LOOKSMART LTD - 10-Q Quarterly Report

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨

As of August 2, 2004, there were 112,690,068 shares of the registrant’s common stock outstanding.

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

LookSmart (the Company) is a provider of commercial search services and a developer of innovative web search solutions. The Company provides consumers with highly relevant search results through a distribution network that includes LookSmart.com and other portals and ISPs, while delivering targeted sales leads to online businesses.

The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Investments in 20% to 50% owned partnerships and affiliates are accounted for by the equity method and investments in less than 20% owned affiliates, over which the Company does not exert any significant influence, are accounted for by the cost method. As of June 30, 2004, the Company does not have any investments accounted for under either the equity method or the cost method.

Certain prior years’ balances have been reclassified to conform to the current year’s presentation. In the first six months of 2003, payments to distribution partners for referral of customers to our LookListings program were reflected as sales and marketing expense. These costs have been reclassified and are reflected in cost of revenue. The amount reclassified in the first six months of 2003 was $2.5 million.

Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents and accounts receivable. The Company’s short-term investments are managed by one institution. The Company maintains an allowance for doubtful accounts receivable based upon expected collectibility.

The Company derived approximately 18% and 14% of its listings revenues in the three and six months ended June 30, 2004 and less than 10% in the three and six months ended June 30, 2003, respectively, from its relationship with Interchange Corporation.

The Company derived approximately 16% and 18% of its listings revenues in the three and six months ended June 30, 2004, respectively, and less than 10% in the three and six months ended June 30, 2003, respectively, from its relationship with Mamma.com.

The Company derived less than 10% and 22% of its listings revenue in the three and six months ended June 30, 2004, respectively, and 69% and 70% of its listings revenues in the three and six months ended June 30, 2003, respectively, from its relationship with Microsoft.

The Company derived 100% of the licensing revenues in 2003 and 2004 from the Company’s relationship with Microsoft.

The Company accounts for stock-based employee compensation under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (APB No. 25) and related interpretations. Under APB No. 25, compensation cost is equal to the difference, if any, on the date of grant between the fair value of the Company’s stock and the amount an

employee must pay to acquire the stock. Statement of Financial Accounting Standards SFAS 123 (“SFAS 123”), “Accounting for Stock-based Compensation,” established accounting and disclosure requirements using a fair value based method of accounting for stock-based employee compensation plans. As allowed by SFAS 123, the Company has elected to continue to apply the intrinsic value based method of accounting described above, and has adopted the disclosure requirements of SFAS 123 and related Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (“SFAS 148”).

The following table illustrates the effect on net income (loss) and net income (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation (in thousands, except per share data):

For purposes of computing pro forma net income (loss), the Company estimates the fair value of each option grant on the date of grant using the Black-Scholes option pricing model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, characteristics not present in the Company’s option grants. Additionally, option valuation models require the input of highly subjective assumptions, including the expected volatility of the stock price. Because the Company’s employee stock options and employee stock purchase plans have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimates, in management’s opinion, the existing models do not provide a reliable single measure of the fair value of its stock-based awards.

Options vest over several years, and new option awards are generally granted each year. Because of this, the pro forma amounts shown above may not be representative of the pro forma effect on reported net income in future years.

In 2003, the Company had two operating segments: listings and licensing. As of January 1, 2004, the Company reduced to one operating segment, listings, due to the expiration of the Company’s only licensing agreement with Microsoft in January of 2004.

With the exception of accounts receivable, deferred revenue and goodwill, information (for the purposes of making decisions about allocating resources) available to the chief operating decision makers, the Chief Executive Officer and the Chief Financial Officer, the Company did not include allocations of assets and liabilities or operating costs to the Company’s segments in 2003. As of June 30, 2004 and

December 31, 2003, all of the Company’s accounts receivable, intangible assets, goodwill and deferred revenue related to the listings segment.

In December 2003, the FASB issued Interpretation No. 46R (“FIN 46R”), a revision to FIN 46. FIN 46R clarifies some of the provisions of FIN 46, “Consolidation of Variable Interest Entities”, and exempts certain entities from its requirements. FIN 46R is effective at the end of the first interim period ending after December 15, 2003. The adoption of FIN 46R did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In December 2003, the SEC issued Staff Accounting Bulletin No. 104 (“SAB 104”), “Revenue Recognition”, which supercedes Staff Accounting Bulletin No. 101 (“SAB 101”), “Revenue Recognition in Financial Statements.” The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, which was superceded as a result of the issuance of Emerging Issues Task Force 00-21 (“EITF 00-21”), “Accounting for Revenue Arrangements with Multiple Deliverables.” SAB 104 also incorporated certain sections of the SEC’s “Revenue Recognition in Financial Statements—Frequently Asked Questions and Answers” document. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The adoption of SAB 104 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In March 2004, the FASB approved the consensus reached on the Emerging Issues Task Force (“EITF”) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance for identifying impaired investments and new disclosure requirement for investments that are deemed to be temporarily impaired. The accounting provisions of EITF 03-1 are effective for all reporting periods beginning after June 15, 2004, while the disclosure requirements are effective only for annual periods ending after June 15, 2004. The Company does not believe the impact of adopting EITF 03-1 will be significant to its overall results of operations or financial position.

On April 22, 2004, the Company acquired the business and certain assets of NetNanny, a division of Bionet Systems LLC, a privately held company, for $850,000 in cash, 1,972,387 million shares of common stock, valued at $4.2 million and $27,000 of costs related to completing the transaction. NetNanny is a desktop-based product, which provides online parental control and content filtering of search results.

The common stock issued was valued at $2.15 per share in accordance with EITF Issue No. 99-12, “Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination,” using the average of the closing prices of the Company’s common stock for the two days prior to and including April 22, 2004, which was prior to the announcement date of April 29, 2004.

Purchased technology and other intangible assets acquired are being amortized over their estimated useful lives of two to six years. The consolidated financial statements include the operating results of NetNanny from the date of purchase. Pro forma results of operations have not been presented because the effect of this acquisition was not material to the results of prior periods presented.

The following table summarizes the purchase price allocation. These amounts were determined through established valuation techniques in the technology industry (In thousands):

The accompanying unaudited condensed consolidated financial statements reflect all adjustments which are normal recurring in nature and, in the opinion of management, are necessary for a fair statement of the results of operations for the periods shown. The results of operations for such periods are not necessarily indicative of the results expected for any full fiscal year or for any future period.

Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to the Securities and Exchange Commission’s rules and regulations. The year-end condensed consolidated balance sheet data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States. These unaudited interim condensed consolidated financial statements should be read in conjunction with LookSmart’s audited consolidated financial statements and notes for the year ended December 31, 2003 included in its Annual Report on Form 10-K, filed with the Securities and Exchange Commission.

The Company’s intangible assets consist primarily of purchased technology and have estimated useful lives of two to seven years. The Company performs an annual reassessment of the expected useful lives of existing intangible assets. This reassessment did not result in any significant changes to the useful lives. Goodwill and intangible assets are as follows (in thousands):

Intangible asset amortization expense was $0.4 million and $0.8 million for the three and six months ended June 30, 2004, respectively, and $0.5 and $1.0 for the three and six months ended June 30, 2003, respectively, and are included in cost of revenue and product development costs.

Accrued expenses and other current liabilities consisted of the following (in thousands):

The Company leases office space under non-terminable operating leases that expire at various dates through 2009.

Future minimum payments under all operating leases, in total and net of minimum sublease income, at June 30, 2004 are as follows (in thousands):

The Company has a $1.6 million Standby Letter of Credit (“SBLC”) with a financial institution in support of the building lease of the Company’s headquarters.

The above SBLC contains two financial covenants, the first requiring a minimum net worth of $20 million and the second requiring minimum liquid assets, as defined by the agreement, of $40 million. At June 30, 2004, the Company was in compliance with both covenants.

During its normal course of business, the Company has made certain guarantees, indemnities and commitments under which it may be required to make payments in relation to certain transactions. These indemnities include intellectual property and other indemnities to the Company’s customers and distribution partners in connection with the sales of its products, indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease, and indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of Delaware. Historically, we have not incurred any losses or recorded any liabilities related to performance under these types of indemnities.

In August 2004, Mario Cisneros and Michael Voight filed a proposed class action lawsuit in Superior Court in San Francisco County. The complaint named thirteen search engines or web publishers as defendants (including the Company) and alleged unfair business practices, unlawful business practices and other causes of action in connection with the display of advertisements from Internet gambling companies. The complaint sought restitution, unspecified compensatory damages, injunctive relief and attorneys’ fees. The Company has not filed an answer to the complaint.

Pursuant to the settlement agreement with British Telecommunications (“BT”) for the dissolution of the joint venture, LookSmart and BT are jointly liable for the costs incurred to shut down operations of the joint venture. The Company does not expect to incur significant additional expenses to shut down the joint venture.

In accordance with the requirements of SFAS No. 128, a reconciliation of the numerator and denominator of basic and diluted loss per share is provided as follows (in thousands, except per share amounts):

Options and warrants to purchase common stock are not included in the diluted income (loss) per share calculations if their effect is antidilutive. The antidilutive securities include potential common stock relating to stock options and warrants as follows (in thousands):

In 2002, the Company loaned Dianne Dubois, the Company’s former Chief Financial Officer, $0.3 million. The loan was interest-free and subject to forgiveness ratably over a period of four years, subject to certain performance measures being met. In addition, the Company has agreed to pay taxes due related to forgiveness of the loan and imputed interest. The amount of imputed interest and tax adjustments charged to operations were $3,000 and $3,000, respectively, for the three months ended June 30, 2004, respectively, and $6,000 and $6,000 for the six months ended June 30, 2004. The amount forgiven, imputed interest and tax adjustments were $0, $3,000 and $3,000 for the three months ended June 30, 2003 and $16,000, $7,000 and $35,000 for the six months ended June 30, 2003. Due to the resignation of the Chief Financial Officer in 2003, the outstanding unforgiven balance of $0.2 million was due no later than June 30, 2004, and has not yet been paid.

A former member of the Company’s Board of Directors became a member of senior management of a significant customer in late 2003. Revenue associated with this customer was less than 5% of total revenue in the first six months of 2004. This member of the Board of Directors resigned in July 2004 due to increasing demands on his time placed on him in his role of Chief Financial Officer of the significant customer.

In November 2003, the Company implemented a restructuring plan to eliminate 115 redundant positions worldwide due to the loss of the ongoing relationship with Microsoft. The reduction affected all departments within the Company. Of the 115 positions, 69 were from the Company’s editorial team, which is included in product development. The remaining positions included a reduction in the Company’s sales force of 29 positions, a reduction in the Company general and administrative departments of 13 positions and an additional reduction in the Company’s product development department of 4 positions. The substantial portion of all severance costs have been paid as of June 30, 2004. The restructuring in the fourth quarter of 2003 included severance charges associated with the reduction in force of $1.0 million and costs related to closing redundant leased facilities of $3.1 million. These reductions were designed to significantly reduce costs in 2004.

In the first quarter of 2004, the Company announced that it eliminated an additional 33 positions worldwide. Of the 33 positions, 13 were from the Company’s editorial team. The remaining positions included a reduction in the Company’s sales force of 12 positions, a reduction in the Company’s general and administrative departments of 1 position and a reduction in the Company’s product development department of 7 positions. This reduction resulted in a $0.5 million restructuring charge recognized in the first quarter of 2004. All severance costs have been paid as of June 30, 2004. Also in the first quarter of 2004, the Company incurred an additional restructuring expense of $3.2 million on further leased facilities that were vacated during the period.

In the second quarter of 2004, the Company announced that it eliminated an additional 14 positions in the United States, which included a reduction in the Company’s sales force of 3 positions, a reduction in the Company’s general and administrative departments of 4 positions and a reduction in the Company’s product development department of 7 positions. This reduction resulted in a $0.4 million restructuring charge recognized in the second quarter of 2004. All severance costs will be paid by the end of the third quarter of 2004.

These costs were classified as restructuring charges on the Statement of Operations and Comprehensive Income (Loss), and included in Operating Expenses. As of June 30, 2004 the restructuring liability was $6.6 million. Of this amount, $1.5 million was included in other accrued liabilities and $5.1 million was included in other long-term liabilities on the Consolidated Balance Sheet.

A reconciliation of the liability for the restructuring charge of 2003 and the six months ended June 30, 2004 for severance and lease restructuring costs is as follows (in thousands):

In the first quarter of 2003, the Company recognized an extraordinary gain, net of tax, of $0.2 million in connection with the dissolution of BT LookSmart and the assumption of its Japan and United Kingdom operations. This amount represents the fair value of net assets of the Japan and United Kingdom operating entities of BT LookSmart. The Company acquired these net assets on March 14, 2003 for nominal consideration. The results of these operating entities have been included in the Company’s consolidated financial statements as of March 1, 2003.

In the first quarter of 2004, the Company signed agreements to sell certain of the assets and activities of its international subsidiaries for approximately $1.5 million. The assets include fixed assets with a carrying value of $0.1 million and intellectual property rights with a carrying value of zero. The Company continued to operate the subsidiaries through transition periods ending in the second quarter of 2004 and retained the rights to revenues generated on existing customers and significant risks and rewards of the businesses during these transition periods. The gain on the disposal of the operations is shown net of adjustments of $0.4 million for transition expenses.

In the second quarter of 2004, substantially all of the Company’s ongoing involvement in the international operations ceased and the Company recognized the gain from discontinued operations of $1.0 million, substantially all of which related to the gain on disposal.

Pretax net income (loss) from discontinued operations includes approximately $0.4 related to the reversal of the allowance for bad debts in the second quarter of 2004, as substantially all accounts have been collected in certain locations.

Revenue and pretax net income from international operations, previously included in the listings segment of the business, reported in discontinued operations were as follows (in thousands):

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

The following discussion should be read in conjunction with the consolidated financial statements and the notes to those statements which appear elsewhere in this Quarterly Report on Form 10-Q. The following discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We use words such as “believes,” “intends,” “expects,” “anticipates,” “plans,” “may,” “will” and similar expressions to identify forward-looking statements. All forward looking statements, including but not limited to, projections or estimates concerning our business, including demand for our products and services, mix of revenue streams, ability to control and/or reduce operating expenses, anticipated gross margins and operating results, cost savings, product development efforts, general outlook of our business and industry, future profits or losses, opportunities abroad, competitive position, integration of our search services into recent acquired products to differentiate us from our competitors, stock compensation and adequate liquidity to fund our operations and meet our other cash requirements, are inherently uncertain as they are based on our expectations and assumptions concerning future events. These forward-looking statements are subject to numerous known and unknown risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including our ability to regain net profitability in future quarters, our ability to expand and diversify our network of distribution partners, the success of our listings business and all other risks described below in the section entitled “Factors Affecting Operating Results” and elsewhere in this report. All forward-looking statements in this document are made as of the date hereof, based on information available to us as of the date hereof, and we assume no obligation to update any forward-looking statements.

LookSmart is a provider of Internet search solutions for portals, Internet service providers and media companies, as well as a provider of marketing products for advertisers who want to be included in relevant search results. Our LookListings suite of products provides businesses of all sizes the opportunity to have listings for their company and products included in our broadly distributed web search results, so that their listings are available to Internet users at the moment when they are searching for relevant information. By enabling advertisers to reach millions of users in a highly targeted search context, we provide a proven method of acquiring customers, converting advertising leads into sales and generating useful marketing information for individual customer campaigns. Our campaign reporting technology enables advertisers to

monitor the performance of their search marketing campaigns and request additions or changes to their listings through the use of password-protected online accounts.

We distribute our search results across a distribution network by partnering with Internet portals, ISP’s, search engines and media companies. These companies have increasingly recognized the valuable nature of search services for their web sites. We offer distribution partners a search solution with two important benefits. First, our search solution provides highly relevant search results for their users, which can help to maintain the users’ satisfaction and increase repeat visits of those users. Second, we share with our distribution partners a portion of the listings revenues that we generate from clicks on paid listings in those search results.

In preparing our consolidated financial statements, we make assumptions, judgments and estimates that can have a significant impact on our revenue, operating income and net income, as well as on the value of certain assets and liabilities on our consolidated balance sheet. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. On a regular basis we evaluate our assumptions, judgments and estimates and make changes accordingly.

The following discussion highlights those policies and the underlying estimates and assumptions, which management considers critical to an understanding of the financial information in this report. Historically, our assumptions, judgments and estimates relative to our critical accounting policies have not differed materially from actual results.

Revenue Recognition. Revenues associated with listings products, including LookListings and affiliate commissions are generally recognized once collectibility is established, as delivery of services occurs, once all performance obligations have been satisfied, and when no refund obligations exist. Upfront fees are recognized ratably over the longer of the term of the contract or the expected relationship with the customer, which is currently estimated to be twelve months.

Listings revenue generated from our LookListings platform is primarily composed of per-click fees that we charge customers. The per-click fee charged for inclusion-targeted listings is set by the customer when the account is established. The per-click fee charged for keyword targeted listings is calculated based on the results of online bidding on keywords, up to a maximum cost per keyword set by the customer.

Affiliate revenues are included in listings revenue and are based on commissions received for participation in affiliate programs. Affiliate programs are programs operated by affiliate network services or online merchants, in which merchants pay traffic providers on a cost-per-acquisition basis. By participating in affiliate programs, we generate revenues when Internet users make a purchase from a participating merchant’s web site after clicking on the merchant’s listing in our search results. Revenues from affiliates are earned on a per-sale basis or as a percentage of sale rather than a per-click basis. Revenue is recognized in the period in which a merchant finalizes a sale and reports to the Company via its affiliate network.

Revenues associated with our licensing agreement with Microsoft were recognized in the period in which URLs were added to the database and the database was delivered to Microsoft. Payments from Microsoft received in advance of delivery were recorded as deferred revenues. We recognized quarterly licensing revenues under this contract based on the number of URL listings added to our database during the quarter relative to the total number of URL listings we were required to add to our database during the relevant six-month period. Due to the expiration of our agreement with Microsoft, we will no longer recognize revenue associated with licensing after January 2004. In addition, our distribution agreements with About.com’s Sprinks and Yahoo’s Inktomi, which collectively accounted for approximately 9.5% of our listings revenues in 2003, expired in December 2003 and February 2004, respectively.

Determination of collectibility of payments requires significant judgment on the part of management and includes performing initial and ongoing credit evaluations of customers. The Company provides an allowance for doubtful accounts receivable based upon expected collectibility, which reflects management’s judgment based on ongoing credit evaluation. In addition, the Company provides an allowance against revenue for estimated credits resulting from billing adjustments and sales adjustments in the event of product returns. The amount of this allowance is evaluated quarterly based upon historical trends.

Stock-Based Compensation. The Company accounts for stock-based employee compensation arrangements in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB No. 25”) and related interpretations, and complies with the disclosure provisions of SFAS No. 123, “Accounting for Stock-based Compensation” and SFAS No. 148 “Accounting for Stock-Based Compensation—Transition and Disclosure.” The disclosure provisions of SFAS No. 123 and SFAS No. 148 require judgments by management as to the estimated lives of the outstanding options. Management has based the estimated life of the options on historical option exercise patterns. If the estimated life of the options increases, the valuation of the options will increase as well.

As a result of the repricing of stock options, which primarily occurred in the first quarter of 2001, the Company will incur a charge for compensation expense or a reversal of a charge in connection with variable accounting for outstanding repriced stock options, depending on the market price of the Company’s common stock at the end of each quarter until the repriced stock options are vested, cancelled or forfeited.

Goodwill and Intangible Assets. We have recorded goodwill and intangible assets in connection with our business acquisitions. Management exercises judgment in the assessment of the related useful lives, and the fair value and recoverability of these assets. The majority of intangible assets are amortized over two to seven years, the period of expected benefit. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” the Company periodically reassesses the valuation and asset lives of intangible assets to conform to changes in management’s estimates of future performance. Management considers existing and anticipated competitive and economic conditions in such assessments. Goodwill is reviewed for impairment at least annually and as a result of any event which significantly changes the Company’s business.

The announcement of the termination of the Company’s distribution and licensing agreement with Microsoft was a triggering event, which required the Company to perform the impairment tests at October 6, 2003, the date of the announcement. The impairment analysis was performed based on discounted future cash flows. The Company did not record an impairment as a result of the event-driven analysis. Cash flow forecasts used in evaluation of long-lived assets were based on trends of historical performance and management’s estimate of future performance.

Internal Use Software Development Costs. The Company accounts for internal use software in accordance with American Institute of Certified Public Accountants (“AICPA”) Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” (SOP 98-1). In accordance with the capitalization criteria of SOP 98-1, the Company has capitalized external direct costs of materials and services consumed in developing and obtaining internal-use computer software and the payroll and payroll-related costs of employees who devote time to the internal-use computer software project.

Management’s judgment is required in determining the point at which various projects enter the stages at which costs may be capitalized, in assessing the ongoing value of the capitalized costs on a regular basis, and in determining the estimated useful lives over which the costs are amortized. We expect to continue to invest in internally developed software and to capitalize these costs in accordance with SOP 98-1.

Deferred Taxes. We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying values and the tax bases of assets and liabilities. LookSmart regularly reviews its deferred tax assets for recoverability and establishes a valuation allowance based on historical taxable

income, projected future taxable income, and the expected timing of the reversals of existing temporary differences. If we operate at a loss or are unable to generate sufficient future taxable income, or if there is a material change in the actual effective tax rates or time period within which the underlying temporary differences become taxable or deductible, we could be required to increase the valuation allowance against all or a significant portion of our deferred tax assets which could substantially increase our effective tax rate for such period. Alternatively, if our future taxable income is significantly higher than expected and/or we are able to utilize our tax credits, we may be required to reverse all or a significant part of our valuation allowance against such deferred tax assets which could substantially reduce our effective tax rate for such period. Therefore, any significant changes in statutory tax rates or the amount of our valuation allowance could have a material impact on the value of our deferred tax assets and liabilities, and our reported financial results.

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

During the second quarter of 2004, we continued to focus on three primary operating priorities:

Listings. Listings revenues in the three and six months ended June 30, 2004 decreased compared to the three and six months ended June 30, 2003 due primarily to the winding down of our relationship with Microsoft, which began in January of 2004. This decrease was partially offset by a 74% increase in our core, non-Microsoft, revenue, primarily due to the addition of new distribution partners in the first and second quarters of 2004.

We derived less than 10% and 21% of our listings revenues in the three and six months ended June 30, 2004, respectively, and 69% and 70% of our listings revenues in the three and six months ended June 30, 2003, respectively, from our relationship with Microsoft.

We expect our core, non-Microsoft, listings revenue to increase throughout the remainder of 2004 as we add more distribution partners and proprietary traffic to our network. Listings revenue from continuing operations for 2004 is expected to be between $77 million and $80 million.

Licensing. We exclusively licensed our database content to Microsoft and customized it for their use. We derived all of our licensing revenue from our agreement with Microsoft, which expired on January 15, 2004. We do not expect additional licensing revenue in 2004.

Cost of revenue consists of (1) revenue-sharing payments to distribution partners and fees paid to distribution partners based on the affiliate vendor commissions, or traffic acquisition costs, and (2) other costs, including connectivity costs, personnel costs of our sales operations employees, including stock-

based compensation, equipment depreciation, expenses relating to hosting advertising operations, commissions paid to advertising agencies and amortization of certain intangible assets.

The decrease in cost of revenue in the three and six months ended June 30, 2004 compared to the three and six months ended June 30, 2003 was primarily attributable to the decrease in revenue and the associated decrease in revenue-sharing payments to partners.

We expect traffic acquisition costs as a percent of listings revenue of approximately 53-55% throughout 2004.

Sales and Marketing. Sales and marketing expenses include salaries, commissions, stock-based compensation and other costs of employment for the Company’s sales force, sales administration and customer service staff, overhead, facilities, allocation of depreciation and the provision for reserves for doubtful trade receivables. Sales and marketing expenses also include the costs of advertising, trade shows and public relations activities.

Sales and marketing expenses changed as follows (dollar figures are in thousands):

Stock compensation related to variable options is the result of repriced stock options. It is based on the Company’s stock price at the end of each quarter and will continue to fluctuate as the Company’s stock price fluctuates until the repriced stock options are vested, cancelled or forfeited.

In the first quarter of 2003, the Company released $0.3 million of the allowance for bad debts. The release was due to the improvement in the Company’s rate of collections and applying the improved collection rates to the Company’s accounts receivable balance as of March 31, 2003, net of cash collected subsequent to the end of the period. Bad debt was 4% of selling costs in the three and six months ended June 30, 2004. We expect bad debt to decline during the remainder of 2004 as we continue to focus on improving our collections.

Other sales and marketing expenses decreased primarily due to a reduction of $1.7 million in the three months ended June 30, 2004 compared to the three months ended June 30, 2003 and $2.9 million in the six months ended June 30, 2004 compared to the six months ended June 30, 2003, in salaries, wages and benefits, which was the result of the Company’s restructuring activities. In addition, marketing expenses declined $0.1 million in the three months ended June 30, 2004 compared to the three months ended June 30, 2003 and $0.2 million in the six months ended June 30, 2004 compared to the six months ended June 30, 2003. This reduction was due to the Company’s overall cost reductions efforts. We expect sales and marketing expenses to decrease slightly during the remainder of 2004 as the full impact of the restructuring activities is realized.

Product Development. Product development costs include all costs related to the development and engineering of new products and continued development of our search databases and additional features for

our customer account management platform. These costs include salaries and associated costs of employment, including stock-based compensation, overhead, facilities and amortization of intangible assets. Costs related to the development of software for internal use in the business, including salaries and associated costs of employment, are capitalized. Software licensing and computer equipment depreciation related to supporting product development functions are also included in product development expenses.

Product development expenses changed as follows (dollar figures are in thousands):

Stock compensation related to variable options is the result of repriced stock options. It is based on the Company’s stock price at the end of the period and will continue to fluctuate as the Company’s stock price fluctuates until the repriced stock options are vested, cancelled or forfeited.

The decrease other product development expense for the three months ended June 30, 2004 compared to the three months ended June 30, 2003 included a reduction in salaries and benefits of $1.3 million offset by a write off in the second quarter of $0.8 million in software previously capitalized for projects that were cancelled in the second quarter as they related to projects that are not aligned with our 2004 operating plan. We do not anticipate additional write offs during 2004.

The increase in other product development expenses in the six months ended June 30, 2004 compared to the six months ended June 30, 2003 was due primarily to a reduction in salaries and benefits of $2.7 million due to the restructuring activities starting in the fourth quarter of 2003, offset by $0.9 million in retention bonuses paid to key employees in 2004 and by the write off in the second quarter of $0.8 million in software previously capitalized for projects that were cancelled in the second quarter. We expect other product development expenses to decrease slightly during the remainder of 2004 as the full impact of the restructuring activities is realized.

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

General and administrative expenses changed as follows (dollar figures are in thousands):

Other general and administrative expense decreased in the three months ended June 30, 2004 compared to the three months ended June 30, 2003 primarily due to a decrease in salaries of $0.5 million and a decrease in professional services of $0.4 million. Other professional services in the second quarter of 2003 related to settlement litigation expenses. The decrease in expenses in the six months ended June 30, 2004 compared to June 30, 2003 was due to a decrease in salaries and benefits of $0.8 million and a decrease in professional services of $0.9 million, primarily related to legal settlement expenses in the first half of 2003, partially offset by non-restructuring separation payments of $0.5 million and $0.3 million loss on sale of fixed assets, both of which occurred in the first quarter of 2004. We expect other general and administrative expenses to decrease slightly in during the remainder of 2004 as the full impact of the restructuring activities is realized. However, we anticipate an increase in professional fees in 2004 related to compliance with the Sarbanes-Oxley Act.

In November 2003, the Company implemented a restructuring plan to eliminate 115 positions worldwide due to the loss of the ongoing relationship with Microsoft. The reduction affected all departments within the Company. Of the 115 positions, 69 were from the Company’s editorial team, which is included in product development. The remaining positions included a reduction in the Company’s sales force of 29 positions, a reduction in the Company’s general and administrative departments of 13 positions and an additional reduction in the Company’s product development department of 4 positions. These reductions were designed to significantly reduce costs in 2004. The restructuring included severance charges associated with the reduction in force of $1.0 million and costs related to closing redundant leased facilities of $3.1 million in the fourth quarter of 2003. During the first quarter of 2004, additional costs of $0.1 million in severance costs were recorded related to the fourth quarter restructuring.

In the first quarter of 2004, the Company announced that it eliminated an additional 33 positions in the worldwide. Of the 33 positions, 13 were from the Company’s editorial team. The remaining positions included a reduction in the Company’s sales force of 12 positions, a reduction in the Company’s general and administrative departments of 1 position and a reduction in the Company’s product development department of 7 positions. The first quarter 2004 restructuring included severance charges of $0.5 million associated with the reduction in force and costs related to closing of further redundant leased facilities of $3.2 million.

The Company does not currently expect to incur significant further restructuring charges related to additional reductions in force or additional costs related to closing redundant leased facilities in the remainder of 2004. We believe we are sufficiently resourced to carry out our operating plan for the remainder of 2004.

If it takes longer than expected to sublease the redundant leased facilities, or if available sublease rates change significantly from the assumptions used, the actual costs related to these facilities could exceed estimated accrued facility costs and may require adjustment to the original estimates.

Interest and Other Non-Operating expenses, net. Interest and other non-operating expense decreased significantly in 2004 compared to 2003 due to the reduction in foreign currency translation expenses and expenses related to the BTLS joint venture.

Share of Joint Venture Loss. In 2003, share of joint venture loss included LookSmart’s 50% share of the loss of BT LookSmart. We do not expect significant additional gains or losses from the joint venture in the future.

The reduction in our income tax expense was due to the net loss incurred in the three and six months ended June 30, 2004 compared to net income in the three and six months ended June 30, 2003.

The effective tax rate in the upcoming quarters and for the year ending December 31, 2004 may vary due to a variety of factors, including but not limited to, losses incurred in the quarters, the relative income contribution by tax jurisdiction, changes in statutory tax rates, the amount of tax exempt interest income generated during the year, the ability to utilize foreign tax credits and foreign net operating losses, and any non-deductible items related to acquisitions or other non-recurring charges.

In the first quarter of 2003, as part of the dissolution of the joint venture, BT LookSmart transferred ownership of its directories and of its European and Japanese subsidiaries to LookSmart. LookSmart received net assets of $0.2 million along with the ongoing operating and revenue-generating relationships contained in these entities as part of the dissolution and settlement for nominal consideration. In connection with the acquisition of the joint venture entities, the Company recorded an extraordinary gain of $0.2 million, which represents the fair value of net assets we recorded in excess of the consideration paid upon the acquisition.

Revenue and pretax net income from international operations (excluding gain on disposal), previously included in the listings segment of the business, reported in discontinued operations were as follows (in thousands):

Our primary source of cash is receipts from revenue. Another source of cash is proceeds from the exercise of employee stock options. The primary uses of cash are payroll (salaries, bonuses and benefits), general operating expenses (office rent, marketing, travel) and partner payments, which are included in cost of revenue.

Collections of accounts receivable can impact our operating cash flows. Management places significant emphasis on collection efforts and has assessed the allowance for doubtful accounts as of June 30, 2004 and has deemed it to be adequate.

The termination of the Company’s distribution and licensing agreement with Microsoft significantly reduced the Company’s revenue and cash from operating activities in the six months ended June 30, 2004. In order to minimize the impact of the termination on the Company’s liquidity, we restructured our operations and significantly reduced our operating expenses in 2004, which has partially offset the reduction in cash from operating activities due to the termination of the agreement with Microsoft.

Cash used in operating activities in the first half of 2004 was $5.2 million compared to cash provided by operating activities in the first half of 2003 of $6.4 million. This decrease was primarily due to the net loss and a decrease in accrued liabilities of $14.0 million caused by lower accruals for partner payments related to lower cost of revenue. This decrease was offset by net non-cash related expenses of $3.2 million,

and a decrease in accounts receivable of $16.1 million. Accounts receivable decreased in the first half of 2004 due to lower revenue compared to the first half of 2003 and improvement in collections.

Net cash used in investing activities in the first half of 2004 and 2003 included purchases of equipment and capitalization of costs related to internally developed software of $1.8 million and $2.5 million, respectively, and the purchase of NetNanny, which used $0.9 million in cash. This was partially offset by proceeds from the sale of discontinued operations of $1.5 million. Cash used in investing activities in six months ended June 30, 2004 included the purchase of short-term investments of $22.1 million. Cash used in the six months ended June 30, 2003 included sales of short-term investments of $3.4 million.

In the six months ended June 30, 2004 and 2003, net cash provided by financing activities was primarily due to proceeds from the exercise of employee stock options of $3.5 million and $4.0 million, respectively. Cash used by financing activities in the six months ended June 30, 2003 also included the repayment of notes payable of $0.9 million.

We believe that our working capital will provide adequate liquidity to fund our operations and meet other cash requirements for the next 12 months. We may seek to raise additional capital through public or private debt or equity financings in order to fund our operations and capital expenditures, take advantage of favorable business opportunities, develop and upgrade our technology infrastructure, develop new product and service offerings, take advantage of favorable conditions in capital markets or respond to competitive pressures. In addition, unanticipated developments in the short term, such as the entry into agreements requiring large cash payments or the acquisition of businesses with negative cash flows, may necessitate additional financing. We cannot assure you that additional financing will be available on terms favorable to us, or at all. If we issue additional equity or convertible debt securities, our existing stockholders may experience substantial dilution.

We do not have any off balance-sheet arrangements, investments in special purpose entities or undisclosed borrowings or debt. Additionally, we are not a party to any derivative contracts or synthetic leases.

We incur various contractual obligations and commercial commitments in our normal course of business. Such obligations and commitments primarily consist of the following:

Capital Lease Obligations—We have one capital lease for the purchase of telephone equipment.

Operating Lease Obligations—We have various operating leases covering facilities in San Francisco, New York and Los Angeles and various international offices.

Note Obligations —We have entered into note agreements to finance tenant improvements.

Guarantees Under Letters of Credit—We have obtained standby letters of credit from time to time as security for certain liabilities. At June 30, 2004, outstanding letters of credit related to security of building leases and security for payroll processing totaled $2.0 million. In comparison with what we disclosed in our Annual Report on Form 10-K for fiscal 2003, we believe that there have been no significant changes except as noted above.

You should carefully consider the risks described below before making an investment decision regarding our common stock. If any of the following risks actually occurs, our business, financial condition and

results of operations could be harmed. In that case, the trading price of our common stock could decline and you could lose all or part of your investment. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations.

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

Microsoft accounted for approximately 64% of our listings revenues and all of our licensing revenue in 2003. The loss of a substantial portion of our Microsoft listings revenues and all of our licensing revenues in the first half of 2004 materially and adversely affected our financial results. We had a net loss of $8.4 million in the first half of 2004 and as of June 30, 2004, our accumulated deficit was $184.7 million. We may be unable to achieve profitability in the foreseeable future and, if we regain profitability, we may be unable to maintain it.

Our ability to achieve and maintain profitability in future quarters will depend largely on our ability to generate additional revenues and contain our expenses. In order to generate additional revenues, we will need to expand our network of distribution partners, maintain or expand our advertiser base, and generate additional paid clicks. We may be unable to do so because of increased competition from other search services, because of the other risks identified in this report, or for unforeseen reasons. Also, we may be unable to contain our costs due to the need to make revenue sharing payments to our distribution partners, to develop and expand our databases of Internet listings, particularly in the U.S., and to develop new listings and other products, and enhance our search services. Because of the foregoing factors, and others outlined in this report, we will likely be unable to obtain profitability on a quarterly or annual basis in 2004.

We rely primarily on our network of distribution partners to generate paid clicks; if we were unable to maintain or expand this network, our ability to generate revenues would be seriously harmed

Our revenues are generated by paid clicks, which depends on the volume of search traffic on our distribution network. We have in the past, and may in the future, be unable to maintain key partners in our distribution network. In the fourth quarter of 2003 and first quarter of 2004, we lost distribution relationships with Microsoft’s MSN, Yahoo’s Inktomi and About.com’s Sprinks. As a result of the loss of these partners, our volume of clicks is likely to decline significantly in 2004 compared to 2003.

Our agreements with the largest network partners account for a significant portion of our revenues. Our two largest network partners accounted for approximately 32% of our revenues in the first half of 2004. If any of our key distribution contracts are not renewed, or if they are terminated, we would need to find alternative sources of click traffic or otherwise replace the lost paid clicks. Although alternate sources of click traffic are currently available in the market, the search market is consolidating and there is fierce competition among search providers to sign agreements with traffic providers. We face the risk that we might be unable to negotiate and sign agreements with such providers on favorable terms, if at all. If we are unsuccessful in maintaining and expanding our distribution network, then our ability to generate revenues would be seriously harmed.

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

Our revenues and operating results will likely fluctuate significantly from quarter to quarter as a result of a variety of factors, including:

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

Our financial results are highly concentrated in the listings business; if we were unable to grow listings revenues and find alternative sources of revenue, then our financial results would suffer

Listings accounted for 99% of our revenues in the first six months of 2004 and will likely account for substantially all of our revenues in 2004. Our success will depend upon the extent to which advertisers choose to use and partners choose to distribute our listings products. Some of our products will require both modification of existing software and systems and the creation or acquisition of new software and systems. We may lack the managerial, editorial and technical resources necessary to expand our product offerings in a timely manner. Even if we expand our product offerings, customers and partners may not adopt our products at projected rates. For these and other reasons, these initiatives may not generate sufficient revenues to reach our profitability goals. If we are unable to generate significant additional revenues from our listings business or significantly reduce our operating costs, our results of operations and financial condition will suffer.

Any failure in the performance of our operating systems could harm our business and reputation, which could materially adversely affect our revenues

Any system failure that interrupts our search service, whether caused by computer viruses, software failure, power interruptions, unauthorized intruders and hackers, or other causes, could harm our financial results. For example, our system for tracking paid clicks is dependent upon certain key personnel and software. If we lose such personnel or experience a failure of key software, we may be unable to track paid clicks and invoice our customers. Any of these events could adversely affect our financial results and business reputation.

The occurrence of a natural disaster or unanticipated problems at our principal headquarters or at a third-party facility could cause interruptions or delays in our business, loss of data or could render us unable to provide some services. Our California facilities exist on or near known earthquake fault zones and a significant earthquake could cause an interruption in our services. We do not have back-up sites for our main customer operations center and editorial department, which are both located at our San Francisco, California office. An interruption in our ability to serve search results, track paid clicks, and provide customer support would materially and adversely affect our financial results.

If we fail to detect click-through fraud, we could lose the confidence of our advertisers, thereby causing our business to suffer.

We are exposed to the risk of fraudulent clicks on our listings. We have occasionally reduced invoices or refunded revenue to our customers due to click-through fraud, and we expect to do so in the future. Click-through fraud occurs when a person or robot software clicks on a listing displayed on a web site for some reason other than to view the underlying content. If we are unable to stop this fraudulent activity, these refunds may increase. If we find new evidence of past fraudulent clicks we may have to issue refunds retroactively of amounts previously paid by our advertisers, yet we may still have to pay revenue share to

our network partners. This would negatively affect our profitability, and these types of fraudulent activities could hurt our brand. If fraudulent clicks are not detected, the affected advertisers may experience a reduced return on their investment in our advertising programs because the fraudulent clicks will not lead to potential revenue for the advertisers. This could lead the advertisers to become dissatisfied with our advertising programs, which could lead to loss of advertisers and revenue.

If we account for employee stock options using the fair value method, it could significantly reduce our net income

There has been ongoing public debate whether stock options granted to employees should be treated as a compensation expense and, if so, how to properly value such charges. On March 31, 2004, the Financial Accounting Standard Board (FASB) issued an Exposure Draft, Share-Based Payment: an amendment of FASB Statements No. 123 and 95, which would require a company to recognize, as an expense, the fair value of stock options and other stock-based compensation to employees beginning in 2005 and subsequent reporting periods. Currently, we do not recognize compensation expense for stock options other than amortization of deferred stock-based compensation amounts relating to options assumed in purchase business combinations and options accounted for under the variable method. If we elect or are required to record an expense for our stock-based compensation plans using the fair value method as described in the Exposure Draft, we could have on-going accounting charges significantly greater than those we have recorded under our current method of accounting for stock options.

We may incur unexpected costs or delays in restructuring our operations and reducing our costs, which could materially and adversely affect our financial results

In the fourth quarter of 2003, we began to restructure our operations and reduce our costs in light of the expected loss of the Microsoft relationship. However, we will likely be unable to adjust spending quickly enough to ensure that we are profitable in the foreseeable future. Also, we may incur unexpected costs, such as the possibility of litigation stemming from workforce reductions, in connection with the restructuring. Our costs are based in part on expectations of future revenues and, to a large extent, are fixed. We may incur restructuring charges and our operating results may vary in future quarters as a result of changes in our expenses and costs.

We may lose additional customers and our revenue per click may fall further as a result of reduced distribution by Microsoft, which would cause a decline in our revenues

In February 2004, we amended our agreement with Microsoft. The amended agreement has resulted in reduced distribution of our listings by Microsoft, and allows for termination by either party on short notice. The reduced distribution by Microsoft has resulted in some loss of advertisers and related revenues. We may lose additional advertisers from our advertiser base and our average revenue per click may fall if Microsoft further reduces or ceases distribution of our listings. Advertisers may decide that their return on investment has decreased as a result of the loss of paid clicks from MSN and the shift toward other, less well-known distribution partners. Most of our advertising contracts are short-term in nature and are terminable on short notice. It is difficult to predict whether, and to what extent, we will lose additional advertisers or advertisers will pay reduced revenues per click because we are no longer a principal source of MSN’s search results. If enough of our advertisers terminate their advertising contracts with us, or if our revenue per click falls significantly, then our listings revenues and results of operations would be materially and adversely affected.

We may face liability for claims related to our listings business, and these claims may be costly to resolve

Companies in the Internet, technology and media industries own large numbers of patents, copyrights, trademarks and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. As we face increasing competition, the possibility of intellectual property rights claims against us grows. These claims might, for example, be made for trademark, copyright or patent infringement, defamation, negligence, personal injury, breach of contract,

unfair advertising, unfair competition, invasion of privacy or other claims. Allegations are made against us from time to time concerning these types of matters, and we have been subject to purported class action lawsuits in connection with our listings services. Our technologies may not be able to withstand any third-party claims or rights against their use. In addition, we are obligated under some agreements to indemnify our partners in the event that they are subject to claims that our listings or services infringe on the rights of others.

Litigating these claims could consume significant amounts of time and money, divert management’s attention and resources, cause delays in integrating acquired technology or releasing new products, or require us to enter into royalty or licensing agreements. Royalty or licensing agreements, if required, may not be available on acceptable terms, if at all. Our insurance may not adequately cover claims of this type, if at all. If a court were to determine that some aspect of our search services or listings infringed upon or violated the rights of others, we could be prevented from offering some or all of our services, which would negatively impact our revenues and business. There can be no assurance that our services will not infringe the intellectual property rights of third parties. A successful claim of infringement against us and our failure or inability to license the infringed or similar technology could have a material adverse effect on our business, operating results and financial condition.

We face growing competitive pressures in the search marketing industry, which could materially and adversely affect our financial results

We compete in the relatively new and rapidly evolving paid listings industry, which presents many uncertainties that could require us to further refine our business model. Our success will depend on many factors, including our ability to:

We compete with companies that provide paid placement products, paid inclusion products, and other forms of search marketing, including AOL Time Warner, Ask Jeeves, FindWhat, Google (and its AdWords and Sprinks services), Microsoft’s MSN, Terra Lycos and Yahoo (and its Overture service). In the paid inclusion field, we compete for advertisers on the basis of the relevance of our search results, the price per click charged to advertisers, the volume of clicks that we can deliver to advertisers, tracking and reporting of campaign results, customer service and other factors. Some of our competitors have greater capital or technical resources, larger distribution networks or proprietary user bases, longer operating histories and greater brand recognition than we have.

The search industry has recently experienced rapid consolidation, particularly with the acquisitions of companies offering algorithmic search indices and paid inclusion programs. In March 2003, Yahoo acquired Inktomi, which offers a paid inclusion program for its algorithmic search index. In April 2003, Overture Services acquired AltaVista and the web search unit of FAST Search & Transfer, each of which also offers a paid inclusion program and algorithmic search indices. In October 2003, Yahoo acquired Overture Services and Google announced its acquisition of Sprinks from About.com. Industry consolidation may result in larger competitors with a greater focus on algorithmic search, sponsored listings or paid inclusion products. If these industry trends continue, or if we are unable to compete in the sponsored listings and paid inclusion industries, our financial results may suffer.

We may experience downward pressure on our revenue per click, which could have a material and adverse effect on our financial results

We have experienced, and may in the future experience, downward pressure on advertising prices in the industry due to cost-cutting efforts by businesses and the increasing amount of advertising inventory becoming available on the Internet. We compete with other web search services, online publishers and high-traffic web sites, as well as traditional media such as television, radio and print, for a share of our customers’ total advertising expenditures. Many potential advertisers and advertising agencies have only limited experience advertising on the Internet and have not devoted a significant portion of their advertising expenditures to search marketing. Acceptance of the search marketing among advertisers will depend, to a large extent, on its perceived effectiveness and the continued growth of commercial usage of the Internet. If we experience downward pricing pressure for our products in the future, our financial results may suffer.

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

The stock market has experienced significant price and volume fluctuations in recent years, and the stock prices of Internet companies have been extremely volatile. Because of our limited operating history and the changes necessary in light of the reduction of the Microsoft distribution, it is extremely difficult to evaluate our business and prospects. You should evaluate our business in light of the risks, uncertainties, expenses, delays and difficulties associated with managing and growing a relatively new business, many of which are beyond our control. Our stock price may decline, and you may not be able to sell your shares for a profit, as a result of a number of factors including:

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

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

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

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

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

We use proprietary and licensed software to crawl the web and index web pages, create and edit directory listings, search the database, distribute our search results, compile our search results, and track paid clicks. Any of these software systems may contain undetected errors, defects or bugs or may fail to operate with other software applications. The following developments may strain our capacity and result in technical difficulties with our web site or the web sites of our distribution partners:

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

Our business depends on Internet service providers, and any failure or system downtime experienced by these companies could materially and adversely affect our revenues

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

We have an agreement with Savvis Communications, Inc. to house equipment for web serving and networking and to provide network connectivity services. We also have an agreement with AboveNet Communications, Inc. to provide network connectivity services. Our network connectivity and network hardware infrastructure are fully redundant using equipment and connectivity at our Savvis data center and our San Francisco offices. However, we do not presently maintain fully redundant click tracking, customer account and web serving systems at separate locations. Accordingly, our operations depend on Savvis and AboveNet to protect the systems in their data centers from system failures, earthquake, fire, power loss, water damage, telecommunications failure, hackers, vandalism and similar events. Neither Savvis nor AboveNet guarantees that our Internet access will be uninterrupted, error-free or secure. We have deployed firewall hardware at each facility to thwart hacker attacks. We have not developed a disaster recovery plan to respond in the event of a catastrophic loss of our primary systems. Although we maintain property insurance and business interruption insurance, we cannot guarantee that our insurance will be adequate to compensate us for all losses that may occur as a result of a catastrophic system failure.

We rely on insurance to mitigate some risks and, to the extent the cost of insurance increases or we are unable to maintain sufficient insurance to mitigate the risks, our operating results may be diminished

We contract for insurance to cover potential risks and liabilities. In the current environment, insurance companies are increasingly specific about what they will and will not insure. It is possible that we may not be able to get enough insurance to meet our needs, may have to pay very high prices for the coverage we do get or may not be able to acquire any insurance for certain types of business risk. This could leave us exposed to potential claims. If we were found liable for a significant claim in the future, our operating results could be negatively impacted. Also, to the extent the cost of maintaining insurance increases, our operating results will be negatively affected.

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

Our success depends, in part, on the continued service of our key management personnel. The loss of the services of any of our key employees could adversely affect our business. Our success depends on our ability to identify, attract, retain and motivate a highly skilled chief executive officer and search development, technical, marketing and other management personnel. We cannot assure you that we will be able to retain our key employees or that we can identify, attract and retain highly skilled personnel in the future.

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

Although we currently have no plans, proposals or agreements to make acquisitions, if we are presented with appropriate opportunities, we intend to make acquisitions of, or significant investments in, complementary companies or technologies to increase our technological capabilities and expand our service offerings. Acquisitions may divert the attention of management from the day-to-day operations of LookSmart. It may be difficult to retain key management and technical personnel of the acquired company during the transition period following an acquisition. Acquisitions or other strategic transactions may also result in dilution to our existing stockholders if we issue additional equity securities and may increase our debt. We may also be required to amortize significant amounts of intangible assets or record impairment of goodwill in connection with future acquisitions, which would adversely affect our operating results.

We have acquired businesses and technologies in recent years, including the acquisition of certain assets of BioNet Systems, LLC in the second quarter of 2004. Integration of acquired companies and technologies into LookSmart is likely to be expensive, time-consuming and strain our managerial resources. We may not be successful in integrating any acquired businesses or technologies and these transactions may not achieve anticipated business benefits. We intend to license to end users certain software we acquired from BioNet

Systems, LLC, but we may lack the managerial and technical resources necessary to implement a software licensing business model in a timely manner. Unlicensed copying and use of such software in the United Sates and abroad will represent a loss of revenue to us. Furthermore, end users may not license our products at projected rates.

If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud. As a result, current and potential stockholders could lose confidence in our financial reporting, which would harm our business and the trading price of our stock.

Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. If we cannot provide reliable financial reports or prevent fraud, our brand and operating results could be harmed. We have in the past discovered, and may in the future discover, areas of our internal controls that need improvement. We have devoted significant resources to remediate and improve our internal controls. Although we believe that these efforts have strengthened our internal controls, we are continuing to work to improve our internal controls. We cannot be certain that these measures will ensure that we implement and maintain adequate controls over our financial processes and reporting in the future. Any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet our reporting obligations. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock.

If we become subject to employment claims, we could incur liability for damages and incur substantial costs in defending ourselves

Companies in our industry whose employees accept positions with competitors frequently claim that these competitors have engaged in unfair hiring practices or that the employment of these persons would involve the disclosure or use of trade secrets. These claims could prevent us from hiring personnel or cause us to incur liability for damages. We may also be sued in connection with our restructuring and workforce reductions by employees claiming wrongful termination or similar causes of action. We could also incur substantial costs in defending ourselves or our employees against these claims, regardless of their merits. Defending ourselves from these claims could also divert the attention of our management away from our operations.

We may incur unforeseen expenses and liabilities in connection with the dissolution of BT LookSmart and closure of our international offices

In the fourth quarter of 2002, we and BT agreed to close our joint venture, BT LookSmart. We are still in the process of dissolving the joint venture and our other international offices. In January 2004, we sold our Australian business to Sensis, a subsidiary of Telstra. In March 2004, we sold our Japanese business to ValueCommerce Co. Ltd. Withdrawal from foreign markets and closure or dissolution of foreign offices may be more time-consuming and costly than we anticipated, and we may incur costs in excess of the amounts we forecasted in connection with these activities.

We may be unable to collect invoiced amounts from some of our customers, which could materially and adversely impact our business

We derive a portion of our revenues from the sale of listings to companies that represent credit risks. Some of our customers have gone out of business, have limited operating histories or are operating at a loss. Moreover, many of these companies have limited cash reserves and limited access to additional capital. We have in some cases experienced difficulties collecting outstanding accounts receivable. Our allowance for doubtful accounts receivable as of June 30, 2004 was $1.9 million, or 23% of our total accounts receivable. We may continue to have these difficulties in the future, and if a significant part of our customer base experiences financial difficulties or is unable or unwilling to pay our search marketing fees for any reason, our business will suffer.

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

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

As is typical with most web sites, our web site places information, known as cookies, on a user’s hard drive, generally without the user’s knowledge or consent. This technology enables web site operators to target specific users with a particular advertisement and to limit the number of times a user is shown a particular advertisement. Although some Internet browsers allow users to modify their browser settings to remove cookies at any time or to prevent cookies from being stored on their hard drives, many consumers are not aware of this option or are not knowledgeable enough to use this option. Some privacy advocates and governmental bodies have suggested limiting or eliminating the use of cookies. If this technology is reduced or limited, the Internet may become less attractive to advertisers and sponsors, which could result in a decline in our revenues.

We and some of our partners or advertisers retain information about our users. If others were able to penetrate the network security of these user databases and access or misappropriate this information, we and our partners or advertisers could be subject to liability. These claims may result in litigation, our involvement in which, regardless of the outcome, could require us to expend significant time and financial resources.

New regulation of search engines may adversely affect the commercial use of our search service and our financial results

New laws and regulations applicable to the search engine industry may limit the delivery, appearance and content of our advertising. If such laws are enacted, or if existing laws are interpreted to limit our ability to place advertisements for certain kinds of advertisers, it could and have a material and adverse effect on our financial results. For example, in 2002, the Federal Trade Commission, in response to a petition from a private organization, reviewed the way in which search engines disclose paid placement or paid inclusion practices to Internet users and issued guidance on what disclosures are necessary to avoid misleading users about the possible effects of paid placement or paid inclusion listings on the search results. In 2003, the Justice Department issued statements indicating its belief that displaying advertisements for online gambling might be construed as aiding and abetting an illegal activity under federal law. If any government agency were to require changes in the labeling, delivery or content of our listings, it may reduce the desirability of our services or the types of advertisements that we can run, and our business could be materially and adversely harmed.

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

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

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

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

In comparison with what we disclosed in our Annual Report on Form 10-K for fiscal 2003, we believe that there have been no significant changes in our market risk exposures for the three or six months ended June 30, 2004.

(a) Evaluation of disclosure controls and procedures. Our Chief Executive Officer and Chief Financial Officer are responsible for establishing and maintaining “disclosure controls and procedures” (as defined in rules promulgated under the Securities Exchange Act of 1934, as amended) for our company. Based on their evaluation as of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were sufficiently effective to ensure that the information required to be disclosed by us in this Quarterly Report on Form 10-Q was recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and Form 10-Q.

(b) Changes in internal controls. There were no changes in our internal controls over financial reporting during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

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

In May 2002, Legal Staffing Partners, Inc., an express listing customer, filed a proposed class action lawsuit in Superior Court in San Francisco County. The complaint alleged breach of contract, unfair business practices and false advertising in connection with the launch of the Company’s new Small Business Listings product announced in April 2002. The complaint sought restitution, unspecified compensatory damages, injunctive relief and attorneys’ fees. In July 2002, Curt Kramer, an express listing customer, filed a proposed class action lawsuit in Superior Court in San Francisco County alleging claims that were substantially similar to those alleged by Legal Staffing Partners. In October 2002, the two plaintiffs agreed to withdraw their complaints and file a single consolidated amended complaint in Superior Court in San Francisco County containing substantially the same allegations as the prior two complaints. The Company filed an answer to the amended complaint in January 2003. In June 2003, the Company reached a tentative agreement to settle the matter and in October 2003 the Superior Court approved the settlement. The settlement provided that class members receive between zero and 75 free clicks per month through June 12, 2004, depending on when they originally purchased their listings, and that other class members were eligible to receive a cash payment. The period for appeal of the final settlement expired in January 2004 without an appeal being filed by any class members. The Company concluded its obligations under the settlement agreement in June 2004.

In August 2004, Mario Cisneros and Michael Voight filed a proposed class action lawsuit in Superior Court in San Francisco County. The complaint named thirteen search engines or web publishers as defendants (including the Company) and alleged unfair business practices, unlawful business practices and other causes of action in connection with the display of advertisements from internet gambling companies. The complaint sought restitution, unspecified compensatory damages, injunctive relief and attorneys’ fees. The Company has not filed an answer to the complaint.

ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

On April 22, 2004, the Company issued 1,972,387 shares of common stock to BioNet Systems, LLC, in connection with the acquisition of Net Nanny business operations and assets. There were no underwriters employed in connection with the foregoing transaction. The issuance of securities described above was deemed to be exempt from registration under the Securities Act in reliance on Section 4(2) of the Securities Act as a transaction by an issuer not involving a public offering. BioNet Systems LLC acquired the securities for investment only and not in connection with any distribution thereof and appropriate legends were affixed to the share certificate issued in such transaction. BioNet Systems LLC either received adequate information about the Registrant or had access, through employment or other relationships, to such information.

On June 8, 2004, the Company held its annual stockholder meeting. At the meeting, a quorum of the stockholders of the Company considered two proposals: (1) the election of three directors to the board of directors, and (2) the ratification of the appointment of the Company’s independent registered public accounting firm, PricewaterhouseCoopers LLP, for the fiscal year ending December 31, 2004. The remaining directors (Ellery, Santora, Thornley and West), were incumbent directors who did not stand for election at the meeting. The following table shows the results of the voting on these matters.

The Company filed current reports on Form 8-K on April 29, 2004 (first quarter financial results and Net Nanny acquisition), June 28, 2004 (election of Chair of Board of Directors), July 29, 2004 (second quarter financial results), and August 2, 2004 (resignation of director).

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


LOOKSMART, LTD.

By:		/s/ WILLIAM B. LONERGAN
		William B. Lonergan, Chief Financial Officer (Principal Financial and Accounting Officer)


Delaware		13-3904355
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)


		Page
PART I FINANCIAL INFORMATION

ITEM 1:	Condensed Consolidated Financial Statements (unaudited)

	Condensed Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003	3

	Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the three and six months ended June 30, 2004 and 2003	4

	Condensed Consolidated Statements of Cash Flows for the six months ended June, 2004 and 2003	6

	Notes to Condensed Consolidated Financial Statements	7

ITEM 2:	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16

	Factors Affecting Operating Results	27

ITEM 3:	Quantitative and Qualitative Disclosures About Market Risk	36

ITEM 4:	Controls and Procedures	36

PART II OTHER INFORMATION

ITEM 1:	Legal Proceedings	37

ITEM 2:	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities	37

ITEM 4:	Submission of Matters to a Vote of Security Holders	37

ITEM 6:	Exhibits and Reports on Form 8-K	38

ITEM 7:	Signature	38

EXHIBIT INDEX		39


	June 30, 2004			December 31, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	38,960		$	63,866
Short-term investments		28,202			6,068
Trade accounts receivable, net of allowance for doubtful accounts of $1,893 at June 30, 2004 and $2,504 at December 31, 2003		6,378			22,265
Prepaid expenses		1,171			2,308
Other current assets		762			372

Total current assets		75,473			94,879
Property and equipment, net		7,507			8,444
Other assets		4,246			6,124
Intangible assets, net		6,392			5,713
Goodwill		14,422			10,932

Total assets	$	108,040		$	126,092


LIABILITIES & STOCKHOLDERS’ EQUITY
Current liabilities:
Long term debt, current portion	$	46		$	101
Trade accounts payable		1,931			3,600
Other accrued liabilities		10,868			27,125
Deferred revenue and customer deposits		3,483			5,362

Total current liabilities		16,328			36,188
Long term debt		261			283
Other long term liabilities		5,612			3,324

Total liabilities		22,201			39,795
Commitments and contingencies (Note 6)
Stockholders’ equity:
Common stock, $.001 par value; Authorized: 200,000 at June 30, 2004 and December 31, 2003; Issued and Outstanding: 112,700, and 107,808 at June 30, 2004 and December 31, 2003		111			106
Additional paid-in capital		269,663			261,792
Other equity		800			773
Accumulated deficit		(184,735	)		(176,374	)

Total stockholders’ equity		85,839			86,297

Total liabilities and stockholders’ equity	$	108,040		$	126,092


	Three Months Ended June 30, 2004						Six Months Ended June 30, 2004
	2004			2003			2004			2003
Revenues:
Listings	$	19,131		$	28,816		$	42,793		$	55,765
Licensing		—			3,756			188			7,704

Total revenues		19,131			32,572			42,981			63,469
Cost of revenues		11,003			17,089			24,826			33,576

Gross profit		8,128			15,483			18,155			29,893

Operating expenses:
Sales and marketing		1,794			3,752			4,549			7,521
Product development		5,991			6,442			13,282			13,063
General and administrative		2,252			3,119			5,363			6,031
Restructuring costs		420			—			4,054			—

Total operating expenses		10,457			13,313			27,248			26,615

Income (loss) from operations		(2,329	)		2,170			(9,093	)		3,278
Non-operating income (expense):
Interest and other non-operating income (expense), net		52			(396	)		147			(1,011	)
Share of joint venture loss		—			(307	)		—			(563	)

Income (loss) from continuing operations before income taxes and extraordinary gain		(2,277	)		1,467			(8,946	)		1,704
Income tax expense		—			(466	)		—			(573	)

Income (loss) from continuing operations before extraordinary gain		(2,277	)		1,001			(8,946	)		1,131
Gain from discontinued operations, net of tax		1,040			158			584			967

Income (loss) before extraordinary gain		(1,237	)		1,159			(8,362	)		2,098
Extraordinary gain from the purchase of BTLS joint venture entities, net of tax		—			—			—			202

Net income (loss)		(1,237	)		1,159			(8,362	)		2,300
Other comprehensive income (loss):
Change in unrealized gain on short-term investments		3			—			1			—
Change in translation adjustment		(310	)		147			16			215

Comprehensive income (loss)	$	(1,544	)	$	1,306		$	(8,345	)	$	2,515


	Three Months Ended June 30, 2004					Six Months Ended June 30, 2004
	2004			2003		2004			2003
Income (loss) per share:
Basic net income (loss) per share:
Income (loss) from continuing operations	$	(0.02	)	$	0.01	$	(0.08	)	$	0.01
Gain from discontinued operations		0.01			0.00		0.01			0.01
Extraordinary gain from the purchase of BTLS joint venture entities		0.00			0.00		0.00			0.00

Net income (loss)	$	(0.01	)	$	0.01	$	(0.08	)	$	0.02

Diluted net income (loss) per share:
Income (loss) from continuing operations	$	(0.02	)	$	0.01	$	(0.08	)	$	0.01
Gain from discontinued operations		0.01			0.00		0.01			0.01
Extraordinary gain from the purchase of BTLS Joint Venture entities		0.00			0.00		0.00			0.00

Net income (loss)	$	(0.01	)	$	0.01	$	(0.08	)	$	0.02

Weighted average shares outstanding used in per share calculation—basic		111,235			102,693		109,716			101,102
Weighted average shares outstanding used in per share calculation—diluted		111,235			110,324		109,716			108,682

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	Six Months Ended June 30,
	2004			2003
Cash flows from operating activities:
Net income (loss)	$	(8,362	)	$	2,300
Adjustments to reconcile net income (loss) from continuing operations to net cash provided by operating activities:
Share of joint venture loss		—			563
Depreciation and amortization		3,936			3,852
Stock based compensation		61			1,154
Gain from sale of assets and other non-cash charges		(771	)		(15	)
Extraordinary gain from the purchase of BTLS joint venture entities		—			(202	)
Changes in operating assets and liabilities, net of effects of acquisitions and disposals:
Trade accounts receivable		16,059			(1,988	)
Prepaid expenses		1,137			588
Other assets		365			(884	)
Trade accounts payable		(1,669	)		(1,295	)
Other accrued liabilities		(14,030	)		4,141
Deferred revenue and customer deposits		(1,879	)		(1,827	)

Net cash (used in) provided by operating activities		(5,153	)		6,387

Cash flows from investing activities:
Acquisition of assets of Grub, Inc.		—			(612	)
Acquisition of NetNanny		(877	)		—
Proceeds from sale of short-term investments		—			3,405
Purchases of short-term investments		(22,133	)		—
Funding to joint venture		—			(500	)
Payments for property, equipment and capitalized software development		(1,800	)		(2,533	)
Proceeds from the sale of property and equipment		82			1
Proceeds from sale of discontinued operations		1,484			—

Net cash used in investing activities		(23,244	)		(239	)

Cash flows from financing activities:
Repayment of notes		(50	)		(858	)
Proceeds from issuance of common stock		3,557			4,040

Net cash provided by financing activities		3,507			3,182

Effect of exchange rate changes on cash		(16	)		215

Increase (decrease) in cash and cash equivalents		(24,906	)		9,545
Cash and cash equivalents, beginning of period		63,866			47,696

Cash and cash equivalents, end of period	$	38,960		$	57,241

Supplemental disclosure of non-cash investing activities:
Issuance of common stock as consideration in a business combination	$	4,234			—


Accounts receivable, net of reserves	$	171
Inventory		34
Purchased technology		510
Goodwill		3,490
Other intangible assets		940

Total assets acquired		5,145
Less: current liability assumed		34

Net assets acquired	$	5,111


	June 30, 2004		December 31, 2002
Goodwill	$	14,422	$	10,932

Intangible assets	$	11,213	$	9,763
Less accumulated amortization		4,821		4,050

Intangible assets, net	$	6,392	$	5,713


Year	Estimated Remaining Amortization of Intangibles
2004	$	864
2005		1,727
2006		1,197
2007		1,164
2008		1,068
Thereafter		372


	June 30, 2004		December 31, 2003
Accrued compensation and related expenses	$	2,108	$	3,798
Restructuring accrual related to severance costs and current portion of lease obligations		1,463		1,653
Accrued distribution and partner costs		4,136		17,288
Other		3,161		4,386

	$	10,868	$	27,125


	Operating Leases		Operating Leases, Net of Sublease Income
Year:
2004 remaining amount	$	2,365	$	2,126
2005		4,588		4,174
2006		4,622		4,553
2007		4,689		4,689
2008		4,751		4,751
Thereafter		4,412		4,412

Total	$	25,427	$	24,705


	Three Months Ended June 30,					Six Months Ended June 30,
	2004			2003		2004			2003
Numerator – basic and diluted:
Income (loss) as reported	$	(1,237	)	$	1,159	$	(8,362	)	$	2,300

Denominator
Weighted average common shares outstanding:
Shares used to compute basic EPS		111,235			102,693		109,716			101,102
Dilutive common equivalent shares:
Options		—			6,419		—			6,368
Warrants		—			415		—			415
Escrow Shares		—			797		—			797

Shares used to compute diluted EPS		111,235			110,324		109,716			108,682

Net income (loss) per share:
Basic	$	(0.01	)	$	0.01	$	(0.08	)	$	0.02
Diluted	$	(0.01	)	$	0.01	$	(0.08	)	$	0.02


	Three Months Ended June 30,		Six Months Ended June 30,
	2004	2003	2004	2003
Options	1,364	548	1,832	569
Warrants	45	32	50	32

Total antidilutive shares	1,409	580	1,882	601


	Employee Severance Costs			Lease Restructuring Costs			Total
Total 2003 restructuring charges	$	977		$	3,161		$	4,138
Reclassification of deferred rent		—			165			165

Accrual at December 31, 2004		977			3,326			4,303
Adjustments to accrual during the period ended June 30, 2004		76			—			76
Additional restructuring costs		963			3,160			4,123
Reclassification of deferred rent		—			192			192

		2,016			6,678			8,694
Amortization of lease restructuring costs		—			(413	)		(413	)
Cash payments		(1,692	)		—			(1,692	)

Balance at June 30, 2004	$	324		$	6,265		$	6,589


	Three Months Ended June 30,						Percent Change		Six Months Ended June 30,						Percent Change
	2004			2003			Percent Change		2004			2003			Percent Change
Listings	$	19,131		$	28,816		(34	)%	$	42,793		$	55,765		(23	)%
Percentage of total revenues		100	%		88	%				100	%		88	%
Licensing		—			3,756		(100	)%		188			7,704		(98	)%
Percentage of total revenues		0	%		12	%				0	%		12	%

Total revenues	$	19,131		$	32,572		(41	)%	$	42,981		$	63,469		(32	)%


	Three Months Ended June 30,						Percent Change		Six Months Ended June 30						Percent Change
	Three Months Ended June 30,								Six Months Ended June 30
	2004			2003					2004			2003
Stock compensation related to variable options		(8	)		14					(2	)		275
Bad debt provision		69			158					170			(323	)
Other sales and marketing expenses		1,733			3,580					4,381			7,569

Sales and marketing	$	1,794		$	3,752		(52	)%	$	4,549		$	7,521		(40	)%
Percentage of total revenues		9	%		12	%				11	%		12	%


	Three Months Ended June 30,						Percent Change		Six Months Ended June 30,						Percent Change
	Three Months Ended June 30,								Six Months Ended June 30,
	2004			2003					2004			2003
Stock compensation related to variable options		(7	)		102					13			622
Other product development expenses		5,998			6,340					13,269			12,441

Total product development expenses	$	5,991		$	6,442		(7	)%	$	13,282		$	13,063		2	%
Percentage of total revenues		31	%		20	%				31	%		21	%


	Three Months Ended June 30, 2004					Six Months Ended June 30, 2004
	2004		2003			2004			2003
Revenue	$	2,126	$	5,835		$	6,036		$	8,340

Pretax net income (loss) (excluding gain on disposal)		17		177			(439	)		995
Tax impact		—		(19	)		—			(28	)
Gain on disposal		1,023		—			1,023			—

Net gain from discontinued operations	$	1,040	$	158		$	584		$	967


*(000’s)*	Six Months Ended June 30, 2004			Six Months Ended June 30, 2003
Cash, cash equivalents and short term investments	$	67,162		$	69,934
Cash flows provided by (used in) operating activities		(5,153	)		6,387
Cash flows used in investing activities		(23,244	)		(239	)
Cash flows provided by financing activities		3,507			3,182


Proposal	Description	For	Against	Abstain
1	Nominees for directors:
	Anthony Castagna	85,164,078	—	953,193
	Teresa Dial	83,760,390	—	2,356,881
	Mark Sanders	83,757,409	—	2,359,862
2	Ratification of PricewaterhouseCoopers as independent registered	85,193,070	753,619	170,582


Exhibit Number		Description of Document
3.1(1)		Restated Certificate of Incorporation
3.2(2)		Bylaws
4.1(1)		Form of Specimen Stock Certificate
4.2(1)		Second Amended and Restated Investor Rights Agreement dated March 24, 1999
10.1(1)		Form of Indemnification Agreement entered into between the Registrant and each of its directors and officers
10.2(1)		Amended and Restated 1998 Stock Plan
10.3(1)		1999 Employee Stock Purchase Plan
10.7(3)		Zeal Media, Inc. 1999 Stock Plan
10.8(4)		Wisenut, Inc. 1999 Stock Incentive Plan
10.12(1)		Lease Agreement with Rosenberg SOMA Investments III, LLC for property located at 625 Second Street, San Francisco, California, dated May 5, 1999
10.16(1)		Summary Plan Description of 401(k) Plan
10.42(+)		Amendment to the Prioritized Listings Syndication Agreement between the Registrant and Interchange Corporation dated as of June 30, 2004
10.43		Letter agreement between the Registrant and its interim chief executive officer dated as of January 22, 2004
10.44		Prioritized Listings Syndication Agreement between the Registrant and ELiberation, Inc., dated as of October 19, 2001.
31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002