Looksmart 10Q 2002 Q3 Quarterly report

U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.
20549

FORM 10-Q

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

For the Quarterly Period Ended September 30, 2002

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

For the Transition Period from _______ to ________ .

Commission File Number: 000-26357

LOOKSMART, LTD.
(Exact Name of Registrant as Specified in its Charter)

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

625 Second Street San Francisco, California 94107
(Address of Principal Executive Offices and Zip Code)

(415) 348-7000
(Registrant’s Telephone Number, Including Area Code)

Check whether the registrant: (1) 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

As of October 31, 2002, there were 98,118,854 shares of the registrant’s common stock outstanding.

FORM 10-Q

INDEX

		Page

PART I	FINANCIAL INFORMATION
ITEM 1:	Condensed Consolidated Financial Statements (unaudited)	3
	Condensed Consolidated Balance Sheets as of December 31, 2001 and September 30, 2002	3
	Condensed Consolidated Statements of Operations and Comprehensive Loss for the three and nine months ended September 30, 2001 and 2002	4
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2001 and 2002	5
	Notes to Condensed Consolidated Financial Statements	6
ITEM 2:	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
	Factors Affecting Operating Results	23
ITEM 3:	Quantitative and Qualitative Disclosures About Market Risk	32
PART II	OTHER INFORMATION
ITEM 1:	Legal Proceedings	32
ITEM 4:	Controls and Procedures	32
ITEM 6:	Exhibits and Reports on Form 8-K	33
ITEM 7:	Signature	34

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

LOOKSMART, LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In Thousands, except per share amounts)

			December 31, 2001			September 30, 2002

ASSETS
Current assets:
	Cash and cash equivalents		$	29,766		$	50,487
	Restricted cash			3,728			1,750
	Short-term investments			14,346			1,201
	Trade accounts receivable, net			9,294			9,995
	Accounts receivable from related parties			906			138
	Prepaid expenses			2,144			2,595
	Other current assets			617			1,043

		Total current assets		60,801			67,209
Property and equipment, net				10,272			9,451
Goodwill and intangible assets, net				9,969			15,460
Security deposits				2,878			2,642
Other long-term assets				2,182			2,417

		Total assets	$	86,102		$	97,179

LIABILITIES & STOCKHOLDERS’ EQUITY
Current liabilities:
	Trade accounts payable		$	2,323		$	3,038
	Other accrued liabilities			14,647			15,614
	Deferred revenue			9,152			8,038
	Current portion of long-term debt			—			39,280

		Total current liabilities		26,122			65,970
Long-term debt				35,777			992
Other liabilities				559			859

		Total liabilities		62,458			67,821
Stockholders’ equity:
	Capital stock $.001 par value; authorized: 200,000 at December 31, 2001 and September 30, 2002; issued and outstanding: 93,004 and 98,054 at December 31, 2001 and September 30, 2002, respectively			93			98
	Additional paid-in capital			234,841			245,190
	Other equity (deficit)			(1,198	)		502
	Accumulated deficit			(210,092	)		(216,432	)

		Total stockholders’ equity		23,644			29,358

		Total liabilities and stockholders’ equity	$	86,102		$	97,179

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

LOOKSMART, LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(Unaudited)
(In Thousands, except per share amounts)

				Three Months Ended September 30,						Nine Months Ended September 30,

				2001			2002			2001			2002

Revenues:
		Listings		$	9,140		$	18,747		$	23,651		$	47,403
		Advertising			4,501			1,384			19,846			5,665
		Licensing			3,421			3,635			11,470			11,135
		Ecommerce			499			—			8,995			573

			Total revenues		17,561			23,766			63,962			64,776
Cost of revenues:
		Listings			2,321			8,406			5,538			18,655
		Advertising			1,250			1,527			3,934			4,250
		Ecommerce			221			—			5,559			64

			Total cost of revenues		3,792			9,933			15,031			22,969

Gross profit					13,769			13,833			48,931			41,807

Operating expenses:
		Sales and marketing (includes deferred stock and variable option stockcompensation of $338 and $162 in the three months ended September 30, 2001 and 2002, respectively, and $1,362 and $792 in the nine months ended September 30, 2001 and 2002, respectively)			7,723			4,364			34,504			15,800
		Product development (includes deferred stock and variable option stockcompensation of $317 and $184 in the three months ended September 30, 2001 and 2002, respectively, and $903 and $855 in the nine months ended September 30, 2001 and 2002, respectively)			8,081			5,108			24,283			17,288
		General and administrative (includes deferred stock and variable optionstock compensation of $112 and $(32) in the three months ended September 30, 2001 and 2002, respectively, and $363 and $123 in the nine months ended September 30, 2001 and 2002, respectively)			2,825			2,794			8,831			7,784
		Amortization of goodwill			524			—			3,725			—
		Asset impairment and restructuring charges			—			—			11,791			—

			Total operating expenses		19,153			12,266			83,134			40,872

			Income (loss) from operations		(5,384	)		1,567			(34,203	)		935
Non-operating income (expenses):
		Interest and other non-operating income (expense), net			(2,418	)		(1,161	)		(5,742	)		(3,774	)
		Share of joint venture loss			(2,237	)		(874	)		(7,805	)		(2,803	)

			Loss from continuing operations before income taxes		(10,039	)		(468	)		(47,750	)		(5,642	)
Income tax and minority interest					21			1			(55	)		(23	)

			Loss from continuing operations		(10,018	)		(467	)		(47,805	)		(5,665	)
Loss from discontinued operations					(163	)		—			(678	)		(972	)

			Net loss	$	(10,181	)	$	(467	)	$	(48,483	)	$	(6,637	)

Other comprehensive loss:
		Change in foreign currency translation adjustment during the period			54			28			(164	)		426
		Change in unrealized gains/(losses) during the period			3			—			336			(1	)

			Comprehensive loss	$	(10,124	)	$	(439	)	$	(48,311	)	$	(6,212	)

Basic and diluted net loss per share:
	Loss from continuing operations				(0.11	)		(0.00	)		(0.52	)		(0.06	)
	Loss from discontinued operations				(0.00	)		—			(0.01	)		(0.01	)
		Net loss			(0.11	)		(0.00	)		(0.53	)		(0.07	)
Weighted average shares outstanding used in basic and diluted per share calculation					92,406			97,246			91,648			95,798

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

LOOKSMART, LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In Thousands)

					Nine Months Ended September 30,

					2001			2002

Cash flows from operating activities:
	Net loss				$	(48,483	)	$	(6,637	)
	Adjustments to reconcile net loss to cash provided by (used in) operating activities:
		Share of joint venture loss				7,805			2,803
		Depreciation and amortization				11,018			5,672
		Impairment of goodwill				8,371			—
		Loss from discontinued operations				—			972
		Non-cash charges				205			154
		Stock compensation				2,628			1,716
		Loss on foreign currency transactions				14			—
		Net (gains) losses from the sales of assets				(100	)		157
		Changes in operating assets and liabilities:
			Trade accounts receivable			9,877			(962	)
			Prepaid expenses			5,408			(447	)
			Other assets			3,928			177
			Trade accounts payable			(5,597	)		839
			Other liabilities			828			4,821
			Deferred revenues			(3,408	)		(1,072	)
		Minority interest				106			—

				Net cash provided by (used in) operating activities		(7,400	)		8,193

Cash flows from investing activities:
	Purchase of short-term investments					(12,388	)		—
	Proceeds from sale of short-term investments					4,036			13,146
	Proceeds from the sale of property and equipment					152			94
	Funding to joint venture and subsidiaries					(4,000	)		(1,516	)
	Payments for property, equipment and software development					(1,374	)		(4,247	)
	Restricted cash					—			1,978
	Business acquisition, cash acquired					—			311

		Net cash provided by (used in) investing activities				(13,574	)		9,766

Cash flows from financing activities:
	Proceeds from issuance of notes					—			1,622
	Repayment on notes					(25	)		(991	)
	Repayments on equipment lease					(699	)		(458	)
	Proceeds from issuance of common stock					352			2,364

		Net cash provided by (used in) financing activities				(372	)		2,537

Effect of exchange rate changes on cash						(124	)		225

Increase (decrease) in cash and cash equivalents						(21,470	)		20,721
Cash and cash equivalents, beginning of period						52,617			29,766

Cash and cash equivalents, end of period					$	31,147		$	50,487

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

LOOKSMART, LTD. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Summary of Significant Accounting Policies

Nature of Business and Principles of Consolidation

LookSmart (“LookSmart” or the “Company”)is a leader in search marketing, helping online and offline businesses acquire qualified leads from the Internet through search. LookSmart provides search results through its network of leading Internet portals, ISPs and Internet media companies. The acquisition of WiseNut in April 2002 has enhanced LookSmart’s ability to provide highly relevant and valuable search results to portals and Internet search providers (“ISPs”) using the WiseNut technology and our proprietary directories. By providing its search results through a network of partners, LookSmart enables businesses to gain access to qualified consumers at the moment that they are searching for relevant products, services and information.

The consolidated financial statements include the accounts of the Company and its subsidiaries: LookSmart International Pty Ltd., LookSmart Holdings (Delaware), Ltd., LookSmart Netherlands B.V., LookSmart (Barbados), Inc. and LookSmart Germany GmbH. 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.

Revenue Recognition

The Company generates revenues from listings, advertising, licensing and in prior periods, ecommerce activities. Revenues associated with listings products generally are recognized once collectibility is established, as delivery of services occurs, once all performance obligations have been satisfied and when no refund obligations exist. Listings revenue is recognized as clicks are delivered. Upfront fees are recognized ratably over the longer of the term of the contract or the expected relationship with the customer, which is currently twelve months.

Advertising revenues are recognized as impressions or clicks are delivered over the period in which the advertisement is displayed, provided that no significant Company obligations remain at the end of a period and collection of the resulting receivable is reasonably assured. Company obligations typically include guarantees of a minimum number of “impressions,” or times that an advertisement appears in pages viewed by users of the Company’s or its partners’ online properties.

Revenue associated with the Company’s licensing contract is recognized as delivery occurs as specified under the contract, all performance obligations have been satisfied, and no refund obligations exist. Payments from customers received in advance of delivery are recorded as deferred revenues.

The Company’s ecommerce revenues were generated by the sale of merchandise. Revenue is recognized at the time goods are shipped. In April 2002, the Company exited the ecommerce business.

For the purpose of determining when to recognize revenue in any of our segments, the time of delivery of the applicable services or merchandise is readily determinable. However, 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 recognizes revenues once collectibility is established

and maintains a reserve for doubtful accounts receivable based upon expected collectibility, which reflects management’s judgment based on this ongoing credit evaluation. In addition, the Company provides a reserve against revenue for estimated credits resulting from billing adjustments.

Expense Recognition

Generally, all costs are expensed as incurred. However, product development costs have been capitalized to the extent that costs for internal use software are required to be capitalized and amortized under American Institute of Certified Public Accountants Statement of Position No. 98-1, “Accounting for the Cost of Computer Software Developed or Obtained for Internal Use” (“SOP 98-1”). The Company had capitalized software, net of accumulated depreciation, of $0.7 million and $2.5 million as of December 31, 2001 and September 30, 2002, respectively. These amounts are included in other long-term assets on the balance sheet.

Recently Issued Accounting Pronouncements

BUSINESS COMBINATIONS AND GOODWILL AND OTHER INTANGIBLE ASSETS

On January 1, 2002, the Company adopted Statement No. 141, “Business Combinations” (“SFAS No. 141”), and Statement No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). SFAS No. 141 revises the accounting treatment for business combinations, requiring the use of purchase accounting and prohibiting the use of the pooling-of-interests method for all business combinations initiated after June 30, 2001, and broadens the criteria for recording intangible assets separate from goodwill for all business combinations completed after June 30, 2001. SFAS No. 142 revises the accounting for goodwill and other intangible assets by not allowing the amortization of goodwill and establishing accounting for the impairment of goodwill and other intangible assets. Under SFAS No. 142, the Company ceased amortizing goodwill. All of the Company’s goodwill is attributed to the Listings segment of the business.

The Company’s intangible assets are comprised primarily of purchased technology and have estimated useful lives of 3 to 7 years. The Company has reassessed the expected useful lives of existing intangible assets. This reassessment did not result in any significant changes to the useful lives. The Company reported the following (in thousands):

			December 31, 2001		September 30, 2002

			(Unaudited)
Goodwill			$	11,546	$	11,546
	Less accumulated amortization			2,694		2,694

		Goodwill, net	$	8,852	$	8,852
Intangible assets			$	1,935	$	8,475
	Less accumulated amortization			818		1,867

		Intangible assets, net	$	1,117	$	6,608

Intangible asset amortization expense was $0.4 million and $1.0 million for the three and nine months ended September 30, 2002, respectively, and $0.8 million and $1.3 million for the three and nine months ended September 30, 2001, respectively. Estimated intangible amortization expense for each of the years ending December 31 is as follows (in thousands):

Year	Estimated Amortization of Intangibles

2002	$	1,474
2003		1,328
2004		928
2005		927
2006		923
Thereafter		2,076

SFAS No. 142 requires the Company to test goodwill for impairment using a two-step process. The first step is a screen for potential impairment, while the second step measures the amount of impairment. The first step of the impairment test required a comparison of the fair value of each reporting unit to its carrying value to determine whether there was an indication that impairment existed. If there had been an indication of impairment, the Company would have allocated the fair value of the reporting unit to its assets and liabilities as if the reporting unit had been acquired in a business combination. The Company completed the impairment test as of January 1, 2002 using a fair value approach in accordance with SFAS No. 142. No impairment losses were recorded upon the initial adoption of SFAS No. 142.

The reconciliation of net income to adjusted net income as if there had been no goodwill amortization in any period presented is as follows for the three and nine months ended September 30, 2001. There was no goodwill amortization for the three and nine months ended September 30, 2002 (in thousands, except per share amounts):

				Three months Ended Sept. 30, 2001			Nine months Ended Sept. 30, 2001

				(unaudited)			(unaudited)
	Reported net loss			$	(10,181	)	$	(48,483	)
		Goodwill amortization			524			3,725

			Adjusted net loss	$	(9,657	)	$	(44,758	)
Reported basic and diluted earnings per share:
	Net loss			$	(0.11	)	$	(0.53	)
		Goodwill amortization			0.01			0.04

			Adjusted net loss	$	(0.10	)	$	(0.49	)

ACCOUNTING FOR CONSIDERATION GIVEN BY A VENDOR TO A CUSTOMER

In November 2001, the Financial Accounting Standards Board (“FASB”) Emerging Issues Task Force (“EITF”) reached consensus on Issue 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)” (EITF 01-9). The issue provides guidance on accounting for certain payments made by a vendor of goods and services to a customer. Under certain conditions, amounts paid to customers are required to be shown as a reduction in the corresponding revenues recorded from those customers, rather than be shown as expenses in the income statement. EITF 01-9 is generally effective for fiscal years or interim periods beginning after December 15, 2001. Effective January 1, 2002, the Company has adopted the provisions of EITF 01-09, which has had no material impact on the consolidated financial statements.

ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS

On January 1, 2002, the Company adopted Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“Statement 144”). Statement 144 supersedes Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business. Statement 144 also amends ARB No. 51, Consolidated Financial Statements, to eliminate the exception to consolidation for a subsidiary for which control is likely to be temporary. The Company’s disposal of FutureCorp is presented as a discontinued operation in compliance with Statement 144.

RESCISSION OF FASB STATEMENTS NO. 4, 44, AND 64, AMENDMENT OF FASB STATEMENT NO. 13, AND TECHNICAL CORRECTIONS

In April 2002, the FASB issued Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections (“Statement 145”). Statement 145 rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, and FASB Statement No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. Statement 145 also rescinds FASB Statement No. 44, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. Statement 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. Statement 145 shall be applied in fiscal years beginning after May 15, 2002. Early adoption of Statement 145 is encouraged and may be as of the beginning of the fiscal year or as of the beginning of the interim period in which the statement was issued.

ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES

In July 2002, the FASB issued Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. This statement requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing, or other exit or disposal activity. Management does not believe adoption of this statement will materially impact the Company’s financial position or results of operations.

Reclassifications

Certain reclassifications have been made to prior period consolidated financial statements to conform to the current presentation.

2. Unaudited Interim Financial Information

The accompanying unaudited condensed consolidated financial statements reflect all adjustments which are normal and 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 generally accepted accounting principles have been condensed or omitted pursuant to the Securities and Exchange Commission’s rules and regulations. 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, 2001, as included in LookSmart’s Annual Report to Shareholders on Form 10-K, as filed with the Securities and Exchange Commission.

3. Loss from Discontinued Operations

4. Asset Impairment and Restructuring Charges

In January 2001, the Company announced a restructuring of its management and operations. The costs associated with these activities resulted in an impairment and restructuring charge related to LookSmart’s exit from non-core businesses, such as Inside The Web and LookSmart Live!, the amendment of certain marketing agreements, and a reduction in staff of 172 employees. The restructuring resulted in a one-time charge of $9.4 million during the first quarter of 2001. In April 2001, the Company recognized an impairment charge of $2.4 million related to goodwill from the 1999 Guthy-Renker Internet asset purchase. The Company had no asset impairment and restructuring charges in the first nine months of 2002 and all payments were made in the period the expense was recorded.

5. Business Concentration

The Company has a number of agreements with distribution partners that generate traffic, increasing the Company’s revenues from listings products. The Company derives the majority of its outside traffic from one distribution partner. The Company could replace this partner with other suppliers, however the loss of this distribution partner would have a significantly adverse effect on the Company’s operations, at least in the short term.

6. Net Loss Per Share

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):

		Three months ended September 30,						Nine months ended September 30,

		2001			2002			2001			2002

		(unaudited)						(unaudited)
Numerator—Basic and diluted:
	Loss from continuing operations	$	(10,018	)	$	(467	)	$	(47,805	)	$	(5,665	)
	Loss from discontinued operations		(163	)		—			(678	)		(972	)

	Net loss	$	(10,181	)	$	(467	)	$	(48,483	)	$	(6,637	)

Denominator—Basic and diluted:
	Weighted average common shares outstanding		92,406			97,246			91,648			95,798

	Basic and diluted loss per share:
	Loss from continuing operations	$	(0.11	)	$	(0.00	)	$	(0.52	)	$	(0.06	)
	Loss from discontinued operations	$	(0.00	)		—		$	(0.01	)	$	(0.01	)

	Basic and diluted loss per share	$	(0.11	)	$	(0.00	)	$	(0.53	)	$	(0.07	)

Options and warrants to purchase common shares are not included in the diluted loss per share calculations as their effect is antidilutive for all periods. The antidilutive securities included common stock equivalents relating to stock options and warrants to purchase common shares and were as follows (in thousands):

	As of September 30,

	2001		2002

	(unaudited)
Options		15,191		17,957
Warrants		2,015		2,015

Total dilutive shares		17,206		19,972

7. Related Party Transactions

The Company had a distribution agreement with Guthy-Renker Corporation (“GRC”), one of the Company’s stockholders. The distribution agreement with GRC terminated pursuant to its terms on April 2, 2002. During the first nine months of 2002, the Company earned $940,000 in revenue from GRC and paid GRC $18,000 for marketing and administrative support. During the three and nine months ended September 30, 2001, the Company earned $791,000 and $9,246,000, respectively, in revenue from GRC. During the three and nine months ended September 30, 2001, the Company paid GRC $8,000 and $100,000, respectively, for marketing and administrative support.

In April 2002, the Company loaned an executive officer of the Company $250,000. The loan is interest free and may be forgiven 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. In the event that the officer’s employment terminates during the four year period, the outstanding unforgiven balance is due upon the next anniversary date of the loan. The amount being forgiven, plus imputed interest and payments to cover taxes, are charged to operations ratably over the life of the loan.

In October 2001, the Company entered into a license agreement with Viator Ventures, Inc., a technology company wholly owned by an executive officer of the Company. In February 2002, the Company exercised its contractual option to make the license exclusive. In connection with the license, the Company paid $400,000 and issued 300,000 shares of Company common stock valued at $660,000 to Viator Ventures. The license is classified as property and equipment on the balance sheet and has an estimated useful life of three years.

8. Segment Information

Until April 2002, when the Company exited the ecommerce business, the Company operated in four segments: listings, advertising, licensing and ecommerce. Since the discontinuance of its ecommerce business, the Company has operated in three segments: listings, advertising and licensing. In the Condensed Consolidated Statements of Operations and Comprehensive Loss, the Company reports revenue and cost of revenues for these four segments based on the services currently provided by each. With the exception of accounts receivable and deferred revenue, information available to the chief operating decision makers of the Company does not include allocations of assets and liabilities or operating costs to the Company’s segments. As of December 31, 2001 and September 30, 2002, accounts receivable by segment were as follows (in thousands):

	December 31, 2001			September 30, 2002

	(unaudited)
Listings	$	7,336		$	10,610
Advertising		4,956			1,826
Licensing		99			94
Ecommerce		12			—

Total		12,403			12,530
Allowance for doubtful accounts		(3,109	)		(2,535	)

Accounts receivable, net	$	9,294		$	9,995

As of December 31, 2001 and September 30, 2002 deferred revenue by segment was as follows (in thousands):

	December 31, 2001		September 30, 2002

	(unaudited)
Listings	$	329	$	2,998
Advertising		330		166
Licensing		8,493		4,874

Total	$	9,152	$	8,038

9. Stock Option Plan

During the nine months ended September 30, 2002, the Company granted 6,448,744 stock options at the then current fair market value of its underlying common stock. During such period, employees exercised an aggregate of 2,042,544 options, and 2,465,384 options were cancelled. Total outstanding stock options were 17,956,812 as of September 30, 2002.

10. Acquisition

On April 2, 2002, the Company completed the acquisition of WiseNut, Inc. (“WiseNut”), a patent pending next generation search engine technology that combines link popularity with contextual analysis. Management believes the acquisition will enhance the Company’s search technology.

The Company issued 2,646,000 million shares of common stock at a price per share of $2.47, assumed 293,000 stock options with a fair value of $659,000, incurred direct costs of the transaction in the amount of $474,000 and recorded a liability in the amount of $859,000 for all the outstanding capital stock of WiseNut. Of the total assumed stock options, approximately 132,000 stock options with an intrinsic value of $378,000 were unvested. In accordance with FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation,” these unvested options were accounted for as deferred stock-based compensation and are being recognized over their related vesting periods.

The common stock issued was valued 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, the date of and the two days after the announcement date of March 12, 2002. The assumed stock options were valued using the Black-Scholes valuation model using a volatility rate of 130%, a risk-free interest rate of 4.3% and an estimated life of four years.

The preliminary allocation of the purchase price was to tangible and intangible assets, unearned compensation and liabilities assumed. Approximately $6.5 million was allocated to existing search technology and $0.1 million was allocated to an existing customer contract. These amounts were determined through established valuation techniques in the technology industry. Technology acquired will be amortized over a seven-year period and the acquired customer contract will be amortized through November 2002, when the contract is due to expire.

Under the terms of the acquisition agreement, 1.2 million shares of common stock were placed in an escrow account for a period of 12-18 months. The shares are held in escrow pending the outcome of certain seller representations and warranties. If and when these contingently issuable shares are released from escrow, their fair value at that time will be recorded as goodwill and will be assigned to the Company’s Listings segment.

The Company’s consolidated financial statements include the operating results of WiseNut from the date of acquisition. Pro forma results of operations have not been presented because the effects were not material.

The following table presents details of WiseNut’s assets and liabilities acquired by the Company as of the acquisition date (in thousands):

Cash and cash equivalents	$	311
Other current assets		165
Fixed assets		1,327
Technology		6,460
Customer contract		80
Accrued liabilities		(195	)
Deferred compensation		378

Net assets acquired	$	8,526

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

Cautionary Note Regarding Forward-Looking Statements

The following discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect our plans, estimates and beliefs, including without limitation forward-looking statements regarding anticipated revenue growth, trends in costs of revenues and operating expenses, international expansion, introduction of additional services, the extent of our distribution network, the adequacy of our capital reserves and our future need for additional capital. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed below and elsewhere in this report, particularly in “Factors Affecting Operating Results”. Except as may be required by applicable law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. The following discussion should be read in conjunction with the condensed consolidated financial statements and the notes to those statements, which appear elsewhere in this Form 10-Q.

Overview

LookSmart is a leader in search marketing, helping online and offline businesses obtain qualified leads on the Internet through search. LookSmart provides search results through its network of leading Internet portals, ISPs and Internet media companies. The acquisition of WiseNut in April 2002 has enhanced LookSmart’s ability to provide highly relevant and valuable search results to portals and ISP’s using the WiseNut technology and our proprietary directories By providing its search results through a network of partners, LookSmart enables businesses to gain access to qualified consumers at the moment that they are searching for relevant products, services and information.

Revenues and Cost of Revenues

Listings. The Company’s listings revenues are derived from LookListings and affiliate partner commissions. LookListings fees are charged on a “cost per click” basis, and are recognized as the clicks are delivered. We expect listings revenues to continue to grow in total and as a proportion of our overall revenues as search marketing continues to be recognized as a highly effective direct marketing tool. However, as described in the Factors Affecting Operating Results, listings revenues may fluctuate due to a variety of factors.

Prior to April 9, 2002, the Company charged small businesses a fee to perform an accelerated review of their web sites for possible inclusion in the Company’s directory. Revenue was recognized when the review was completed. On April 9, 2002, LookSmart released Small Business Listings as part of the LookListings Small Business product suite and discontinued the “pay-for-review” service. This new product offers small businesses inclusion in our search results for continuing fees which are charged on a “cost per click” basis, and are recognized as the clicks are delivered. In addition, there is a small one-time review fee, which is recognized ratably over the client’s estimated life in the directory, currently estimated to be twelve months.

The Company’s costs of listings revenues include the distribution fees paid to partners based on LookListings “cost-per-click” revenues when there is no LookSmart branding or other direct sales and marketing efforts associated with the generation of these clicks and revenues. Amortization of certain intangible assets is also included in costs of listings revenues for the three and nine months ended September 30, 2002. We expect distribution costs as a percentage of revenue to increase slightly over the next several quarters as our listings revenues increase and higher contractual revenue sharing obligations apply.

Advertising. The Company’s graphical advertising revenues are typically derived from two to four month agreements requiring the Company to serve a minimum number of advertising impressions or clicks over the term of the agreement. We offer advertisers the ability to specify the category of traffic for their advertisements, and we are able to charge premiums on some categories based on advertisers’ perceptions of the associated economic value. This value is derived from the location of the advertisement on the page, the targeting by category or keyword and the size of the audience requesting the page.

The principal components of cost of advertising revenues are personnel costs of our in-house advertising employees, equipment depreciation, other expenses relating to hosting advertising operations and agency commissions paid to outside advertising agencies. Our costs of advertising revenues are generally fixed, at least in the short term, and cannot be expected to follow short-term fluctuations in advertising revenues. To the extent that advertising costs do not coincide with changes in advertising revenues, fluctuations from this revenue source will have a disproportionate impact on net income or loss.

Advertising revenues, both in absolute terms and as a percent of total revenues, have declined over the past year. We expect this trend to continue as we de-emphasize this segment of our business.

Licensing. We license our database content to Microsoft. We expect revenues from licensing to fluctuate from period to period because these revenues are dependent upon the timing of delivery of new non-commercial links to the database under the licensing agreement with Microsoft and the expiration, renewal and addition of agreements with current and future partners.

Ecommerce. The Company’s ecommerce revenues were generated primarily by the sale of merchandise through online stores such as BuyItOnTheWeb (a wholly-owned business unit of LookSmart). Associated direct product costs are reported as cost of revenues. The Company expects no further ecommerce revenue or expenses due to the decision to exit this segment of the business effective April 2002.

Operating Expenses

We do not track operating expenses by reportable segment, but treat these as shared overhead of our four reportable segments.

Sales and Marketing. Sales and marketing expenses include salaries and associated costs of employment for the Company’s sales force, sales administration and customer service staff, payments to distribution partners for directing online users to LookSmart search results and referring Small Business customers, overhead, facilities, allocation of depreciation, amortization of unearned compensation, the impact of variable stock option compensation, and provisions for doubtful trade receivables. Sales and marketing expenses also include the costs of advertising, trade shows and public relations activities. We expect that sales and marketing headcount related expenses will remain stable with increases in strategic areas.

Product Development. Product development costs include all costs related to development and engineering of new products and continued development of our search databases. These costs include salaries and associated costs of employment, overhead, facilities and amortization of intangible assets, amortization of unearned stock-based compensation and the impact of variable stock option compensation. Costs related to the development of software for internal use in the business, including salaries and associated costs of employment, are capitalized as required by generally accepted accounting principles. Software licensing and computer equipment depreciation related to supporting product development functions are also included in product development expenses. Product development costs are relatively stable in the short term, but are expected to increase in the future as the Company continues to invest selectively in this area.

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, overhead, facilities, allocation of depreciation, amortization of unearned compensation and the impact of variable stock option compensation. General and administrative expenses include related consulting and professional service fees that will vary significantly over time.

Amortization of Goodwill. In accordance with SFAS No. 142 (See Note 1—Recently Issued Accounting Pronouncements in the Notes to Consolidated Financial Statements which appear in Item 1 in this Form 10-Q), commencing January 1, 2002, the Company ceased amortizing goodwill.

Asset Impairment and Restructuring Charges. In January 2001, LookSmart announced a restructuring of its management and operations. The costs associated with these activities resulted in an impairment and restructuring charge related to LookSmart’s exit from non-core businesses, such as Inside The Web and LookSmart Live!, the amendment of certain marketing agreements, and a reduction of staff by 172 employees. In April 2001, the Company recognized an impairment charge of $2.4 million related to goodwill from the 1999 Guthy-Renker Internet asset purchase. The Company had no asset impairment and restructuring charges in the nine months ended September 30, 2002.

Income Taxes. Although we are not yet profitable on a consolidated tax basis, tax charges are incurred in connection with our operations in foreign jurisdictions.

Critical Accounting Policies

The financial condition and results of operations of the Company are based upon certain critical accounting policies, which include estimates, assumptions, and judgments on the part of management. 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. See Note 1—Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements which appear in Item 1 in this Form 10-Q for additional information about these and other accounting policies used in the preparation of the consolidated financial statements included in this Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2001.

Allowance for Doubtful Accounts. The Company records allowances for doubtful accounts based on a customer-specific analysis, and general matters such as current assessments of past due balances and economic conditions. 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.

Internal Use Software and Web Site 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 for employees who are directly associated with and who devote time to the internal-use computer software project.

The Company capitalizes certain costs incurred in the development of its web sites in accordance with Emerging Issues Task Force (EITF) Issue No. 00-02 Consensus, “Accounting for Web Site Development Costs.” These are costs incurred during the infrastructure, graphics and content development stages.

Management 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, and determining the estimated useful lives over which the costs are amortized.

Goodwill and Intangible Assets. We have recorded goodwill and intangible assets in connection with our business acquisitions. Management judgment is required in the assessment of the related useful lives, and the fair value and recoverability of these assets. Historically, there have been no circumstances that resulted in revised assumptions or impairment charges. The majority of intangible assets are amortized over three to seven years, the period of expected benefit. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” valuation of intangible assets is reassessed periodically to conform to changes in management’s estimates of future performance giving consideration to existing and anticipated competitive and economic conditions. Goodwill is reviewed for impairment at least annually. The Company did not record a goodwill impairment charge in the current year as a result of the initial review. Cash flow forecasts used in evaluation of goodwill and intangibles are based on trends of historical performance and management’s estimate of future performance.

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.” The disclosure provisions of SFAS No. 123 require judgments made by management as to the expected lives of the outstanding options. Management has based the estimated useful 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, the Company will incur compensation expense or negative expense in connection with variable accounting for outstanding stock options that have been repriced as the market price of the Company’s common stock increases or decreases.

Revenue Recognition. The Company generates revenues from listings, advertising and licensing and until April 2002, generated revenues from ecommerce activities. Revenues associated with listings products generally are recognized once collectibility is established, as delivery of services occurs, once all performance obligations have been satisfied and when no refund obligations exist. In some cases there is also an upfront fee, which is recognized ratably over the longer of the term of the contract or the expected relationship with the customer, which is currently twelve months.

On April 9, 2002, LookSmart released its Small Business Listings product as part of the LookListings Small Business product suite. This new product is based on continuing “cost per click” fees, which are recognized as revenue when clicks are delivered. In addition, there is a small one-time review fee, which is recognized as revenue ratably over the client’s estimated life in the directory, which is currently estimated to be twelve months.

Revenues associated with our licensing contract is recognized as delivery of directory links occurs as specified under the contract, all performance obligations have been satisfied, and no refund obligations exist. Payments from customer received in advance of delivery are recorded as deferred revenues.

For the purpose of determining when to recognize revenue in any of our segments, the time of delivery of the services is readily determinable. However, 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 recognizes revenues once collectibility is established and provides a reserve for doubtful accounts receivable based upon expected collectibility, which reflects management’s judgment based on this ongoing credit evaluation. In addition, the Company establishes a revenue reserve for estimated billing adjustments based on historical trends.

Results of Operations

Revenues

Paid clicks, which include both advertising clicks and listings clicks, increased to 120 million and 277 million for the three and nine months ended September 30, 2002, respectively. This represents increases of 135% and 90% compared to 51 million and 146 million in the corresponding periods in 2001. The increase over the prior year resulted from a refocus of the Company’s business emphasis to the listings business and away from the advertising business, due to the emergence of listings as a strong direct marketing channel for advertisers.

Revenue per click decreased from $0.20 per click in the third quarter of 2001 to $0.17 per click in the third quarter of 2002. This decrease was primarily the result of declining rates for graphical advertising clicks from the previous year and increased volumes from lower-than-average value clicks in the third quarter of 2002.

Listings. Listings revenues were $18.7 million and $47.4 million for the three and nine months ended September 30, 2002, respectively, representing 105% and 100% increase over revenue of $9.1 million and $23.7 million for the three and nine months ended September 30, 2001, respectively. The growth is due to the successful enhancement of our LookListings suite of products, including products for both large and small businesses, an increase in the number of paid listings included in our database, improved relevance of our search results, and our sales and marketing efforts to promote these new products. Listings revenue accounted for 79% and 73% of total revenues in the three and nine months ended September 30, 2002, respectively, an increase from 52% and 37% in the corresponding periods in 2001. Listings revenues represented the largest revenue segment for LookSmart for the last six consecutive quarters.

Advertising. Graphical advertising revenues were $1.4 million for the quarter ended September 30, 2002, and $5.7 million in the first nine months of 2002, representing decreases of 69% and 71%, respectively, from revenue of $4.5 million and $19.8 million in the corresponding periods in 2001. The decreases in advertising revenues are attributable to the downturn in the online advertising market, reduced demand and prices for these products and the Company’s de-emphasis of this segment of our business.

Licensing. Licensing revenue was $3.6 million for the quarter ended September 30, 2002 and $11.1 million in the first nine months of 2002, representing an increase of 6% from revenue of $3.4 million in the third quarter of 2001 and a 3% decrease from revenue of $11.5 million for the first nine months of 2001. The decrease in licensing revenue is attributable primarily to an unusually high number of expedited non-commercial directory links ordered by Microsoft in the first quarter of 2001. In late 2001, deliveries to Microsoft returned to customary levels. The year-to-date decline was also caused by the timing of delivery of URLs under our agreement with Microsoft.

Ecommerce. The Company had no ecommerce revenue during the third quarter of 2002. Ecommerce revenue was $0.6 million for the first nine months of 2002, representing a decrease of 94% from the first nine months of 2001. The decrease is the result of the Company’s decision to exit the ecommerce line of business in April of 2002.

Cost of Revenues

Distribution costs as a percentage of revenue, which includes costs for both advertising and listing distribution, increased from 29% in the third quarter of 2001 to 43% in the third quarter of 2002. This increase is due to the impact of the new small business revenue sharing arrangements with our portal partners and the shift in mix of our clicks, as we now receive more clicks from higher cost distribution. We expect distribution costs as a percent of revenue to increase slightly over the next several quarters as our listings revenues increase and higher contractual revenue sharing obligations apply. We expect further increases if we enter into agreements with additional significant distribution partners.

Listings. Listings costs of revenues were $8.4 million for the quarter ended September 30, 2002 and $18.7 million for the first nine months of 2002. This represents increases of 262% and 237% over costs of revenue of $2.3 million and $5.5 million for the third quarter of 2001 and first nine months of 2001, respectively. The increase in listings cost of revenues is primarily attributable to the growth in revenue and increased partner distribution expenses for the listings products. The costs have increased as the listings business matures and becomes a principal segment of our business and because we are now sharing revenue on Small Business Listings clicks with our partners. Listings costs of revenues are generally variable as a result of variations in the amount of revenue shared with distribution partners under each agreement.

Advertising. Advertising costs of revenues remained relatively flat at $1.5 million for the quarter ended September 30, 2002, and $4.3 million for the first nine months of 2002, compared to costs of revenue of $1.3 million for the third quarter of 2001 and $3.9 million for the first nine months of 2001. Because most of our costs of advertising revenues are generally fixed in the short-term, they cannot be expected to follow declines in advertising revenue.

Ecommerce. We had no Ecommerce cost of revenues for the quarter ended September 30, 2002, and $0.1 million for the first nine months of 2002, compared to costs of revenues of $0.2 million and $5.6 million in the corresponding periods in 2001. The decrease is the result of the Company’s decision to exit the ecommerce line of business in the second quarter of 2002.

Operating Expenses

Sales and Marketing. Including charges for amortization of unearned compensation and depreciation, sales and marketing expenses changed as follows (dollar figures are in thousands):

	Three Months Ended September 30,						% change			Nine Months Ended September 30,						% change

	(unaudited)									(unaudited)
	2001			2002						2001			2002

Amortization of deferred stock compensation	$	338		$	226			(33	)%	$	1,362		$	738			(46	)%
Stock compensation related to variable options		—			(64	)		(100	)%		—			54			100	%
Other sales and marketing expense		7,385			4,202			(43	)%		33,142			15,008			(55	)%

Total sales and marketing expense	$	7,723		$	4,364			(43	)%	$	34,504		$	15,800			(54	)%
As % of revenue		44	%		18	%					54	%		24	%

The decline in these quarterly and year to date expenses, and expenses as a percentage of revenues was driven primarily by termination of unprofitable advertising distribution agreements, a reduction in employee-related expenses, and reduced corporate marketing and branding-related spending. We expect that sales and marketing headcount related expenses will remain stable with measured increases in strategic areas. The

stock compensation expense/benefit incurred in connection with variable accounting for repriced stock options will continue to fluctuate as the market price of the Company’s stock increases or decreases.

Product Development. Including charges for amortization of unearned compensation and depreciation, product development expenses changed as follows (dollar figures are in thousands):

	Three Months Ended September 30,						% change			Nine Months Ended September 30,						% change

	(unaudited)									(unaudited)
	2001			2002						2001			2002

Amortization of deferred stock compensation	$	317		$	255			(20	)%	$	903		$	778			(14	)%
Stock compensation related to variable options		—			(71	)		(100	)%		—			77			100	%
Other product development expense		7,764			4,924			(37	)%		23,380			16,433			(30	)%

Total product development expense	$	8,081		$	5,108			(37	)%	$	24,283		$	17,288			(30	)%
As % of revenue		46	%		21	%					38	%		27	%

The decrease in quarterly expenses, as well as expenses as a percent of revenue, was driven by the overall decrease in employee-related expenses. In the last half of 2001, the Company invested in licensing the technology and hiring the senior management team of Primary Knowledge, an online marketing business intelligence firm. This investment was intended to enhance the Company’s ability to track and report to its customers the effectiveness of its advertising and listings products. The stock compensation expense/benefit incurred in connection with variable accounting for repriced stock options will continue to fluctuate as the market price of the Company’s stock increases or decreases. We expect product development costs to increase as we continue to invest in search technology.

General and Administrative. Including charges for amortization of unearned compensation and depreciation, general and administrative expenses changed as follows (dollar figures are in thousands):

	Three Months Ended September 30,						% change			Nine Months Ended September 30,						% change

	(unaudited)									(unaudited)
	2001			2002						2001			2002

Amortization of deferred stock compensation	$	112		$	20			(82	)%	$	363		$	89			(75	)%
Stock compensation related to variable options		—			(52	)		(100	)%		—			34			100	%
Other general and administrative expense		2,713			2,826			4	%		8,468			7,661			(8	)%

Total general and administrative expense	$	2,825		$	2,794			(1	)%	$	8,831		$	7,784			(12	)%
As % of revenue		16	%		12	%					14	%		12	%

The decrease in quarterly expenses as well as expenses as a percent of revenues, was driven by the overall decrease in employee-related expenses resulting from the January 2001 restructuring and continuing cost management. We anticipate general and administrative expenses to remain relatively flat. However, these expenses may fluctuate somewhat due to unpredictable consulting and professional fees. The stock compensation expense/benefit incurred in connection with variable accounting for repriced stock options will continue to fluctuate as the market price of the Company’s stock increases or decreases.

Amortization of Goodwill. In accordance with the adoption of SFAS No. 142 (See Note 1—Recently Issued Accounting Pronouncements in the Notes to Consolidated Financial Statements which appear in Item 1 in this Form 10-Q), the Company no longer amortizes goodwill.

Asset Impairment and Restructuring Charges. In January 2001, LookSmart announced a restructuring of its management and operations. The costs associated with these activities resulted in a one-time charge of $9.4 million in the quarter ended March 31, 2001. This included charges related to the exit from non-core businesses, such as Inside The Web and LookSmart Live! (write-off of $6.0 million in goodwill and capitalized development costs), the termination of certain marketing contracts (write-off of $1.2 million in prepaid advertising), and a reduction in staff of 172 employees ($2.2 million in severance and related employee payments). In April 2001, the Company recognized an impairment charge of $2.4 million related to goodwill from the 1999 Guthy-Renker Internet asset purchase. Asset impairment and restructuring charges were $11.8 million for the nine months ended September 30, 2001, all of which were incurred during the first and second quarters of 2001. LookSmart incurred no asset impairment and restructuring charges in the nine months ended September 30, 2002.

Interest and Other Non-Operating Expense. Interest and other non-operating expense primarily includes interest expense on our debt and capital lease obligations, net of interest income from our cash, cash equivalents and investments, realized gains or losses on investments, and foreign currency transaction gains and losses arising from the change in the value of foreign currencies, primarily the Australian dollar, relative to the United States dollar.

Interest and other non-operating expense decreased by 52% to $1.2 million in the quarter ended September 30, 2002 and by 34% to $3.8 million for the first nine months of 2002, compared to $2.4 million and $5.7 million in the same periods of 2001. These quarterly and year-to-date decreases resulted from the renegotiation and partial repayment of the credit facility between LookSmart and British Telecommunications in December 2001.

Share of Joint Venture Income (Expense), Net. Share of Joint Venture Income (Expense), Net includes LookSmart’s 50% share of the loss of BT LookSmart. LookSmart recorded $0.9 million of expense for the quarter ended September 30, 2002 and $2.8 million for the first nine months of 2002. This represents decreases in expense of 61% and 64%, respectively, compared to $2.2 million and $7.8 million recorded during the corresponding periods of 2001. These decreases are a result of BT LookSmart’s combined revenue growth and reduced expenses.

Income Taxes and Minority Interest

We recorded an income tax benefit of $1,000 in the quarter ended September 30, 2002 and income tax expense of $23,000 in the nine months ended September 30, 2002, compared to income tax benefit of $21,000 in the quarter ended September 30, 2001 and income tax expense of $55,000 in the nine months ended September 30, 2001. Income tax expense is primarily associated with our Australian operations. Minority interest expense is associated with the Company’s ownership interest in Futurecorp, which was disposed of in the first quarter of 2002.

Loss from Discontinued Operations

In the first quarter of 2002, the Company transferred its 52.8% ownership interest in its consolidated subsidiary, Futurecorp, to the minority shareholders. The Company paid Futurecorp AU$90,000 (approximately US$47,000) and issued 16,437 shares of LookSmart common stock in connection with the transfer. As required by SFAS No. 144, the Company reported the results of operations of this component as a loss from discontinued operations of $972,000, which includes a $1,035,000 loss on disposal, in the first quarter of 2002 and for the nine months ended September 30, 2002. Revenue and pretax net income reported in discontinued operations for the nine months ended September 30, 2002 were $642,000 and $63,000, respectively. Loss from discontinued operations was $163,000 and $678,000 in the third quarter of 2001 and first nine months of 2001. There was no impact from discontinued operations in the third quarter of 2002.

Joint Venture

In February 2000, LookSmart entered into a joint venture agreement with British Telecommunications (“BT”). LookSmart and BT have an equal equity interest in the joint venture, BT LookSmart, which provides search services in Europe and Asia. We account for our investment in the joint venture using the equity method of accounting.

Our share of the joint venture’s net income or loss is reported as non-operating income or expense. In December of 2001, the joint venture agreement was amended to allow either party to the joint venture to exercise a call option (the “Call”), which would require the other party to sell its share of the joint venture for cash to the party initiating the Call. The purchase price would be based upon the fair market value of the joint venture at the time of the Call. The agreement provides a process for either party to outbid the other in subsequent Calls, until a sale is concluded. The Call became effective in September 2002. The agreement was also amended to transfer ownership of the intellectual property rights in the local databases from LookSmart (Barbados), Inc. to the joint venture, effective December 2001.

The joint venture agreement requires that LookSmart and BT provide funding equally for the operations of the joint venture. Under the terms of the agreement, BT extended to LookSmart a $50.0 million credit facility with interest at 20% per annum. LookSmart drew down $50.0 million from the credit facility in February 2000. In December 2001, LookSmart renegotiated the loan and restructured the $50.0 million outstanding loan and $19.5 million of accrued interest, repaying $35.0 million of the total outstanding. The new credit facility of $35.0 million bears interest of 15% per annum. The credit facility and accrued interest are due in full by March 2003, or earlier if the BT LookSmart joint venture is dissolved. If we do not repay the loan in full or in part, BT may exercise its contractual right to take some or all of our equity stake in the BT LookSmart joint venture. We believe that recovery of our equity stake in the BT LookSmart joint venture is BT’s only recourse against the Company in the event of a default, but in the event of default, BT may attempt to pursue other remedies against us.

Liquidity and Capital Resources

LookSmart invests cash pending use in investment grade debt instruments with maturities of less than one year, with the intent to make such funds available for operating purposes. As of September 30, 2002, LookSmart had $51.7 million of unrestricted cash, cash equivalents and short-term investments and $1.75 million of restricted cash. Restricted cash is only available for investment in BT LookSmart.

Cash provided by operating activities was $8.2 million for the first nine months of 2002 compared to cash used in operating activities of $7.4 million in the same period in 2001. The improvement in cash provided by operating activities is primarily attributable to increased revenue in the nine months ended September 30, 2002 compared to the same period in 2001, reduced employee-related expenses and continuing cost management. We have generated cash from operating activities for the last four consecutive quarters.

Net cash provided by investing activities was $9.8 million for the first nine months of 2002, compared to cash used in investing activities of $13.6 million in the same period in 2001. During the nine months ended September 30, 2002, investment activity consisted primarily of the rollover of investments into shorter term maturities classified as cash equivalents due to the prevailing interest rate environment.

Net cash provided by financing activities was $2.5 million in the first nine months of 2002, compared to cash used in financing activities of $0.4 million in the same period in 2001.

The Company’s contractual obligations at September 30, 2002 and the effect such obligations are expected to have on its liquidity and cash flow in future periods have not changed materially since December 31, 2001.

Management believes that our current cash balance is sufficient to meet our operating requirements and funding commitments to the joint venture for the foreseeable future. However, we may need to seek additional financing to fund our business operations. We cannot assure you that such financing will be available on reasonable terms, if at all. If we raise funds through the issuance of equity or convertible debt securities, our existing stockholders will experience dilution of their holdings.

Recently Issued Accounting Pronouncements

See Note 1 in the Notes to the Condensed Consolidated Financial Statements.

FACTORS AFFECTING OPERATING RESULTS

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.

We have a history of net losses and may continue to incur net losses

We have incurred net losses from inception to date, including net losses of approximately $6.6 million in the first nine months of 2002, $59.6 million in 2001, $62.6 million in 2000 and $64.7 million in 1999. As of September 30, 2002, we had an accumulated deficit of approximately $216.4 million. We may continue to have net losses in future quarters, depending on our ability to contain expenses, grow revenues and capitalize on new sources of revenue. We expect to spend significant amounts to:

•	maintain and expand our network of distribution partners;

•	continue to develop and expand our databases of Internet listings, both in the U.S. and abroad;

•	develop new products and enhance the functionality of our search and LookListings services;

•	develop our international business, particularly through our BT LookSmart joint venture with British Telecommunications; and

•	acquire complementary technologies and businesses.

Because of the foregoing factors, and others outlined in this report, we may be unable to achieve profitability on a quarterly or annual basis.

We derive a significant amount of our revenues from Microsoft, and if Microsoft terminates its contract with us, our business could be harmed

Revenues from the licensing portion of our agreement with Microsoft accounted for substantially all of our licensing revenues in the quarter ended September 30, 2002. Either party may terminate the licensing portion of the agreement for any reason on six months’ notice. If the licensing portion of the agreement is terminated, our revenues and results of operations would decline significantly.

The cash payments we receive for each six-month period under the licensing portion of the agreement are subject to full or partial refund if we fail to provide the stated number of listings during that period. After the agreement is terminated, Microsoft has the right to continue to use the content we delivered during the term of the agreement. Microsoft also has the right to sublicense these rights to others, both during and for up to two years after the term of the agreement.

Also, Microsoft accounted for more than half of our total paid clicks and listings revenues in the quarter ended September 30, 2002. Either party may terminate the distribution portion of our agreement with Microsoft for any reason on six months’ notice. If the distribution portion of the agreement is terminated, the number of clicks on our listings would decline significantly, as would revenues from our listing products, our related distribution costs, and our results of operations.

Our success depends on maintaining and expanding our network of distribution partners

Our success depends on our ability to distribute our search results through our network of portals, ISPs, and media companies. Because our listings revenues depend on click-throughs on our customers’ listings, growth in our listings business depends on increasing the volume of traffic on our distribution network. We have invested, and will continue to invest, a significant amount of our human and capital resources to expand this network. However, we face competition from other search marketing providers, some of whom have greater technical and capital resources than we do, to sign agreements with major distribution partners. We cannot assure you that we will maintain and expand our distribution network on financially favorable terms, if at all. If we are unsuccessful in maintaining and expanding our distribution network, then our ability to generate revenues could be seriously harmed.

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

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

•	the number of search queries on our and our distribution partners’ web sites;

•	the cost-per-click we receive from advertisers;

•	the demand for, and prevailing prices of, Internet advertising and marketing services;

•	the timing of revenue recognition under our listings, licensing and advertising contracts;

•	the timing of our entry into and termination of new contracts for licensing, distribution and advertising;

•	technical difficulties and systems downtime or failures, whether caused by us, third party service providers or hackers;

•	changes in our or our partners’ pricing policies; and

•	the timing of our delivery of listings under our contract with Microsoft. We recognize quarterly licensing revenues under this contract based on the number of listings added to our database during the quarter relative to the total number of listings we are required to add to our database during the relevant six-month period. As a result, to the extent that we satisfy our database update obligations unevenly, the revenues we recognize under this contract may be skewed on a quarter-to-quarter basis.

Our expense levels are based in part on expectations of future revenues and, to a large extent, are fixed. We may be unable to adjust spending quickly enough to compensate for any unexpected revenue shortfall. Our operating results may vary as a result of changes in our expenses and costs. Also, we may incur stock compensation expenses as a result of changes in our stock price, and these expenses could negatively

affect our net income. 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 them as indicators 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 growth prospects depend on the success of our listings business

To increase our revenues and reach profitability, we will need to continue expanding our listings business. Listings accounted for $18.7 million or 78.9% of our revenues in the quarter ended September 30, 2002. Our success will depend upon the extent to which advertisers choose to use 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, or customers may not adopt our new 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, our results of operations and financial condition will suffer.

Although we expect our listings revenues to continue to increase as an absolute number and a percentage of total revenues, this may not be the case due to continued weakness in the online advertising market, reductions in advertising expenditures, and downward pressure on advertising rates industry-wide. We compete with traditional media such as television, radio and print, as well as online advertisers and high-traffic web sites, for a share of our customers’ total advertising expenditures. We have experienced, and may continue to 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. As the Internet evolves, advertisers may find search marketing to be a less effective means of promoting their products or services relative to other advertising media and may reduce or eliminate their expenditures on search marketing. 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.

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

We offer listings services and make listings information available to users of our search services, both on our web site and our distribution partners’ web sites. Although we do not believe that the services we offer or the listings in our database violate any rights of others, we cannot assure you that others will not assert claims against us in the future or that these claims will not be successful. We have been subject to purported class action lawsuits in connection with our listings services, described in “Legal Proceedings” below, and we or our distribution partners could be subject to other claims for defamation, invasion of privacy, trademark infringement, product liability, breach of contract, unfair advertising or other theories based on our listings and services. In addition, we are obligated under some agreements to indemnify our partners in the event of claims that our listings or services infringe on the rights of others. Regardless of whether such claims result in liability to us or our distribution partners, we could incur significant costs and diversion of management time in investigating and defending against them. Our insurance may not adequately cover claims of this type, if at all.

We face risks of claims from third parties for intellectual property infringement and other matters that could adversely affect our business

We make Internet search services available to our users through the use of our proprietary algorithms and databases. This creates the potential for claims to be made against us, either directly or

through indemnification provisions in contracts with partners and customers. These claims might, for example, be made for trademark, copyright or patent infringement, defamation, negligence, personal injury, invasion of privacy or other claims. Allegations are made against us from time to time concerning these types of matters. 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. 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 do 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.

BT LookSmart may not ever become profitable and we may lose our interest in the joint venture if we fail to repay our loan from British Telecommunications

We face many risks associated with our joint venture with British Telecommunications, such as:

•	we recognize 50% of the net loss from the joint venture as a non-operating expense on our statement of operations. For the quarter ended September 30, 2002, our share of the joint venture’s net loss was $0.9 million. We expect the venture to incur significant losses and require capital expenditures for the foreseeable future. We cannot project when BT LookSmart will achieve positive cash flow or profitability, if at all;

•	while the budget for the joint venture will be determined by the joint venture’s board of directors, we project that our financial contributions in 2002 will be approximately $1.5 million. However, there can be no assurance in this regard. If we are unable to meet our financing obligations, our equity ownership of the joint venture will be proportionately reduced;

•	the joint venture faces competition in markets abroad from a range of competitors, including search marketing, media, telecommunications and portal companies, many of which have greater capital resources, customer agreements and local experience in these markets;

•	the joint venture may fail to offer locally-relevant and popular web directories, which could result in narrower adoption of the directories and lower growth in search queries;

•	the joint venture faces risks associated with conducting operations in many different countries, such as currency fluctuations, government and legal restrictions, privacy and tax laws, cultural or technical incompatibilities and economic or political instability;

•	the joint venture may be unable to generate sufficient advertising and listings revenue to reach operating profitability;

•	the joint venture may fail to establish an effective management team and hire experienced and qualified personnel in each of the countries in which it competes; and

•	we may be unable to maintain an effective working relationship with our partner in the joint venture due to differences in business goals, assessment of and appetite for risk, or other factors.

Under our restructured loan arrangement with British Telecommunications, our outstanding indebtedness will be due and payable in full in March 2003. Although we believe that we will have cash at that time which exceeds the amount of the loan, this may not be the case if our future revenues do not meet expectations, if we fail to achieve operating profitability or if we incur unforeseen expenses. If we do not repay the loan in full or in part, British Telecommunications may exercise its contractual right to take some or all of our equity stake in the BT LookSmart joint venture. We believe that recovery of our equity stake in

the BT LookSmart joint venture is British Telecommunications’ only recourse against the Company in the event of a default, but in the event of default, British Telecommunications may attempt to pursue other remedies against us.

We may need additional capital in the future to support our growth and additional financing may not be available to us

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

•	fund our operations and capital expenditures;

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

•	develop and upgrade our technology infrastructure;

•	reduce outstanding debt;

•	develop new product and service offerings;

•	take advantage of favorable conditions in capital markets; or

•	respond to competitive pressures.

The capital markets, and in particular the public equity market for Internet companies, have historically been volatile. It is difficult to predict when, if at all, it will be possible for Internet companies to raise capital through these markets. We cannot assure you that the additional financing will be available on terms favorable to us, or at all.

Our revenues and income potential are unproven and our business model is continuing to evolve

We compete in the relatively new and rapidly evolving search marketing market, which presents many uncertainties that could require us to further refine or change our business model. Because of our limited operating history, 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 success will depend on many factors, including our ability to:

•	profitably establish and expand our listings product offerings;

•	compete with our competitors, many of whom have greater capital or technical resources, larger distribution networks or user bases, longer operating histories and greater brand recognition than we have; and some of whom operate fully commercial search services that do not expend resources on non-commercial listings;

•	expand and maintain our network of distribution relationships, thereby increasing the amount of traffic using our databases; and

•	attract and retain a large number of advertisers from a variety of industries.

We compete with companies that provide pay-for-placement listings, targeted advertising, search and directory services, search algorithms and other forms of Internet advertising. As we expand the scope of

our Internet services, we will compete directly with a greater number of targeted marketing providers and other web search companies across a wide range of different online services. To date, the search marketing market has been characterized by intense competition for consumer traffic. This has resulted in the payment of user traffic fees by us and others to frequently-used web sites, portals and ISPs. If these companies fail to provide search traffic to us, or the cost of search traffic increases, our business and financial results would be harmed.

Some of our customers represent credit risks

We expect to continue to derive a significant portion of our revenues from the sale of listings and advertising to companies that represent credit risks. Many 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 and, as a result, our allowance for doubtful accounts receivable as of September 30, 2002 was $2.5 million, or 20% of our accounts receivable. We may continue to have these difficulties in the future. 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.

We face risks associated with acquisition of businesses and technologies; acquisitions will likely also dilute our existing stockholders

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, including the acquisition of WiseNut, Inc. in the second quarter of 2002. Integration of acquired companies and technologies into LookSmart could be expensive, time-consuming and strain our managerial resources. We may not be successful in integrating any acquired businesses or technologies and these transactions may not achieve anticipated business benefits.

Our stock price is extremely volatile and investors may not be able to resell their shares for a profit

The stock market has recently experienced significant price and volume fluctuations, and the market prices of Internet companies have been extremely volatile. 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:

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

•	quarterly fluctuations in our operating results;

•	our potential failure to meet analyst expectations on a quarterly basis;

•	changes in ratings or financial estimates by securities analysts;

•	announcements of technological innovations, partnerships, acquisitions or new products or services by us or our competitors;

•	the sales of substantial amounts of our common stock in the public market by participants in our pre-IPO equity financings or owners of businesses we have acquired, or the perception that such sales could occur;

•	the exchange by CDI holders of CDIs for shares of common stock and resale of such shares in the Nasdaq National Market (as of September 30, 2002, the CDIs registered for trading on the Australian Stock Exchange were exchangeable into an aggregate of approximately 21.9 million shares of common stock); or

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

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

We may be unable to address capacity constraints on our software and infrastructure systems in a timely manner

We have developed custom, proprietary software for use by our editors to create the LookSmart directories, and we also use proprietary and licensed software to search the database, distribute the directories and serve advertising to associated web pages. 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:

•	substantial increases in editorial activity or the number of listings in our directory;

•	customization of our directory for distribution to particular partners;

•	substantial increases in the number of search queries to our database; or

•	the addition of new products, features or changes in our directory structure.

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.

The performance of our operating systems is critical to our business and reputation

Any system failure, including network, software or hardware failure, whether caused by us, a third party service provider, power interruptions, unauthorized intruders and hackers, or natural disasters, that causes an interruption in our service or a decrease in the responsiveness of the web pages that we serve could result in reduced user traffic, a decline in revenues and damage to our reputation. Our users, partners and customers depend on ISPs, online service providers and other third parties for access to the LookSmart directories. These service providers have experienced significant outages in the past and could experience outages, delays and other operating difficulties in the future.

We have agreements with Savvis Communications, Inc. and AboveNet Communications, Inc. to house our networking and web serving hardware equipment. Our networking hardware infrastructure is now fully redundant at separate locations. However, we do not presently maintain fully redundant web serving

systems at both locations, so our operations depend on each of Savvis’ and AboveNet’s ability to protect the systems in its data center 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.

Our success depends on our ability to attract and retain key personnel

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 also depends on our ability to identify, attract, retain and motivate highly skilled administrative, technical, editorial, finance and marketing 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.

If we become subject to unfair hiring claims, we could be prevented from hiring needed personnel, 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 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.

Our business prospects depend on the continued growth in the use of the Internet

Our business is dependent upon continued growth in the use of the Internet as a medium for search marketing, advertising and commercial transactions. Internet usage for these purposes may not grow at projected rates for various reasons, such as:

•	user inability or frustration in locating and accessing required information;

•	actual or perceived lack of security of information;

•	limitations of the Internet infrastructure resulting in traffic congestion, reduced reliability or increased access costs;

•	inconsistent quality of service;

•	government regulation, such as tax or privacy laws;

•	deteriorating economic conditions in target markets and reduced disposable income among Internet users;

•	uncertainty regarding intellectual property ownership and rights on the Internet; and

•	lack of appropriate communications equipment.

If these factors negatively affect the growth in the commercial use of the Internet, our business could be harmed.

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 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 tax treatment of companies engaged in Internet commerce may adversely affect the commercial use of the Internet and our company

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. However, 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, could discourage potential acquisition proposals and could delay or prevent a change of control.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk. The Company’s exposure to market risk for interest rate changes relates primarily to its short-term investments. The Company had no derivative financial instruments as of September 30, 2002 or December 31, 2001. The Company invests its excess cash in debt instruments of high-quality corporate issuers with original maturities greater than three months and current maturities less than twelve months. The amount of credit exposure to any one issue, issuer and type of instrument is limited.

Foreign Currency Risk. International revenues from the Company’s foreign subsidiaries were less than 5% of total revenues in the quarter ended September 30, 2002 and were derived entirely from our Australian operations. The Company’s international business is subject to risks typical of an international business, including but not limited to differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility, partially the exchange rate between the Australian dollar and the United States dollar. The effect of foreign exchange rate fluctuations on the Company in the quarter ended September 30, 2002 was not material.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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 on April 10, 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 containing substantially the same allegations as the prior two complaints. The Company intends to file a motion to dismiss the claims in the amended complaint. Plaintiffs have served document requests, but no other discovery is being sought at this time. LookSmart believes that the allegations against it are without merit and intends to contest the allegations vigorously.

ITEM 4. CONTROLS AND PROCEDURES

Within 90 days prior to the filing date of this Quarterly Report on Form 10-Q, LookSmart carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of LookSmart’s “disclosure controls and procedures” and “internal controls” pursuant to Item 307 of Regulation S-K. Disclosure controls and procedures are designed with the objective of ensuring that (i) information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (ii) information is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Internal controls are procedures designed with the objective of providing reasonable assurance that the Company’s transactions are properly authorized, assets are safeguarded against unauthorized or improper use, and transactions are properly recorded and reported to permit the preparation of the Company’s financial statements in conformity with generally accepted accounting principles.

The evaluation of the Company’s disclosure controls and procedures and internal controls included a review of their objectives and processes, implementation by the Company and effect on the information

generated for use in this quarterly report. In the course of this evaluation, LookSmart sought to identify any significant deficiencies or material weaknesses in LookSmart’s controls, and whether the Company had identified any acts of fraud involving personnel who have a significant role in the Company’s internal controls, and to confirm that any necessary corrective action, including process improvements, were being undertaken. The overall goals of these evaluation activities are to monitor the Company’s disclosure and internal controls and to make modifications as necessary. The Company intends to maintain these controls as processes that may be appropriately modified as circumstances warrant.

Based on the evaluation described above and subject to the discussion below, the Chief Executive Officer and Chief Financial Officer concluded that LookSmart’s controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in this quarterly report. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect those controls since the date of their last evaluation.

However, 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. Management necessarily applied its judgment in assessing the benefits of controls 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, if any, within the Company have been detected. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(1) Exhibits.

Please see the exhibit index below (following the certifications of this report).

(2) Current Reports on Form 8-K.

The Company filed Current Reports on Form 8-K on August 14, 2002 and October 25, 2002.

SIGNATURE

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

Date: November 12, 2002	LOOKSMART, LTD.


By:	/s/ DIANNE DUBOIS

	Dianne Dubois, Chief Financial Officer (Principal Financial and Accounting Officer)

CERTIFICATIONS

I, Jason Kellerman, certify that:

1.	I have reviewed this quarterly report on Form 10-Q of LookSmart, Ltd.;

2.	Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.	Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.	The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
	(a)	designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
	(b)	evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
	(c)	presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.	The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
	(a)	all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
	(b)	any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.	The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: November 12, 2002	/s/ JASON KELLERMAN

	Jason Kellerman Chief Executive Officer

I, Dianne Dubois, certify that:

1.	I have reviewed this quarterly report on Form 10-Q of LookSmart, Ltd.;

2.	Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.	Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.	The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
	(a)	designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
	(b)	evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
	(c)	presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.	The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
	(a)	all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
	(b)	any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.	The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: November 12, 2002	/s/ DIANNE DUBOIS

	Dianne Dubois Chief Financial Officer

EXHIBIT INDEX

Exhibit Number	Description of Document

3.1(1)	Restated Certificate of Incorporation
3.2(1)	Bylaws
4.1(2)	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
10.4+(1)	License and Update Agreement with Microsoft Corporation
10.6+(1)	Development Agreement with Cox Interactive Media, Inc.
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
10.13(1)	Consent to Sublease Agreement with Ninety Park Property LLC, and First Manhattan Consulting Group Inc. for property located at 90 Park Avenue, New York, New York, dated October 22, 1998
10.14(1)	Lease Agreement with Euro Asia Properties Pty Ltd for property located at Level 5, 388 Lonsdale Street, Melbourne, Australia, dated September 1, 1998
10.15(1)	Lease Agreement with Tonicalon Pty Limited for property located at Level 3, 68 Alfred Street, Milsons Point, Sydney, Australia, dated June 1, 1999
10.16(1)	Summary Plan Description of 401(k) Plan
10.17+(3)	Joint Venture Agreement between the Registrant, Transceptgate Ltd., BT LookSmart Ltd., LookSmart (Barbados), Inc. and British Telecommunications Plc dated February 15, 2000
10.18+(3)	Joint Venture Know How Technology and Database License Agreement between the Registrant, BT LookSmart Ltd., and LookSmart (Barbados), Inc. dated February 15, 2000
10.19(3)	Loan Letter Agreement between the Registrant and Transceptgate Ltd. dated February 15, 2000
10.20+(4)	Restated and Final Tagging and Marketing Agreement with Guthy-Renker Corporation dated August 9, 1999
10.21(4)	Employment Agreement with Kevin Berk dated September 29, 2000
10.22(4)	Employment Agreement with Brian Goler dated September 29, 2000
10.23(5)	Loan Facility Agreement between Transceptgate Limited, LookSmart, Ltd. and LookSmart (Barbados) Inc., dated December 7, 2001
10.24(6)	Secured Promissory Note between LookSmart, Ltd. and Dianne Dubois, dated April 2, 2002
10.25(6)	Side Letter between LookSmart, Ltd. and Dianne Dubois, dated July 16, 2002
10.26+(6)	Amendment No. 4 to the License and Update Agreement between LookSmart, Ltd. and Microsoft Corporation dated as of April 9, 2002
10.27	Letter agreement between the Registrant and Robert Goldberg dated March 4, 2002.
10.28	Letter agreement between the Registrant and Brian Cowley dated May 30, 2002.
10.29	Letter agreement between the Registrant and Martin Roberts dated July 1, 2002.
10.30	Letter agreement between the Registrant and Jason Kellerman dated September 24, 2002.
21.1(1)	List of Subsidiaries

(1)	Filed in connection with the Company’s Registration Statement on Form S-1 (File No. 333-80581) filed with the SEC on June 14, 1999.
(2)	Filed in connection with the Company’s Amendment No. 1 to the Registration Statement on Form S-1 (File No. 333-80581) filed with the SEC on July 27, 1999.
(3)	Filed in connection with the Company’s Annual Report on Form 10-K filed with the SEC on March 30, 2000.
(4)	Filed in connection with the Company’s Annual Report on Form 10-K filed with the SEC on March 16, 2001.
(5)	Filed in connection with the Company’s Current Report on Form 8-K filed with the SEC on December 19, 2001.
(6)	Filed in connection with the Company’s Quarterly Report on Form 10-Q filed with the SEC on November 14, 2002.
(+)	Confidential treatment has been granted with respect to portions of the exhibit.

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	8th grade Avg

Looksmart Inactive 10-Q2002 Q3 Quarterly report

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