to meeting these criteria and costs associated with ongoing maintenance are expensed as incurred. We track our costs by project and by each release and objectively determine which projects resulted in additional functionality or new products for which we can improve our offerings and market presence. Our developers, engineers and quality assurance staff currently estimate their time spent on various projects on a weekly basis so we may determine the approximate amount of costs that should be capitalized. Our senior management team reviews these estimates to determine the appropriate level of capitalization. We monitor our existing capitalized software and reduce its carrying value as the result of releases that render previous features or functions obsolete or otherwise reduce the value of previously capitalized costs.

Costs capitalized as internal use software are amortized on a straight-line basis over the estimated useful life of the software, estimated to be three years. Amortization of those costs is included in product and technology expenses as the RL Platform addresses all aspects of our activities, including supporting the IMC selling and consultation process, online publisher integration, efficiencies and optimization, providing insight to our clients into the results and effects of their online advertising campaigns and supporting all of the financial and other back office functions of our business.

Income Taxes

We use the liability method of accounting for income taxes. Significant judgment is required in determining the consolidated provision for income taxes and evaluating our tax positions. In the ordinary course of business, there are many transactions and calculations for which the ultimate tax settlement is uncertain. As a result, we recognize tax liabilities based on estimates of whether additional taxes and interest will be due. These tax liabilities are recognized when, despite our belief that our tax return positions are supportable, we believe that it is more likely than not that those positions may not be fully sustained upon review by tax authorities.

For the periods presented, income tax expense represents minimum income taxes imposed by state and local tax jurisdictions applicable to our North American activities. We are otherwise generating net operating losses in the various tax jurisdictions in which we operate. We believe that it is likely that taxes imposed by state, local and foreign jurisdictions will increase in magnitude, particularly to the extent we become profitable in certain foreign jurisdictions before the time we obtain profitability on a consolidated basis.

Due to a history of losses and except as described in Notes 4 and 10 to the consolidated financial statements, we have provided a full valuation allowance against our deferred tax assets as more fully described in Note 10 of

 

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the consolidated financial statements. The ability to utilize these losses, any future losses and any other tax credits or attributes may be restricted or eliminated by changes in our ownership, including potentially as a result of this public offering, changes in legislation and other rules affecting the ability to offset future taxable income with losses from prior periods. Future determinations on the need for a valuation allowance on our net deferred tax assets will be made on a quarterly basis, and our assessment at March 31, 2010 reflects a continued need for a full valuation allowance.

As a result of the acquisition of the portion of ReachLocal Australia that we did not previously own, we recognized a non-cash gain of $16.2 million. We did not record an income tax provision on the gain since management intends to hold its investment in ReachLocal Australia permanently.

As a result of the acquisition of SMB:LIVE, we recorded a reduction in taxes of $0.7 million in the quarter ended March 31, 2010. See Note 10 of the Company’s Consolidated Financial Statements.

We are required to file income tax returns in the United States and various foreign jurisdictions, which requires us to interpret the applicable tax laws and regulations in effect in such jurisdictions. Such returns are subject to audit by the various federal, state and foreign taxing authorities, which may disagree with our tax positions. We believe that our accruals for tax liabilities are adequate for all open audit years based on our assessment of many factors, including past experience and interpretations of tax law. We review and update our estimates in light of changing facts and circumstances, such as the closing of a tax audit, the lapse of a statute of limitations or a material change in estimate. To the extent that the final tax outcome of these matters differs from our expectations, such differences will impact income tax expense in the period in which such determination is made.

We adopted the provisions of ASC Topic 740 as it pertains to accounting for uncertain tax positions on January 1, 2007. There was no impact to our financial statements as a result of this implementation.

We recognize interest and penalties related to unrecognized tax benefits within the income tax expense line in the accompanying consolidated statement of operations and any accrued amounts are included within the related tax liability line in the consolidated balance sheet.

Goodwill and Intangible Assets

At March 31, 2010, we had $34.1 million of goodwill, which resulted from the acquisition of the portion of ReachLocal Australia that we did not previously own and the acquisition of SMB:LIVE. In addition, in accounting for the acquisitions of ReachLocal Australia and SMB:LIVE, we recorded other intangible assets related to pre-existing client relationships and purchased technology, respectively. We report finite-lived, acquisition-related intangible assets at fair value, net of accumulated amortization. Identifiable intangible assets are amortized on a straight-line basis over their estimated useful lives of three years. Straight-line amortization is used because no other pattern over which the economic benefits will be consumed can be reliably determined.

We evaluate our goodwill for impairment using a two-step process that is performed at least annually, or whenever events or circumstances indicate that goodwill may be impaired. The first step is a comparison of the fair value of an internal reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying value, goodwill of the reporting unit is not considered impaired and the second step is unnecessary. If the carrying value of the reporting unit exceeds its fair value, the second step is performed to measure the amount of impairment by comparing the carrying amount of the goodwill to a determination of the implied value of the goodwill. If the carrying amount of goodwill is greater than the implied value, an impairment is recognized for the difference.

We evaluate our intangible assets for impairment whenever events or circumstances indicate an impairment may exist. The impairment loss is the amount by which the carrying value of the asset exceeds its fair value. We estimate fair value utilizing the projected discounted cash flow method and a discount rate determined by our management to be commensurate with the risk inherent in our current business model. When calculating fair value, we make assumptions regarding estimated future cash flows, discount rates and other factors.

 

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Results of Operations

Comparison of the Three Months Ended March 31, 2009 and 2010

Revenue

     Three Months Ended March 31,  
     2009    2010    2009-2010
% Change
 
(in thousands)                 

Direct Local

   $ 27,676    $ 47,249    70.7

National Brands, Agencies and Resellers

     15,059      16,377    8.8   
                

Total revenue

   $ 42,735    $ 63,626    48.9
                

At period end:

        

Number of IMCs:

        

Upperclassmen

     108      227    110.2

Underclassmen

     277      342    23.5   
                

Total

     385      569    47.8
                

Active Advertisers

     12,400      15,700    26.6

Active Campaigns

     14,900      19,700    32.2

The increase in our Direct Local revenue from the first quarter of 2009 to the first quarter of 2010 was primarily due to the increased productivity of our existing IMC sales force. In particular, the increased contribution of our new Upperclassmen—that is, IMCs who were Underclassmen in the first quarter of 2009 who subsequently became Upperclassmen—represented the largest portion of the revenue growth. The revenue contributed by our Underclassmen IMCs hired between the end of the first quarter of 2009 and the end of the first quarter of 2010 represented the next largest portion of revenue growth, followed by the incremental revenue contributed by our existing Upperclassmen—that is, IMCs who were already Upperclassmen in the first quarter of 2009. The increase in productivity of our IMC sales force was primarily attributable to the increase in tenure of our existing IMCs as, on average, they tend to grow their revenue as they mature, as well as to the release of our ReachDisplay product. The increase in our Direct Local revenue in the first quarter of 2010 also reflects $6.4 million of revenue attributable to ReachLocal Australia.

The increase in our National Brands, Agencies and Resellers revenue from the first quarter of 2009 to the first quarter of 2010 was primarily due to an increase in the number of National Brands clients due to our continued increased focus on the National Brands portion of this channel. Revenue from our National Brands increased by $1.4 million, which was slightly offset by a decrease of $0.1 million in revenue from our Agencies and Resellers.

Cost of Revenue

     Three Months Ended
March 31,
   2009-2010
% Change
    Three Months Ended
March 31,
 
     2009    2010      2009     2010  
(in thousands)                    (as a percentage of revenue)  

Cost of revenue

   $ 23,823    $ 34,839    46.2 %   55.7   54.8
                            

The decrease in our cost of revenue as a percentage of revenue from the first quarter of 2009 to the first quarter of 2010 was primarily due to an increase in publisher rebates, the effect of changes in geographic and product mix and increased media buying efficiency. These decreases were partially offset by higher costs associated with the expansion of the campaign performance group as part of our strategy to enhance the productivity of our IMCs, and the commencement of campaign management and provisioning operations in India

 

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as part of our strategy of lowering these costs over the longer term. Publisher rebates as a percentage of revenue increased from 0.9% in the first quarter of 2009 to 1.9% in the first quarter of 2010 due to the inclusion of our ReachLocal Australia operations, which receive higher rebates as a percentage of revenue, and an increase in rebates from existing and new publishers in North America other than Google.

Our cost of revenue as a percentage of revenue will be affected in the future by the mix and relative amount of media we purchase to fulfill service requirements, the availability and amount of publisher rebates, the mix of products and services we offer, our media buying efficiency and increased costs of support and delivery as we grow our campaign performance group.

Operating Expenses

Over the past several years, we have significantly increased the scale of our operations, and we continue to operate with a view towards increasing our operating scale by increasing our sales force, product offerings and the infrastructure to support them. In managing our business for increased scale, we expect each category of operating expenses to increase. However, unlike a mature business where such operating expense expansion would be tied to current revenue and revenue growth with a goal of meeting a particular immediate operating income target, we are intentionally incurring expenses to support a long-term view of growth, acknowledging, but not managing to, the particular impact such decisions might have on near term periodic operating results. In addition, while we are making significant investments in future growth, we cannot predict accurately to what extent or when these investments will contribute to revenue growth, and, as a result, what our operating expenses will be as a percentage of revenue.

Selling and Marketing

 

     Three Months Ended
March 31,
   2009-2010
% Change
    Three Months Ended
March 31,
 
     2009    2010      2009     2010  
(in thousands)                    (as a percentage of revenue)  

Salaries, benefits and other costs

   $ 11,191    $ 16,530    47.7   26.2   26.0

Commission expense

     5,889      7,410    25.8      13.8      11.6   
                    

Total selling and marketing

   $ 17,080    $ 23,940    40.2   40.0   37.6
                    

Underclassmen Expense included above, excluding commissions

   $ 6,892    $ 7,806    13.3    

The increase in absolute dollars in salaries, benefits and other costs in selling and marketing expenses from the first quarter of 2009 to the first quarter of 2010 was primarily due to an increase in our IMC headcount. The increase also reflects the inclusion of $1.8 million of expenses of ReachLocal Australia. The increase in Underclassmen Expense in absolute dollars from the first quarter of 2009 to the first quarter of 2010 was primarily due to an increase in our IMC Underclassmen headcount, including the addition of 38 Underclassmen from ReachLocal Australia, as well as our decision not to hire Underclassmen in North America until the end of the first quarter of 2009.

The increase in commission expense in absolute dollars from the first quarter of 2009 to the first quarter of 2010 was due to increases in our revenue in our sales channels. As a percentage of revenue, commission expense decreased due to a higher percentage of Direct Local channel revenue, including the additional Direct Local revenue from ReachLocal Australia, for which we pay lower commission rates. We do not expect continued decreases in commission expense as a percentage of revenue due to an expected higher percentage of Upperclassmen, who generally earn higher commission rates based on increased production.

As we continue to invest in additional Underclassmen and retain additional Upperclassmen, selling and marketing expenses will continue to increase in absolute dollars.

 

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Product and Technology

 

     Three Months
Ended March 31,
   2009-2010
% Change
    Three Months Ended
March 31,
 
     2009    2010      2009     2010  
(in thousands)                    (as a percentage of revenue)  

Product and technology

   $ 974    $ 2,344    140.7   2.3   3.7

Capitalized software development costs from product and technology resources

     551      1,457    164.4      1.3      2.3   
                            

Total product and technology costs expensed and capitalized

   $ 1,525    $ 3,801    149.2   3.6   6.0
                            

The increase in product and technology expenses in both absolute dollars and as a percentage of revenue from the first quarter of 2009 to the first quarter of 2010 was primarily attributable to a $0.8 million increase in compensation for additional headcount, including deferred compensation expense of $0.3 million from the SMB:LIVE acquisition, and $0.2 million in additional amortization expense of capitalized software development costs. The increase in headcount was a result of increased investment in RL Platform functionality, new product development related to a customer retention product, and the addition of product and technology personnel from the SMB:LIVE acquisition. The increase in the amount of software development costs capitalized both in absolute dollars and as a percentage of revenue from the first quarter of 2009 to the first quarter of 2010 was a result of increased investment in new product development relating to a customer retention product, development of the SMB:LIVE technology, and additional RL Platform functionality.

We expect the amount of product and technology costs expensed and capitalized to increase in absolute dollars in the future due to the continued expansion of our product development efforts, including the planned investment to develop the technology acquired in our acquisition of SMB:LIVE, and the increased costs associated with supporting a broader product offering. The amount of such costs capitalized will vary from period to period depending upon the status of our product development efforts. See “Critical Accounting Policies and Estimates—Software Development Costs.”

General and Administrative

 

     Three Months
Ended March 31,
   2009-2010
% Change
    Three Months Ended
March 31,
 
     2009    2010      2009     2010  
(in thousands)                    (as a percentage of revenue)  

General and administrative

   $ 3,057    $ 5,385    76.2   7.2   8.5
                            

The increase in the general and administrative expenses in both absolute dollars and percentage of revenue from the first quarter of 2009 to the first quarter of 2010 was primarily due to a $1.0 million increase in salaries and benefits associated with the growth of our administrative headcount as we prepared to become a public company, $0.5 million in general and administrative expense for ReachLocal Australia, a $0.3 million increase in general and administrative costs for business taxes, licenses and insurance resulting from our continued expansion, a $0.3 million increase due to expenses incurred in the acquisition of SMB:LIVE and a $0.2 million increase in professional service costs associated with preparing to become a public company.

We expect general and administrative expenses to increase in absolute dollars as we continue to add administrative personnel and incur additional professional fees and other expenses resulting from continued growth and the compliance requirements associated with being a public company.

Other Income (Expense), Net

The $19,000 decrease in other income (expense), net from the first quarter of 2009 to the first quarter of 2010 was primarily due to interest expense on the deferred payment obligation we incurred in connection with our acquisition of the portion of ReachLocal Australia that we did not already own, which was partially offset by higher interest income in the first quarter of 2010.

 

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Provision (Benefit) for Income Taxes

The income tax benefit of $0.6 million for the first quarter of 2010 was primarily attributable to the acquisition of SMB:LIVE, in which we recorded a one-time discrete deferred tax benefit of $0.7 million. See Note 10 to the Company’s Consolidated Financial Statements.

Results of Operations

Comparison of the Years Ended December 31, 2007, 2008 and 2009

Revenue

 

     Year Ended
December 31,
            
     2007    2008    2009    2007-2008
% Change
    2008-2009
% Change
 

(in thousands)

                 

Direct Local

   $ 21,079    $ 82,852    $ 141,492    293.1   70.8

National Brands, Agencies and Resellers

       47,277      63,835      61,625    35.0      (3.5
                         

Total revenue

   $ 68,356    $ 146,687    $ 203,117    114.6   38.5
                         

At period end:

             

Number of IMCs:

             

Upperclassmen

     16      80      235    400.0   193.8

Underclassmen

     152      337      280    121.7      (16.9
                         

Total

     168      417      515    148.2   23.5
                         

Active Advertisers

     7,400      11,600      14,700    56.8   26.7

Active Campaigns

     8,900      13,500      18,600    51.7   37.8

The increase in our Direct Local revenue from 2008 to 2009 was primarily due to the increased productivity of our existing IMC sales force. In particular, the increased contribution of our new Upperclassmen—that is, IMCs who were Underclassmen in 2008 who became Upperclassmen in 2009—represented the largest portion of the revenue growth. The increase in revenue from our existing Underclassmen—that is, IMCs who were already Upperclasssmen in 2008, represented the next larget portion of the revenue growth, followed closely by the imcremental revenue contributred by the new Underclassmen IMCs hired in 2009. The increase in productivity of our IMC sales force was primarily attributable to the increase in tenure of our existing IMCs in addition to the release of our ReachDisplay product. The increase in our Direct Local revenue in this period includes $6.1 million of revenue attributable to ReachLocal Australia from September 11, 2009.

The decrease in our National Brands, Agencies and Resellers revenue from 2008 to 2009 was primarily due to a reduction in the number of agencies and resellers selling our products and services, as well as a reduction in the sales by our agencies and resellers. In no case was the reduction in revenue from a single agency or reseller material to the total National Brands, Agencies and Resellers revenue. We believe that the combination of macroeconomic conditions affecting advertising agencies in general during this period and a relative increase in our focus on the national brands portion of this channel were the primary factors affecting the sales reductions in this period. During this period, the revenue from our agencies and resellers declined by $8.8 million, which was partially offset by an increase of $6.6 million in revenue from our national brands.

The growth in Direct Local revenue from 2007 to 2008 was driven predominantly by our hiring of IMCs, most of whom were Underclassmen during these periods. The increase in our National Brands, Agencies and Resellers revenue from 2007 to 2008 was due primarily to an increase in the number of our national brand clients, agencies and resellers, as well as an increase in sales by our agencies and resellers.

 

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Cost of Revenue

 

     Year Ended
December 31,
               Year Ended
December 31,
 
     2007    2008    2009    2007-2008
% Change
    2008-2009
% Change
    2007     2008     2009  

(in thousands)

               (as a percentage of revenue)  

Cost of revenue

   $ 39,262    $ 77,496    $ 112,218    97.4   44.8   57.4   52.8   55.2
                                           

The increase in our cost of revenue as a percentage of revenue from 2008 to 2009 was primarily due to a decrease in publisher rebates, partially offset by a reduction in the relative amount of media we purchased to fulfill service requirements, increased media buying efficiency and reductions in negotiated merchant card processing rates. Publisher rebates as a percentage of revenue decreased from 4.1% in 2008 to 1.2% in 2009, due primarily to the cancellation, effective January 1, 2009, of our Google rebate in North America.

The decrease in our cost of revenue as a percentage of revenue from 2007 to 2008 was primarily due to a reduction in the relative amount of media we purchased to fulfill service requirements, an increase in publisher rebates and increased media buying efficiency. Publisher rebates as a percentage of revenue increased from 1.7% in 2007 to 4.1% in 2008.

Operating Expenses

Selling and Marketing

 

     Year Ended
December 31,
               Year Ended
December 31,
 
     2007    2008    2009    2007-2008
% Change
    2008-2009
% Change
    2007     2008     2009  

(in thousands)

               (as a percentage of revenue)  

Salaries, benefits and other costs

   $ 13,142    $ 39,485    $ 50,466    200.4   27.8   19.2   26.9   24.8

Commission expense

     11,293      21,569      25,709    91.0      19.2      16.5      14.7      12.7   
                                           

Total selling and marketing

   $ 24,435    $ 61,054    $ 76,175    149.9   24.8   35.7   41.6   37.5
                                           

Underclassmen Expense included above, excluding commissions

   $ 10,043    $ 27,886    $ 26,824    177.7   (3.8 )%       

The increase in absolute dollars in salaries, benefits and other costs in selling and marketing expenses from 2008 to 2009 was primarily due to an increase in our IMC headcount and related recruiting, training and facilities costs, and the expenses of ReachLocal Australia sales personnel after September 11, 2009. The decrease in selling and marketing expenses as a percentage of revenue from 2008 to 2009 was primarily due to increased revenue arising from increases in both the number of Upperclassmen and the relative percentage of Upperclassmen to all IMCs. Underclassmen Expense declined from 2008 to 2009 due to our decision not to hire Underclassmen in North America until the end of the first quarter of 2009 and to hire Underclassmen at a reduced rate for the remainder of 2009.

The increase in commission expense in absolute dollars from 2008 to 2009 was due to increases in our revenue in our sales channels. As a percentage of revenue, commission expense decreased due to a higher percentage of Direct Local channel revenue, for which we pay lower commission rates.

The increase in absolute dollars in salaries, benefits and other costs in selling and marketing expenses from 2007 to 2008 was primarily due to an increase in our IMC headcount as we expanded our operations, including our first international offices in 2008. Our Underclassmen Expense increased significantly as we accelerated our investment in the Direct Local channel. In addition, our selling and marketing expenses associated with our National Brands, Agencies and Resellers channel increased as that channel expanded its activities. The increase

 

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in selling and marketing expenses as a percentage of revenue from 2007 to 2008 was primarily due to the greater increase in the number of Underclassmen than Upperclassmen.

The increase in commission expense in absolute dollars from 2007 to 2008 was due to increases in our revenue in all of our sales channels. As a percentage of revenue, commission expense decreased due to a higher percentage of Direct Local channel revenue, for which we pay lower commission rates.

Product and Technology

 

     Year Ended
December 31,
               Year Ended
December 31,
 
     2007    2008    2009    2007-2008
% Change
    2008-2009
% Change
    2007     2008     2009  
(in thousands)                               (as a percentage of revenue)  

Product and technology

   $ 1,911    $ 2,938    $ 5,167    53.7   75.9   2.8   2.0   2.5

Capitalized software development costs from product and technology resources

     417      1,390      3,603    233.3      159.2      0.6      0.9      1.8   
                                           

Total product and technology costs expensed and capitalized

   $ 2,328    $ 4,328    $ 8,770    85.9   102.6   3.4   3.0   4.3
                                           

The increase in product and technology expenses in both absolute dollars and as a percentage of revenue from 2008 to 2009 was primarily attributable to a $0.9 million increase in compensation due to additional headcount and to an increase of $0.7 million in amortization expense of capitalized software development costs. The increase in product and technology headcount was due to a planned increase in our product development and engineering efforts focused on newly released products, including ReachDisplay, as well as the commencement of development of a customer retention product. The increase in the amount of software development costs capitalized from 2008 to 2009 both in absolute dollars and as a percentage of revenue was a result of increased investment in new products and RL Platform functionality.

The increase in product and technology expenses in absolute dollars from 2007 to 2008 was primarily attributable to additional headcount. In 2008, we developed and launched additional versions of the RL Platform to support international markets, and we commenced development of the ReachLocal Xchange and our ReachDisplay product. The increase in the amount of software development costs capitalized from 2007 to 2008 was a result of increased investment in new products and RL Platform functionality. Total product and technology costs expensed and capitalized as a percentage of revenue decreased as our revenue increased.

General and Administrative

 

     Year Ended
December 31,
         Year Ended
December 31,
 
     2007    2008    2009    2007-2008
% Change
    2008-2009
% Change
    2007     2008     2009  
(in thousands)                (as a percentage of revenue)  

General and administrative

   $   5,804    $ 12,128    $ 15,534    109.0   28.1   8.5   8.3   7.6
                                           

The increase in general and administrative expenses in absolute dollars from 2008 to 2009 was primarily attributable to an increase of $2.9 million in salaries and benefits and a $0.4 million increase in facilities costs, each associated with an increase in our administrative headcount as we prepared to become a public company. General and administrative costs decreased as a percentage of revenue from 2008 to 2009 due to increased revenue.

The increase in general and administrative expenses in absolute dollars from 2007 to 2008 primarily reflected our increase in personnel and associated overhead as we invested in infrastructure to support the growth of our business in both North America and abroad. General and administrative costs decreased slightly as a percentage of revenue from 2007 to 2008 due to increased revenue.

 

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Gain on Acquisition of ReachLocal Australia

Our purchase of the equity interests in ReachLocal Australia that we did not previously own on September 11, 2009 required that we recognize a gain associated with the proportionate fair value of the assets acquired and liabilities assumed to the carrying value of the shares we already owned. Prior to the acquisition, our interest in ReachLocal Australia had a carrying value of zero as a result of our share of the losses recognized under the equity method of accounting. On the date of the acquisition, our investment was adjusted to fair value, resulting in the one-time non-cash gain of $16.2 million.

Equity in Loss of ReachLocal Australia

In 2007 and 2008, we recognized equity in losses of our investment in ReachLocal Australia of $0.3 million and $0.8 million, respectively, as we increased our investment by making additional contributions of capital in each of those years.

Other Income (Expense), Net

The decrease in other income (expense), net from 2008 to 2009 was primarily attributable to lower yields on our investments as a result of the economic recession. Other income (expense), net increased from 2007 to 2008 as a result of increases in the amounts invested and increases in yields.

 

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Quarterly Results of Operations and Data

The following tables set forth unaudited quarterly consolidated statement of operations data for the four quarters of each of 2008 and 2009 and the first quarter of 2010, as well as the percentage that each line item represented of our revenue. We have prepared the statement of operations data for each of these quarters on the same basis as the audited consolidated financial statements included elsewhere in this prospectus and, in the opinion of management, the statement of operations data includes all adjustments, consisting solely of normal recurring adjustments, necessary for the fair statement of the results of operations for these periods. This information should be read in conjunction with the audited consolidated financial statements and related notes included elsewhere in this prospectus. These quarterly results of operations are not necessarily indicative of our operating results for any future period.

 

     For the Three Months Ended  
     Mar 31,
2008
    June 30,
2008
    Sept 30,
2008
    Dec 31,
2008
    Mar 31,
2009
    June 30,
2009
    Sept 30,
2009
    Dec 31,
2009
    Mar 31,
2010
 

Consolidated Statements of Operations (unaudited):

  

   
(in thousands)                                                       

Revenue

   $ 27,934      $ 34,975      $ 41,284      $ 42,494      $ 42,735      $ 47,970      $ 52,610      $ 59,802      $ 63,626   

Cost of revenue (1)

     14,914        18,425        21,566        22,591        23,823        26,618        29,173        32,604        34,839   

Operating expenses:

                  

Selling and marketing (1)

     11,154        14,631        17,198        18,071        17,080        17,681        19,174        22,240        23,940   

Product and technology (1)

     672        601        711        954        974        1,288        1,319        1,586        2,344   

General and administrative (1)

     2,498        2,958        3,335        3,337        3,057        3,362        4,179        4,936        5,385   
                                                                        

Total operating expenses

     14,324        18,190        21,244        22,362        21,111        22,331        24,672        28,762        31,669   
                                                                        

Loss from operations

   $ (1,304   $ (1,640   $ (1,526   $ (2,459   $ (2,199   $ (979   $ (1,235   $ (1,564   $ (2,882
                                                                        

Consolidated Statements of Operations as a Percentage of Revenue:

  

   

Revenue

     100.0     100.0     100.0     100.0     100.0     100.0     100.0     100.0     100.0

Cost of revenue

       53.4          52.7          52.2          53.2        55.7          55.5          55.5          54.5        54.8   

Operating expenses:

                  

Selling and marketing

     39.9        41.8        41.7        42.5        40.0        36.9        36.5        37.2        37.6   

Product and technology

     2.4        1.7        1.7        2.2        2.3        2.7        2.5        2.7        3.7   

General and administrative

     8.9        8.5        8.1        7.9        7.1        7.0        7.9        8.3        8.5   
                                                                        

Total operating expenses

     51.3        52.0        51.5        52.6        49.4        46.6        46.9        48.1        49.8   
                                                                        

Loss from operations

     (4.7 )%      (4.7 )%      (3.7 )%      (5.8 )%      (5.1 )%      (2.1 )%      (2.4 )%      (2.6 )%      (4.5 )% 
                                                                        

 

(1)    Stock-based compensation, net of capitalization, and depreciation and amortization included in the above line items (in thousands):

 

Stock-based compensation:

        

  

   

Cost of revenue

   $ 4      $ 6      $ 14      $ 10      $ 10      $ 15      $ 33      $ 28      $ 91   

Selling and marketing

     24        40        201        73        69        173        180        144        181   

Product and technology

     26        4        23        20        17        15        69        63        264   

General and administrative

     132        144        614        476        447        554        526        618        549   
                                                                        

Total

   $ 186      $ 194      $ 852      $ 579      $ 543      $ 757      $ 808      $ 853        1,085   
                                                                        

Depreciation and amortization:

  

   

Cost of revenue

   $ 31      $ 41      $ 55      $ 59      $ 63      $ 63      $ 65      $ 70      $ 72   

Selling and marketing

     106        139        167        184        196        196        247        253        245   

Product and technology

     161        208        247        300        355        404        442        564        670   

General and administrative

     22        32        42        58        56        58        66        250        247   
                                                                        

Total

   $ 320      $ 420      $ 511      $ 601      $ 670      $ 721      $ 820      $ 1,137      $ 1,234   
                                                                        

 

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    For the Three Months Ended  
    Mar 31,
2008
    June 30,
2008
    Sept 30,
2008
    Dec 31,
2008
    Mar 31,
2009
    June 30,
2009
  Sept 30,
2009
  Dec 31,
2009
  Mar 31,
2010
 

Other Financial Data:

                 
(in thousands)                                                

Net cash provided by operating activities

  $ 1,626      $ 4,938      $ 2,908      $ 2,590      $ 3,012      $ 5,530   $ 3,574   $ 2,192   $ 2,529   

Capital Expenditures (unaudited)(2)

    884        1,452        1,550        1,266        892        1,068     1,766     2,079  

 

1,777

  

Non-GAAP Financial Measures (unaudited):

   

               
(in thousands)                                                

Adjusted EBITDA (3)

    (798     (1,026     (163     (1,279     (986     499     1,165     715     (228

Underclassmen Expense (4)

    4,932        6,836        7,842        8,276        6,892        5,968     6,389     7,575     7,806   
    Mar 31,
2008
    June 30,
2008
    Sept 30,
2008
    Dec 31,
2008
    Mar 31,
2009
    June 30,
2009
  Sept 30,
2009
  Dec 31,
2009
  Mar 31,
2010
 

Other Operational Data:

                 

Number of IMCs:

                 

Upperclassmen

    30        45        70        80        108        143     208     235     227   

Underclassmen

    246        289        323        337        277        256     317     280     342   
                                                                 

Total

    276        334        393        417        385        399     525     515     569   
                                                                 

Active Advertisers (5)

    8,900        10,600        11,700        11,600        12,400        13,200     14,500     14,700     15,700   

Active Campaigns (6)

    10,400        12,300        13,600        13,500        14,900        16,100     17,600     18,600     19,700   

 

(2) For the definition of Capital Expenditures, see Note 3 from “Selected Consolidated Financial and Other Data.”
(3) For the definition of Adjusted EBITDA, see Note 4 from “Selected Consolidated Financial and Other Data.” The following table presents a reconciliation of Adjusted EBITDA to our loss from operations for each of the periods indicated:

 

     For the Three Months Ended  
      Mar 31,
2008
    June 30,
2008
    Sept 30,
2008
    Dec 31,
2008
    Mar 31,
2009
    June 30,
2009
    Sept 30,
2009
    Dec 31,
2009
    Mar 31,
2010
 
(in thousands)                                                       

Loss from operations

   $ (1,304   $ (1,640   $ (1,526   $ (2,459   $ (2,199   $ (979   $ (1,235 )   $ (1,564   $ (2,882

Add:

                  

Depreciation and amortization

     320        420        511        601        670        721        820        1,137        1,234   

Stock-based compensation

     186        194        852        579        543        757        808        853        1,085   

Acquisition and integration costs

                                                     312        77        335   

Amortization for step-down in deferred revenue on acquisition, net of tax

                                                     460        212        —     
                                                                        

Adjusted EBITDA

   $ (798   $ (1,026   $ (163   $ (1,279   $ (986   $ 499      $ 1,165      $ 715      $ (228
                                                                        

 

(4) For the definition of Underclassmen Expense, see Note 5 from “Selected Consolidated Financial and Other Data.”
(5) For the definition of Active Advertisers, see Note 6 from “Selected Consolidated Financial and Other Data.”
(6) For the definition of Active Campaigns, see Note 7 from “Selected Consolidated Financial and Other Data.”

The fourth quarter of 2009 is the first full quarter to reflect the operations of ReachLocal Australia, the balance of which we acquired on September 11, 2009.

Revenue in the third and fourth quarters of 2009 and the first quarter of 2010 includes $0.6 million, $5.5 million and $6.4 million of revenue, respectively, attributable to our acquisition of the portion of ReachLocal Australia that we did not previously own. The revenue for ReachLocal Australia in the third and fourth quarters reflects a reduction in deferred revenue recorded as of the acquisition date as was required in accounting for the acquisition. We believe our ability to grow revenue is adversely affected in the fourth quarter of each year due to

 

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seasonal factors, such as reduced advertising by service vendors in the holiday period. Revenue in the quarters ended December 31, 2008 and March 31, 2009 remained relatively constant as a result of the economic recession.

Cost of revenue as a percentage of revenue increased commencing in the first quarter of 2009 primarily due to cancellation of certain publisher rebates in North America. The decrease in cost of revenue as a percentage of revenue in the fourth quarter of 2009 was primarily due to the impact of the first full quarter of the consolidation of ReachLocal Australia and reflects the effects of the publisher rebates received by ReachLocal Australia (which, as a percentage of revenue, are higher for ReachLocal Australia than for the remainder of our consolidated operations) as well as a scaling of internal provisioning, support and technical operations costs included in cost of revenue over a larger amount of revenue. The increase in the cost of revenue as a percentage of revenue in the first quarter of 2010 from the fourth quarter of 2009 was primarily due to the expansion of the campaign performance group as part of our strategy to enhance the productivity of our IMCs, and the commencement of campaign management and provisioning operations in India as part of our strategy of lowering these costs over the longer term.

Selling and marketing expenses as a percentage of revenue increased in the first quarter of 2010 primarily due to a 22% increase in our Underclassmen from the end of the fourth quarter of 2009 to the end of the first quarter of 2010. The increase in the fourth quarter of 2009 was primarily due to a $1.2 million increase in Underclassmen Expense, resulting from the recommencement of Underclassmen hiring in North America in March 2009 and the full quarter impact of our acquisition of the portion of ReachLocal Australia that we did not previously own, which had a higher percentage of Underclassmen in its sales force than we did prior to the acquisition. Selling and marketing expenses as a percentage of revenue decreased in the first three quarters of 2009 due to an increase in the number of Underclassmen becoming Upperclassmen, the increased tenure of those Upperclassmen and a decision not to hire Underclassmen in North America in the first quarter of 2009 in response to the economic recession.

The majority of the increase in product and technology costs in the first quarter of 2010 from the fourth quarter of 2009 was due to the acquisition of SMB:LIVE and its ongoing operations.

The increase in general and administrative expenses in the third and fourth quarters of 2009 and the first quarter of 2010 reflects the addition of the general and administrative costs of ReachLocal Australia and an increase in accounting, finance and legal costs in preparation for becoming a public company. In addition, in the first quarter of 2010 and the third quarter of 2009, the increase in general and administrative costs was also attributable to $0.3 million in costs associated with the acquisition of SMB:LIVE and $0.3 million in costs associated with the acquisition of the portion of ReachLocal Australia that we did not already own, respectively.

The increase in Underclassmen Expense in each of the four quarters ended December 31, 2008 reflects our growing investment in our Direct Local channel. Underclassmen Expense declined in the first two quarters of 2009 as a result of our decision to suspend hiring in North America until the end of March 2009 in response to the economic downturn. Underclassmen Expense has increased in each quarter since the second quarter of 2009, which increase was attributable to our resumption of hiring and the addition of Underclassmen Expense attributable to ReachLocal Australia Underclassmen.

Our quarterly financial results have fluctuated in the past and may continue to fluctuate in the future based on a number of factors, many of which are beyond our control. Factors that may cause our operating results to vary or fluctuate include those discussed immediately below, as well as in the “Risk Factors” section of this prospectus.

 

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Liquidity and Capital Resources

 

     Year Ended December 31,     Three Months
Ended March 31,
 
     2007     2008    2009     2009     2010  
                         

Consolidated Statements of Cash Flow Data:

           
(in thousands)                              

Net cash provided by operating activities

   $ 7,421      $ 12,062    $ 14,308      $ 3,012      $ 2,529   

Net cash provided by (used in) investing activities

     (25,482      17,165      (16,862     (822     (4,450

Net cash provided by (used in) financing activities

     20,710        1,323      (979     (135     (752

Capital Expenditures (1)

     2,479        5,152      5,805        892        1,777   

 

(1) Represents purchases of property and equipment and the amount of software development costs capitalized, on an aggregate basis, excluding stock-based compensation and the acquisition of ReachLocal Australia (see Note 4 to the consolidated financial statements).

At March 31, 2010, we had cash and cash equivalents of $32.8 million and short-term investments of $8.1 million. Cash and cash equivalents consist of cash, money market accounts, certificates of deposit and commercial paper. Short term investments consist of certificates of deposit. To date, we have experienced no loss of our invested cash, cash equivalents or short-term investments. We cannot, however, provide any assurances that access to our invested cash, cash equivalents and short-term investments will not be impacted by adverse conditions in the financial markets.

At March 31, 2010, we had no long-term indebtedness for borrowed money and are not subject to any restrictive bank covenants. At March 31, 2010, we had $1.1 million in restricted certificates of deposit to secure letters of credit issued to landlords and as security for certain other operating activities.

At March 31, 2010, our contractual or purchase commitments for capital expenditures that were not reflected on our balance sheet as a liability were less than $0.1 million, such amounts representing unfilled purchase orders of computer equipment. In addition, at March 31, 2010, we had significant internal product and technology resources working on projects that met the criteria for capitalization as software development costs and others that did not, although none of the projects in process were long-term projects (greater than one year). The amount capitalized for such projects in future periods will be determined under the guidance of ASC Topic 350-40 as discussed in the section entitled “Critical Accounting Policies—Software Development Costs” and will impact the portion of costs for those internal resources that reduces net cash provided by operating activities and the portion of such costs that reduces net cash provided by investing activities. Funding for the committed capital expenditures, including software development costs, is expected to be provided by operating cash flow, proceeds from this initial public offering and cash on hand as described below.

Prior to 2007, we financed our operations and capital expenditures through private sales of preferred stock. Since 2007, we have financed our operations, our expansion of our IMC salesforce and the extension of our Direct Local channel into new territories through cash provided by operations. Deferred revenue arising from prepayment by the great majority of our clients and vendor trade financing, principally for the purchase of media, are major components of our cash flow from operations, and the cash provided by deferred revenue and accounts payable has increased since the beginning of 2007 as our business has continued to grow. In general, to the extent our revenue from our Direct Local channel continues to grow, we would expect both the amount of deferred revenue from customer prepayments and the amount of vendor financing for purchased media to increase, which, subject to offset from changes in other operating costs, cash demands or vendor terms, would result in an increase in net cash provided by operations. Should revenue from the Direct Local channel decrease, the amount of deferred revenue and vendor financing would likely decrease, which, subject to changes in other accounts, would cause net cash provided by operations to be reduced, potentially to a negative amount.

Although we expect that cash flow from operations, existing cash balances and proceeds from our initial public offering will be sufficient to continue funding our expansion activities, these investments, including investments in developing new products and services for our clients, could require us to seek additional equity or debt financing, and that financing may not be available on terms favorable to us or at all. In addition, expansion

 

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in the number of IMCs and rapid expansion of new products and services for our clients could require significant capital and entail non-capitalized expenses that could diminish our income from operations. Further, in light of the additional capital provided by our initial public offering and assuming a stable macroeconomic climate, we intend to increase our investment in Underclassmen and in the development of new products.

Operating Activities

Operating activities provided $2.5 million of cash in the first quarter of 2010. The cash flow from operating activities resulted from changes in our operating assets and liabilities, which primarily reflected an increase in deferred revenue of $2.1 million. We had a net loss for the first quarter of 2010 of $2.3 million, which included non-cash depreciation and amortization of $1.2 million and non-cash stock-based compensation of $1.1 million.

Operating activities provided $3.0 million of cash in the first quarter of 2009. The cash flow from operating activities resulted from changes in our operating assets and liabilities, with accounts payable and accrued liabilities increasing $2.2 million and deferred revenue increasing $1.2 million. We had a net loss for the first quarter of 2009 of $2.3 million, which included non-cash depreciation and amortization of $0.7 million and non-cash stock-based compensation of $0.5 million.

Operating activities provided $14.3 million of cash in 2009. The cash flow from operating activities primarily resulted from changes in our operating assets and liabilities, with accounts payable and accrued liabilities increasing $8.4 million and deferred revenue increasing $6.2 million. Accounts payable at December 31, 2009 includes approximately $2.1 million in deferred expenses relating to our initial public offering. Net income of $10.0 million included a non-cash gain of $16.2 million from our purchase of the remaining interest in ReachLocal Australia.

Our operating activities provided $12.1 million of cash in 2008, with accounts payable and accrued liabilities increasing $10.8 million and deferred revenue increasing $4.9 million. We had a net loss in 2008 of $7.0 million, which included non-cash depreciation and amortization of $1.9 million and non-cash stock-based compensation of $1.8 million.

Our operating activities provided $7.4 million of cash in 2007, with accounts payable and accrued liabilities increasing $4.8 million and deferred revenue increasing $4.1 million. We had a net loss in 2007 of $2.6 million, which included non-cash depreciation and amortization of $0.9 million and non-cash stock-based compensation of $0.4 million.

Investing Activities

Our primary investing activities have consisted of purchases of property and equipment, capitalized software development costs and purchases and sales of short-term investments. Our purchases of property and equipment and capitalized software may vary from period to period due to the timing of the expansion of our operations and our software development efforts. During the first quarter of 2010, we invested $2.8 million, net of cash acquired, in the purchase of SMB:LIVE. In addition, in 2009, we invested $3.1 million, net of cash acquired, in the purchase of the remaining interest in ReachLocal Australia. We expect to continue to use capital for purchases of property and equipment and development of software.

Prior to our issuance of 6.0 million shares of preferred stock in 2007, which we refer to as our Series D financing and is discussed further below, we held our excess monies in demand deposits, mutual funds or short- term (less than one year maturity) certificates of deposit. After the Series D financing, we invested $23.4 million in short-term investments, including auction rate securities, which were subsequently liquidated in 2008 for the face amount of principal plus contractual interest, and we now hold all of our excess monies solely in demand deposits, mutual funds or short-term (less than one year maturity) certificates of deposit and directly held obligations of the US government with a maturity of less than 3 months. In addition to the US dollar, these excess monies are deposited in the currencies of our international operations and are subject to appreciation and depreciation based on movements in exchange rates.

 

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Financing Activities

Our financing activities have consisted primarily of net proceeds from the issuance and repurchase of common and preferred stock. During 2006, we issued 3.7 million shares of preferred stock for net proceeds of $5.0 million. In 2007, we issued 6.0 million shares of preferred stock for net proceeds of $53.0 million, of which $32.1 million were used to repurchase 3.3 million outstanding shares of existing preferred and common shares. In 2008, we issued 0.1 million shares of common stock for net proceeds of $1.3 million.

On September 11, 2009, we acquired the approximately 53% of ReachLocal Australia that we did not already own. In exchange for all of the outstanding shares of ReachLocal Australia held by our joint venture partner and certain employees of ReachLocal Australia, we paid total consideration of approximately $17.9 million, which consisted of the issuance of 598,665 shares of common stock with a value of $6.2 million, a cash payment in the amount of $5.8 million and a non-interest bearing deferred payment obligation with a face amount of $6.1 million, recorded net of imputed interest at $5.9 million. The deferred payment obligation is due on the earlier of September 11, 2010 or the consummation of our initial public offering or a liquidating transaction.

In 2009, we incurred $3.1 million in deferred offering costs in anticipation of our initial public offering. During the first quarter of 2010, we incurred $1.4 million in deferred offering costs in anticipation of our initial public offering.

Quantitative and Qualitative Disclosure About Market Risk

We are exposed to market risk in the ordinary course of our business. These risks primarily include interest rate, foreign exchange and inflation risks.

Interest Rate Fluctuation Risk

We do not have any long-term indebtedness for borrowed money. Our investments include cash, cash equivalents and short-term investments. Cash and cash equivalents and short-term investments consist of cash, money market accounts and certificates of deposit. The primary objective of our investment activities is to preserve principal while maximizing income without significantly increasing risk. We do not enter into investments for trading or speculative purposes. Our investments are exposed to market risk due to a fluctuation in interest rates, which may affect our interest income and the fair market value of our investments. Due to the short-term nature of our investment portfolio, we do not believe an immediate 10% increase in interest rates would have a material effect on the fair market value of our portfolio, and therefore we do not expect our operating results or cash flows to be materially affected to any degree by a sudden change in market interest rates.

Foreign Currency Exchange Risk

We have foreign currency risks related to our revenue and operating expenses denominated in currencies other than the U.S. dollar, principally the British pound sterling, the Canadian dollar, the Australian dollar and the Indian Rupee. An unfavorable change in these exchange rates relative to the dollar would result in an unfavorable impact on revenue and operating income. For the first quarter of 2010, an unfavorable 10 percent change in exchange rates would result in a decrease in revenue of $1.1 million and a decrease in our operating loss for the period of less than $0.1 million. We currently do not hedge or otherwise manage our currency exposure given the immaturity and lesser predictability of our international operations. As a result of our acquisition of the portion of ReachLocal Australia that we did not previously own and as our international operations mature, our risks associated with fluctuations in currency rates will become greater, and we will continue to reassess our approach to managing this risk. In addition, currency fluctuations or a weakening U.S. dollar can increase the costs of our international expansion.

 

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Inflation Risk

We do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition and results of operations.

Off-Balance Sheet Arrangements

As of March 31, 2010, we did not have any off-balance sheet arrangements.

Contractual Obligations

The consideration we paid for the shares of ReachLocal Australia that we did not own includes a deferred payment obligation of $6.1 million. This deferred payment obligation is due on the earlier of September 11, 2010 or the consummation of our initial public offering or other liquidating transaction.

The consideration we paid for SMB:LIVE includes a deferred payment obligation of up to approximately $5.7 million of which $4.7 million is payable in shares of the Company’s common stock, based on the offering price of a share of our common stock to the public in connection with our initial public offering, and the balance is payable in cash. This deferred payment obligation, which is payable in three tranches through February 2012, is subject to the achievement of certain employee retention objectives.

We lease our primary office space in Woodland Hills, California and other locations under various non-cancelable operating leases that expire between 2010 and 2013. We have no debt obligations. All property and equipment have been purchased for cash, and we have no capital lease obligations recorded in the financial statements. We have no material long-term purchase obligations outstanding with any vendors or third parties other than the deferred purchase note related to ReachLocal Australia discussed above and minimum payment requirements by an Internet search company in one of our international markets.

Contractual obligations at December 31, 2009 are as follows:

 

Year Ended December 31:

   Payments Under
Operating Leases
   Purchase
Obligations(1)(2)
     (in thousands)    (in thousands)

2010

   $ 5,220    $ 235

2011

     3,925   

2012

     2,507   

2013

     1,909   

2014

     894   

Thereafter

     2,474   
             

Total future minimum payments

   $ 16,929    $ 235
             

 

(1) Represents obligations denominated in Australian dollars, which have been translated to United States dollars based on exchange rates on February 9, 2010.
(2) Table does not include contractual obligations in connection with acquisitions of SMB:LIVE and RL Australia.

Recently Issued Accounting Standards

Effective July 1, 2009, we adopted the Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or the ASC or the Codification, and the Hierarchy of Generally Accepted Accounting Principles under ASC Topic 105. This standard establishes only two levels of U.S. generally accepted accounting principles, or GAAP: authoritative and nonauthoritative. The Codification became the source of authoritative, nongovernmental GAAP, except for rules and interpretive releases of the SEC, which are sources of authoritative GAAP for SEC registrants. All other non-grandfathered, non-SEC accounting literature not included in the

 

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Codification became nonauthoritative. We began using the new guidelines and numbering system prescribed by the Codification when referring to GAAP, and references to specific accounting authority within the ASC are referred to by their Topic number. As the Codification was not intended to change or alter existing GAAP, it did not have a material impact on our financial statements.

ASC Topic 810, Consolidation, eliminates the quantitative approach previously required for determining the primary beneficiary of a variable interest entity and requires ongoing qualitative reassessments of whether an enterprise is the primary beneficiary of a variable interest entity. Additionally, this pronouncement requires additional disclosures about an enterprise’s involvement in variable interest entities and is effective for us as of January 1, 2009. The adoption of this pronouncement did not have a material impact on our consolidated financial statements.

ASC Topic 260-10, Earnings per Share, provides that unvested stock-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. Upon adoption, companies are required to retrospectively adjust their earnings per share data (including any amounts related to interim periods, summaries of earnings and selected financial data) to conform to this pronouncement. This pronouncement is effective for us as of January 1, 2009. The adoption of this pronouncement did not have a material impact on our consolidated financial statements.

ASC Topic 805, Business Combinations, establishes principles and requirements regarding how an acquirer in a business combination recognizes and measures the assets acquired, liabilities assumed, contingent consideration, contractual contingencies and any noncontrolling interest in the acquiree and addresses the recognition and measurement of goodwill acquired in a business combination. This guidance also requires certain disclosures to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This pronouncement is effective for us as of January 1, 2009. We have applied this standard in recording the acquisition of ReachLocal Australia.

ASC Topic 350-30, Intangibles—Goodwill and Other, General Intangibles Other than Goodwill, requires companies estimating the useful life of a recognized intangible asset to consider their historical experience in renewing or extending similar arrangements or, in the absence of historical experience, to consider assumptions that market participants would use about renewal or extension. This pronouncement is effective for us as of January 1, 2009 and the adoption did not have a material effect on our consolidated financial statements.

ASC Topic 820, Fair Value Measurements and Disclosures, delays the effective date of certain fair value measurements to fiscal years beginning after November 15, 2008 for all nonfinancial assets and liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). Assets and liabilities subject to this deferral include goodwill, intangible assets and long-lived assets measured at fair value for impairment assessments, and nonfinancial assets and liabilities initially measured at fair value in a business combination. This pronouncement is effective for us as of January 1, 2009 and the adoption did not have a material effect on our consolidated financial statements as we have not remeasured any of our non-financial assets or liabilities.

ASC Topic 810-10-65-1, Consolidation—Overall, Transition, establishes accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. This pronouncement is effective for fiscal years beginning on or after December 15, 2008. This pronouncement is effective for us as of January 1, 2009. We have no minority interests reported in the financial statements, thus the adoption of this pronouncement did not have a material effect on our consolidated financial statements.

ASC Topic 855-10, Subsequent Events, establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The adoption of ASC 855-10 did not have a material impact on our consolidated financial statements. We have considered subsequent events up to the date of this filing in preparing the consolidated financial statements appearing elsewhere in this prospectus.

 

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Effective June 30, 2009, we adopted three Accounting Standard Updates, or ASUs, which were intended to provide additional application guidance and enhanced disclosures regarding fair value measurements and impairments of securities. They also provide additional guidelines for estimating fair value in accordance with fair value accounting. The first ASU, as codified in ASC Topic 820-10 provides additional guidelines for estimating fair value in accordance with fair value accounting. The second ASU, as codified in ASC Topic 320-10 changes accounting requirements for other-than-temporary-impairment (OTTI) for debt securities by replacing the current requirement that a holder have the positive intent and ability to hold an impaired security to recovery in order to conclude an impairment was temporary with a requirement that an entity conclude it does not intend to sell an impaired security and it will not be required to sell the security before the recovery of its amortized cost basis. The third ASU, as codified in ASC Topic 825-10 increases the frequency of fair value disclosures. These updates are effective for fiscal years and interim periods ended after June 15, 2009. The adoption of these accounting updates did not have a material impact on our financial statements.

In October 2009, ASU No. 2009-13, Multiple-Deliverable Revenue Arrangements, or ASU 2009-13, was issued. This ASU, as codified in ASC Topic 605-25 amends existing revenue recognition accounting pronouncements that are currently within the scope of ASC Topic 605-25. The consensus to ASU 2009-13 provides accounting principles and application guidance on whether multiple deliverables exist, how the arrangement should be separated, and the consideration allocated. This guidance eliminates the requirement to establish the fair value of undelivered products and services and instead provides for separate revenue recognition based upon management’s estimate of the selling price for an undelivered item when there is no other means to determine the fair value of that undelivered item. This new approach is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 and allows for retroactive application. This pronouncement is effective for us as of January 1, 2011. We are currently evaluating the potential impact of this standard on our financial position and results of operations.

 

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BUSINESS

Business Overview

Our mission is to help small and medium-sized businesses, or SMBs, acquire, maintain and retain customers via the Internet. We offer a comprehensive suite of online marketing and reporting solutions, including search engine marketing, display advertising, remarketing and online marketing analytics, each targeted to the SMB market. We deliver these solutions to SMBs through a combination of our proprietary RL Platform and our direct, “feet-on-the-street” sales force of Internet Marketing Consultants, or IMCs, and select third-party agencies and resellers.

We use our RL Platform to create advertising campaigns for SMBs to target potential customers in their geographic area, optimize those campaigns in real time and track tangible results. Through a single Internet advertising budget, we enable our clients to reach local customers across all the major search engines and leading general interest and vertically focused online publishers. Based in or near the cities in which our clients operate, our IMCs establish a direct consultative relationship with our clients and, empowered by the RL Platform, work with the clients to achieve their marketing objectives

At March 31, 2010, we managed 19,700 Active Campaigns across 15,700 Active Advertisers, a substantial majority of which we calculate spend from $500 to $3,000 per month with us. Our clients include SMBs in a number of industry verticals, such as home repair and improvement, automobile sales and repair, medical and health services, legal services and retail and personal services. Since inception, we have delivered to our SMB clients more than 330 million geographically targeted clicks and 25 million phone calls. We employ 569 IMCs in North America, Australia and the United Kingdom and work with over 350 third-party agencies and resellers that use the RL Platform to serve their SMB clients. We intend to expand our IMC sales force both in existing and new markets.

We generate revenue by providing online advertising solutions for our clients through our ReachSearch, ReachDisplay, Remarketing, TotalTrack and other products and services. We reported $203.1 million in revenue in 2009 and $146.7 million in revenue in 2008, an increase of 38.5%, as well as a $6.0 million loss from operations in 2009 and a $7.0 million loss from operations in 2008. We reported $63.6 million in revenue in the three months ended March 31, 2010, an increase of 48.9% from the same period in 2009, as well as a $2.9 million loss from operations.

Industry Overview

The Local SMB Advertising Market

SMBs serving local markets represent significant economic activity, control substantial purchasing power and address the needs of hundreds of millions of consumers. These SMBs include businesses such as lawyers, physicians, car dealers, dentists, plumbers, florists and local operations of national chains. According to Borrell Associates, there were more than 15 million businesses with less than 50 employees in the United States in 2008. According to the Office for National Statistics, t