Looksmart 10-Q 2003 Q3 Quarterly report

U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2003

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from            to            

Commission File Number: 000-26357

LOOKSMART, LTD.

(Exact Name of Registrant as Specified in its Charter)

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

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  x    No  ¨

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

As of October 31, 2003, there were 106,934,073 shares of the registrant’s common stock outstanding.

FORM 10-Q

INDEX

		Page
PART I	FINANCIAL INFORMATION
ITEM 1:	Condensed Consolidated Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002	3
	Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the three and nine months ended September 30, 2003 and 2002	4
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and 2002	6
	Notes to Condensed Consolidated Financial Statements	7
ITEM 2:	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
	Factors Affecting Operating Results	23
ITEM 3:	Quantitative and Qualitative Disclosures About Market Risk	31
ITEM 4:	Controls and Procedures	31
PART II	OTHER INFORMATION
ITEM 1:	Legal Proceedings	32
ITEM 6:	Exhibits and Reports on Form 8-K	32
ITEM 7:	Signatures	32
EXHIBIT INDEX

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PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

LOOKSMART, LTD.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

	September 30, 2003			December 31, 2002
	(Unaudited)			(Audited)
ASSETS
Current assets:
Cash and cash equivalents	$	56,115		$	47,696
Short-term investments		5,143			3,568
Trade accounts receivable, net		21,269			15,852
Prepaid expenses		2,981			2,048
Other current assets		357			1,866
Total current assets		85,865			71,030
Property and equipment, net		8,600			9,404
Security deposits and other assets		6,156			5,086
Intangible assets, net		6,080			6,182
Goodwill		9,111			8,852
Total assets	$	115,812		$	100,554
LIABILITIES & STOCKHOLDERS’ EQUITY
Current liabilities:
Other accrued liabilities	$	24,495		$	18,429
Deferred revenue		5,421			7,798
Trade accounts payable		1,736			3,333
Long term debt, current portion		111			1,188
Total current liabilities		31,763			30,748
Long term debt		1,031			983
Other long term liabilities		—			921
Total liabilities		32,794			32,652
Commitments and contingencies (Note 5)
Stockholders’ equity:
Common stock, $.001 par value; Authorized: 200,000 at September 30, 2003 and December 31, 2002; Issued and Outstanding: 106,273 and 101,421 at September 30, 2003 and December 31, 2002		104			100
Additional paid-in capital		260,809			249,244
Other equity		106			718
Accumulated deficit		(178,001	)		(182,160	)
Total stockholders’ equity		83,018			67,902
Total liabilities and stockholders’ equity	$	115,812		$	100,554

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

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LOOKSMART, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME/(LOSS)

(In thousands, except per share data)

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
Revenues:
Listings	$	36,700		$	20,131		$	100,778		$	53,641
Licensing		3,600			3,635			11,331			11,135
Total revenues		40,300			23,766			112,109			64,776
Cost of revenues		20,016			9,933			55,471			22,969
Gross profit		20,284			13,833			56,638			41,807
Operating expenses:
Sales and marketing		6,007			4,364			17,636			15,800
Product development		8,396			5,108			23,337			17,288
General and administrative		3,393			2,794			9,999			7,784
Total operating expenses		17,796			12,266			50,972			40,872
Income from operations		2,488			1,567			5,666			935
Non-operating income (expense):
Interest and other non-operating expense, net		(347	)		(1,161	)		(263	)		(3,774	)
Share of joint venture loss		—			(874	)		(563	)		(2,803	)
Income (loss) from continuing operations before income taxes and extraordinary gain		2,141			(468	)		4,840			(5,642	)
Income tax (expense) benefit		(283	)		1			(884	)		(23	)
Income (loss) from continuing operations before extraordinary gain		1,858			(467	)		3,956			(5,665	)
Loss from discontinued operations		—			—			—			(972	)
Income (loss) before extraordinary gain		1,858			(467	)		3,956			(6,637	)
Extraordinary gain from the purchase of BTLS joint venture entities, net of tax		—			—			202			—
Net income (loss)		1,858			(467	)		4,158			(6,637	)
Other comprehensive income (loss):
Change in unrealized gain on securities during the period		1			—			1			(1	)
Change in translation adjustment		(103	)		28			112			426
Comprehensive income (loss)	$	1,756		$	(439	)	$	4,271		$	(6,212	)

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LOOKSMART, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME/(LOSS)

(In thousands, except per share data)

(Unaudited)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2003		2002			2003		2002
Net income (loss) per share:
Basic net income (loss) per share:
Income (loss) from continuing operations	$	0.02	$	(0.00	)	$	0.04	$	(0.06	)
Loss from discontinued operations		—		—			—		(0.01	)
Extraordinary gain from the purchase of BTLS joint venture entities, net of tax		—		—			0.00		—
Net income (loss)	$	0.02	$	(0.00	)	$	0.04	$	(0.07	)
Diluted net income (loss) per share:
Income (loss) from continuing operations	$	0.02	$	(0.00	)	$	0.04	$	(0.06	)
Loss from discontinued operations		—		—			—		(0.01	)
Extraordinary gain from the purchase of BTLS joint venture entities, net of tax		—		—			0.00		—
Net income (loss)	$	0.02	$	(0.00	)	$	0.04	$	(0.07	)
Weighted average shares outstanding used in per share calculation—basic		104,730		97,246			102,596		95,798
Weighted average shares outstanding used in per share calculation—diluted		113,375		97,246			110,208		95,798

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

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LOOKSMART, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Nine Months Ended September 30,
	2003			2002
Cash flows from operating activities:
Net income (loss)	$	4,158		$	(6,637	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Share of joint venture loss		563			2,803
Depreciation and amortization		5,833			5,672
Stock based compensation		2,715			1,716
(Income) loss from sale of assets and other non-cash charges		(19	)		311
Loss from discontinued operations		—			972
Extraordinary gain from the purchase of BTLS joint venture entities		(202	)		—
Changes in operating assets and liabilities, net of effects of acquisitions and disposals:
Trade accounts receivable		(5,417	)		(962	)
Prepaid expenses		(933	)		(447	)
Other assets		973			177
Trade accounts payable		(1,597	)		839
Other accrued liabilities		6,993			4,821
Deferred revenue		(2,377	)		(1,072	)
Net cash provided by operating activities		10,690			8,193
Cash flows from investing activities:
Acquisition of assets		(612	)		—
Purchase of short-term investments		(1,575	)		—
Proceeds from sale of short-term investments		—			13,146
Funding to joint venture and subsidiaries		(500	)		(1,516	)
Restricted cash		—			1,978
Payments for property, equipment and capitalized software development		(4,726	)		(4,247	)
Proceeds from the sale of property and equipment		1			94
Business acquisition, cash acquired		—			311
Net cash (used in) provided by investing activities		(7,412	)		9,766
Cash flows from financing activities:
Repayment of notes and leases		(1,161	)		(1,449	)
Proceeds from issuance of notes		—			1,622
Proceeds from issuance of common stock		6,190			2,364
Net cash provided by financing activities		5,029			2,537
Effect of exchange rate changes on cash		112			225
Increase in cash and cash equivalents		8,419			20,721
Cash and cash equivalents, beginning of period		47,696			29,766
Cash and cash equivalents, end of period	$	56,115		$	50,487

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

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LOOKSMART, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Summary of Significant Accounting Policies

Nature of Business and Principles of Consolidation

LookSmart helps businesses of all sizes harness the power of search to generate cost-effective sales leads. LookSmart’s suite of listings products enables businesses to reach Internet users through top portals and ISPs.

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

Use of Estimates

The financial statements have been prepared in conformity with accounting principles generally accepted in the United States. This requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and revenues and expenses during the reporting period. Actual results could differ from those estimates.

Reclassifications

Certain prior year’s balances have been reclassified to conform to the current year’s presentation.

Concentration of Business Risk

The Company derived approximately 66% and 57% of listings revenues in the three months ended September 30, 2003 and 2002, respectively, and 65% and 47% of listings revenues in the nine months ended September 30, 2003 and 2002, respectively, from its relationship with Microsoft. The amended agreement expires on January 15, 2004.

The Company derives all of its licensing revenue from its agreement with Microsoft, which expires on January 15, 2004.

Stock-Based Compensation

The Company accounts for stock-based employee compensation under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (APB No. 25) and related interpretations. Under APB No. 25, compensation cost is equal to the difference, if any, on the date of grant between the fair value of the Company’s stock and the amount an employee must pay to acquire the stock. SFAS No. 123, “Accounting for Stock-based Compensation,” established accounting and disclosure requirements using a fair value based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic value based method of accounting described above, and has adopted the disclosure requirements of SFAS No. 123 and related SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure”.

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

	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
Net income (loss) as reported	$	1,858		$	(467	)	$	4,158		$	(6,637	)
Add: Stock-based employee compensation expense (benefit) included in reported net income (loss), net of related tax effects		1,561			309			2,715			1,771
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of tax		(4,734	)		(4,906	)		(13,696	)		(18,743	)
Pro forma net loss	$	(1,315	)	$	(5,064	)	$	(6,823	)	$	(23,609	)
Basic net income (loss) per share
As reported	$	0.02		$	(0.00	)	$	0.04		$	(0.07	)
Pro forma	$	(0.01	)	$	(0.05	)	$	(0.07	)	$	(0.25	)
Diluted net income (loss) per share
As reported	$	0.02		$	(0.00	)	$	0.04		$	(0.07	)
Pro forma	$	(0.01	)	$	(0.05	)	$	(0.06	)	$	(0.25	)

Net Income (Loss) Per Share

SFAS No. 128, “Earnings per Share,” establishes standards for computing and presenting earnings per share. Basic earnings per share is calculated using the weighted average shares of common stock outstanding. Diluted earnings per share is calculated using the weighted average number of common and potentially dilutive common shares outstanding during the period, using the as-if converted method for convertible preferred stock and the treasury stock method for options and warrants.

Segment Information

Starting on January 1, 2003, the Company has two operating segments: listings and licensing. The Company exited the ecommerce segment after the second quarter of 2002 and ceased reporting the advertising segment after the fourth quarter of 2002, as it no longer manages advertising as a separate product. With the exception of accounts receivable and deferred revenue and goodwill, information (for the purposes of making decisions about allocating resources) available to the chief operating decision makers, the Chief Executive Officer and the Chief Financial Officer, of the Company does not include allocations of assets and liabilities or operating costs to the Company’s segments.

Combined revenues from foreign subsidiaries were 13% and 0% of total revenue in the nine months ended September 30, 2003 and 2002 and were derived from its operations in Australia, Japan and the United Kingdom, all of which were individually less than 10% of total revenue for the three and nine months ended September 30, 2003 and 2002.

As of September 30, 2003 and December 31, 2002, all of the Company’s accounts receivable, intangible assets and goodwill related to the listings segment.

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As of September 30, 2003 and December 31, 2002, deferred revenue by segments was as follows (in thousands):

	September 30, 2003		December 31, 2002
Listings	$	5,399	$	3,983
Licensing		22		3,815
Total	$	5,421	$	7,798

Recently Issued Accounting Pronouncements

In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” This issue addresses how revenue arrangements with multiple deliverables should be divided into separate units of accounting and how the arrangement consideration should be allocated to the identified separate accounting units. EITF No. 00-21 is effective for fiscal periods beginning after June 15, 2003. The Company anticipates that the adoption of EITF 00-21 will not have a significant impact on its results of operations and financial position.

In November 2002, the FASB issued FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others.” FIN No. 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002; while the provisions of the disclosure requirements are effective for financial statements of interim or annual reports ending after December 15, 2002. The adoption of FIN No. 45, at the beginning of 2003, did not have a material impact on our consolidated financial position, results of operations or cash flows.

In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities.” FIN No. 46 expands upon and strengthens existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity. A variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN No. 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN No. 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after December 15, 2003. Disclosure requirements apply to any financial statements issued after January 31, 2003. The Company has considered the provisions of FIN No. 46 and believes it will not be necessary to include in the Company’s financial statements any assets, liabilities, or activities of BT LookSmart, Ltd., its joint venture with British Telecommunications. The Company will continue to evaluate the impact of FIN No. 46 on the consolidated financial statements and related disclosures.

In May 2003, the FASB issued SFAS No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 provides for certain changes in the accounting treatment of derivative contracts and is effective for contracts entered into or modified after June 30, 2003, except for certain provisions that relate to SFAS No. 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003, which will continue to be applied in accordance with their respective effective dates. The guidance will be applied prospectively. Management anticipates that the adoption of SFAS No. 149 will not have a material impact on the Company’s consolidated financial statements.

Also in May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This new statement changes the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. It requires that those instruments be classified as liabilities

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in balance sheets. Most of the guidance in SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the Company’s third quarter of 2003. Management believes that the adoption of SFAS No. 150 will not have a material impact on the Company’s consolidated financial statements.

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 accounting principles generally accepted in the United States have been condensed or omitted pursuant to the Securities and Exchange Commission’s rules and regulations. The year-end condensed consolidated balance sheet data was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States. These unaudited interim condensed consolidated financial statements should be read in conjunction with LookSmart’s audited consolidated financial statements and notes for the year ended December 31, 2002 included in its Annual Report on Form 10-K, as amended, filed with the Securities and Exchange Commission.

3. Acquisitions

WiseNut, Inc.

On April 2, 2002, the Company completed the acquisition of WiseNut, Inc. (“WiseNut”), a search engine technology company. The Company issued 2,646,000 shares of common stock at a price per share of $2.47, assumed 296,000 stock options with a fair value of $0.7 million, incurred direct costs of the transaction in the amount of $0.5 million and recorded a liability in the amount of $0.9 million for all the outstanding capital stock of WiseNut. Of the total assumed stock options, approximately 132,000 stock options with an intrinsic value of $0.4 million 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 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 is amortized over a seven-year period and the acquired customer contract was amortized through November 2002, when the contract expired.

Under the terms of the acquisition agreement, 1.2 million shares of common stock were placed in an escrow account to secure certain seller representations and warranties for a period of up to 18 months.

During the nine months ended September 30, 2003, 0.4 million escrow shares were released in accordance with the agreement. The fair value of these shares was determined on the date of the scheduled release from escrow and were recorded as goodwill and assigned to the Listings segment.

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The following table presents details of WiseNut’s assets and liabilities acquired by the Company (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
Goodwill		1,117
Net assets acquired	$	9,643

The following pro forma results of operations reflect the combined results of LookSmart and Wisenut for the nine months ended September 30, 2002, as if the business combination occurred as of the beginning of the year.

	Nine Months Ended Septmeber 30, 2002
Revenue	$	64,846
Net loss	$	(8,191	)
Loss per share – basic and diluted	$	(0.09	)
Weighted average shares outstanding used in per share calculation – basic and diluted		95,798

Grub, Inc.

In January 2003, the Company acquired intellectual property rights from Grub, Inc. and an individual for total consideration of $1.3 million, consisting of $0.6 million cash payment, including $12,000 of direct costs and the issuance of 217,000 shares of LookSmart common stock valued at $0.7 million.

The intellectual property rights are classified as intangible assets on the balance sheet and have an estimated useful life of three years.

4. Goodwill and Intangible Assets

The Company’s intangible assets consist primarily of purchased technology and have estimated useful lives of three to seven years. The Company has reassessed the expected useful lives of existing intangible assets upon the adoption of SFAS 142 Goodwill and Other Intangible Assets. This reassessment did not result in any significant changes to the useful lives.

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Goodwill and intangible assets are as follows (in thousands):

	September 30, 2003		December 31, 2002
Goodwill	$	11,805	$	11,546
Less accumulated amortization		2,694		2,694
Goodwill, net	$	9,111	$	8,852
Intangible assets	$	9,763	$	8,474
Less accumulated amortization		3,683		2,292
Intangible assets, net	$	6,080	$	6,182

Intangible asset amortization expense was $0.4 million and $0.4 million for the three months ended September 30, 2003 and 2002 and $1.4 million and $1.0 million for the nine months ended September 30, 2003 and 2002, respectively, and was included in cost of revenue and product development costs. Estimated future intangible amortization expense is as follows (in thousands):

Year	Estimated Remaining Amortization of Intangibles
2003	$	368
2004		1,357
2005		1,357
2006		923
2007		923
Thereafter		1,152

5. Commitments and Contingencies

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 in April 2002. The complaint sought restitution, unspecified compensatory damages, injunctive relief and attorneys’ fees. In July 2002, Curt Kramer, an express listing customer, filed a proposed class action lawsuit in Superior Court in San Francisco County alleging claims that were substantially similar to those alleged by Legal Staffing Partners. In October 2002, the two plaintiffs agreed to withdraw their complaints and file a single consolidated amended complaint containing substantially the same allegations as the prior two complaints. In November 2002, the Company filed a motion to dismiss the claims in the amended complaint. The court denied the motion in January 2003. The Company filed an answer to the amended complaint in January 2003. Plaintiffs have served document and deposition requests, but no other discovery is being sought at this time. In June 2003, the Company reached a tentative agreement to settle the matter and in October 2003, the Superior Court approved the settlement.

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From time to time the Company is involved in lawsuits, claims, investigations and proceedings, in addition to those identified above, consisting of intellectual property, commercial, employment and other matters, which arise in the ordinary course of business. In accordance with SFAS No. 5, the Company makes a provision for a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the effects of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case. Litigation is inherently unpredictable. However, the Company believes that it has valid defenses with respect to the legal matters pending against it. It is possible, nevertheless, that cash flows or results of operations could be affected in any particular period by the resolution of one or more of these contingencies.

Joint Venture Funding

Pursuant to the settlement agreement with BT for the dissolution of the joint venture, the Company and BT are jointly liable for the costs incurred to close the operations of the joint venture. The Company does not expect to incur significant additional expenses to dissolve the joint venture.

Indemnities

In the normal course of business, the Company makes indemnities, commitments and guarantees under which it may be required to make payments in relation to certain transactions. These indemnities include intellectual property indemnities to the Company’s customers in connection with the sales of its products, indemnities to distribution partners in connection with the distribution of the Company’s listings, indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease, and indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of Delaware.

6. Net Income (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,
	2003		2002			2003		2002
Numerator—Basic and diluted:
Net income (loss)	$	1,858	$	(467	)	$	4,158	$	(6,637	)
Denominator
Weighted average common shares outstanding:
Shares used to compute basic EPS		104,730		97,246			102,596		95,798
Dilutive common equivalent shares:
Options		7,839		—			6,807		—
Warrants		9		—			8		—
Escrow Shares		797		—			797		—
Shares used to compute diluted EPS		113,375		97,246			110,208		95,798
Net income (loss) per share:
Basic	$	0.02	$	(0.00	)	$	0.04	$	(0.07	)
Diluted	$	0.02	$	(0.00	)	$	0.04	$	(0.07	)

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

	Three Months Ended September 30		Nine Months Ended September 30
	2003	2002	2003	2002
Options	164	6,340	527	3,818
Warrants	22	1,438	28	427
Total antidilutive shares	186	7,778	555	4,245

7. Related Party Transactions:

In June 2003, the Company consolidated its receivable from BT LookSmart and its payable to BT LookSmart into its investment. The Company also wrote down the investment by $0.3 million. The remaining investment balance at September 30, 2003 is $0.4 million, which reflects the estimated value upon final liquidation of the joint venture.

In April 2002, the Company loaned an executive officer of the Company $0.3 million. 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. The amount forgiven, plus imputed interest and payments to cover taxes were charged to operations ratably over the life of the loan was $0.1 million for the three and nine months ended September 30, 2003, respectively. Due to the resignation of the executive officer, the outstanding unforgiven balance of $0.2 million is due no later than April 30, 2004.

8. 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 $1.0 million, which includes a $1.0 million loss on disposal in the nine months ended September 30, 2002. Revenue included in the loss on disposal was $0 and $0.6 million in the nine months ended September 30, 2003 and 2002, respectively. Pretax net loss reported in discontinued operations was $0 and $63,000 in the nine months ended September 30, 2003 and 2002, respectively. Loss from discontinued operations was $0 in 2003 and $1.0 million in 2002.

9. Extraordinary Gain on Acquisition of Joint Venture Entities

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

10. Subsequent Event

On October 6, 2003, the Company announced that Microsoft will not renew its distribution and licensing agreement. The Company and Microsoft have agreed to extend the terms of the current agreement through January 15, 2004, after which the agreement will terminate. The Company is evaluating the impact of this event on the carrying value of its goodwill, intangible and long-term assets, and will record any adjustments in the fourth quarter of 2003.

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

The following discussion should be read in conjunction with the consolidated financial statements and the notes to those statements which appear elsewhere in this Quarterly Report on Form 10-Q. The following discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We use words such as “believes,” “intends,” “expects,” “anticipates,” “plans,” “may,” “will” and similar expressions to identify forward-looking statements. All forward-looking statements, including but not limited to, projections or estimates concerning our business, including demand for our products and services, mix of revenue streams, ability to control and/or reduce operating expenses, anticipated cost of revenues, expenses and operating results, cost savings, product development efforts, general outlook of our business and industry, opportunities abroad, competitive position, stock compensation and adequate liquidity to fund our operations and meet our other cash requirements for the next 12 months, are inherently uncertain as they are based on our expectations and assumptions concerning future events. These forward-looking statements are subject to numerous known and unknown risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including our ability to maintain net profitability in future quarters, our continuing relationship with Microsoft, our ability to expand our network of distribution partners, the success of our listings business and all other risks described below in the section entitled “Factors Affecting Operating Results” and elsewhere in this report. All forward-looking statements in this document are made as of the date hereof, based on information available to us as of the date hereof, and we assume no obligation to update any forward-looking statements.

Overview

LookSmart search listings enable businesses to reach Internet users through top portals and ISPs. Our suite of listings products provides businesses of all sizes the opportunity to have listings for their company and products included in our distributed web search results, so that their listings are available to Internet users at the moment when they are searching for relevant information.

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.

Revenue Recognition. The Company generates revenues from listings and licensing. We exited the ecommerce segment after the second quarter of 2002 and ceased reporting the advertising segment after the fourth quarter of 2002, as we no longer manage advertising as a separate product. Revenues associated with listings products, including directory listings and affiliate commissions are generally recognized once collectibility is established, as delivery of services occurs, once all performance obligations have been satisfied, and when no refund obligations exist. Upfront fees are recognized ratably over the longer of the term of the contract or the expected relationship with the customer, which is currently estimated to be twelve months. This estimate is reviewed on an annual basis.

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

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Advertising revenues are included in listings revenue and 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 the period and collection of the resulting receivable is reasonably assured. Company obligations typically include guarantees of a minimum number of “impressions.” An impression is an appearance of an advertisement in pages viewed by users of the Company’s or its partners’ online properties.

Revenues associated with our licensing agreement with Microsoft are recognized in the period in which URLs are added to the database and the database is delivered to Microsoft, per the agreement, all performance obligations have been satisfied, and no refund obligations exist. Payments from Microsoft received in advance of delivery are recorded as deferred revenues. We recognize quarterly licensing revenues under this contract based on the number of URL listings added to our database during the quarter relative to the total number of URL listings we 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.

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

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

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

Goodwill and Intangible Assets. We have recorded goodwill and intangible assets in connection with our business acquisitions. Management exercises judgment in the assessment of the related useful lives, and the fair value and recoverability of these assets. The majority of intangible assets are amortized over three to seven years, the period of expected benefit. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” the Company periodically reassesses the valuation of intangible assets to conform to changes in management’s estimates of future performance. Management considers existing and anticipated competitive and economic conditions in such assessments. Goodwill is reviewed for impairment at least annually. The Company did not record a goodwill impairment charge in the first nine months of 2003. Cash flow forecasts used in evaluation of goodwill and intangibles are based on trends of historical performance and management’s estimate of future performance. The Company will perform an impairment analysis of its goodwill and intangible assets in the fourth quarter of 2003.

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

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

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

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

Results of Operations

Revenues

On October 6, 2003, we announced that Microsoft will not renew its distribution and licensing agreement beyond January 15, 2004.

Starting on January 1, 2003, LookSmart began reporting two operating segments: listings and licensing. We exited the ecommerce segment after the second quarter of 2002 and ceased reporting the advertising segment after the fourth quarter of 2002, as we no longer manage advertising as a separate product. For purposes of historical comparison, advertising and ecommerce are included in the listings segment on our statement of operations for 2003 and 2002.

Listings. We derive listings revenues from our suite of listings products, including LookListings, affiliate partner commissions and Sponsored Listings. Revenues from LookListings and Sponsored Listings are primarily composed of per-click fees that we charge customers and often also include one-time review fees or set-up fees when generating listings for customers and including them in our search results.

Listings revenues include revenues generated through our participation in affiliate programs. Affiliate programs are programs operated by affiliate network services or online merchants, in which merchants pay traffic providers on a cost-per-acquisition basis. By participating in affiliate programs, we generate revenues when Internet users make a purchase from a participating merchant’s web site after clicking on the merchant’s listing in our search results.

Advertising revenues, which are now included in listings revenues, are typically derived from short-term agreements requiring the Company to deliver a minimum number of graphical advertising impressions or clicks over the term of the agreement. We offer advertisers the ability to specify the category of traffic for their advertisements. Some advertising categories are priced at a premium, depending on the associated economic value, the location of the advertisement on the page and the size of the audience requesting the page.

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Listings revenues were $36.7 million and $100.8 million for the three and nine months ended September 30, 2003, representing an 82% and 88% increase over listings revenue of $20.1 million and $53.6 million for the three and nine months ended September 30, 2002, respectively. The growth is due to a 215% increase in paid URL’s as of September 30, 2003 compared to September 30, 2002 and the addition of 15,000 new customers since September 30, 2002. Listings revenue accounted for 91% and 90% of total revenues for the three and nine months ended September 30, 2003, compared to 85% and 83% for the three and nine months ended September 30, 2002.

We derived 66% and 65% of our listings revenues in the three and nine months ended September 30, 2003, respectively, and 57% and 47% of our listings revenues in the three and nine months ended September 30, 2002, respectively, from our relationship with Microsoft. The increase in the proportion of our listings revenues attributable to Microsoft was due primarily to changes in Microsoft’s search service which resulted in more clicks on our search results, contributing 77% and 86% of the increase for the three and nine months ended September 30, 2003 compared to the three and nine months ended September 30, 2002. Revenue associated with our United Kingdom and Japan subsidiaries accounted for 20% and 8% of the growth for the three and nine months ended September 30, 2003, respectively, compared to the three and nine months ended September 30, 2002.

We believe listings revenues will decline slightly in the fourth quarter of 2003 due to the removal of our directory layer from the UK MSN page. In addition, we expect revenue to decline significantly in the first quarter of 2004.

Paid clicks increased to 224.1 million and 610.6 million for the three and nine months ended September 30, 2003. This represents an increase of 87% and 120% compared to 119.8 million and 277.5 million in the three and nine months ended September 30, 2002. Due to the removal of our directory layer from the UK MSN page in the fourth quarter of 2003 and the termination of our agreement with MSN on January 15, 2004, we expect paid clicks to decline in 2004.

Listings revenue per click, the average cost per click to advertisers, decreased slightly to $0.16 per click for both the three and nine months ended September 30, 2003 from $0.17 per click for the three months ended September 30, 2002 and $0.18 for the nine months ended September 30, 2002. Declining rates for our domestic listings resulted in a decline $0.01 for the nine months ended September 30, 2003 compared to the nine months ended September 30, 2002. In addition, the overall revenue per click declined $0.01 for the three and nine months ended September 30, 2003 due to the integration of our United Kingdom and Japanese subsidiaries. We expect revenue per click to remain relatively constant in the near term.

Licensing. We license our database content to Microsoft and customize it for their use. Licensing revenue was $3.6 million and $11.3 million for the three and nine months ended September 30, 2003, compared to $3.6 million and $11.1 million for the three and nine months ended September 30, 2002. The Company derives all of its licensing revenue from its agreement with Microsoft, which expires on January 15, 2004, after which we expect to have no licensing revenue. After the agreement expires, 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.

Cost of Revenues

Cost of revenues primarily consists of revenue-sharing payments to distribution partners, connectivity costs, sales operations personnel and amortization of certain intangible assets. In cases where there is no LookSmart branding or other direct sales or marketing effort associated with the generation of listings revenues, payments to distribution partners are reflected as cost of revenue. The cost of revenue associated with affiliate partner commissions consists of fees paid to distribution partners based on the affiliate vendor commissions earned by the Company. Cost of revenues also consists of personnel costs of our sales operations employees, including stock-based compensation, equipment depreciation, expenses relating to hosting advertising operations and commissions paid to advertising agencies. Payments to distribution partners for referral of customers to our LookListings program are reflected as sales and marketing expense because LookSmart branding is associated with the promotion of these products.

Cost of revenues were $20.0 million and $55.5 million for the three and nine months ended September 30, 2003, respectively, representing an increase of 102% and 142% over cost of revenues of $9.9 million and $23.0 million for the three

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and nine months ended September 30, 2002, respectively. Distribution costs as a percentage of revenue increased to 54% and 53% for the three and nine months ended September 30, 2003 from 43% and 40% for the three and nine months ended September 30, 2002, respectively.

The increases in cost of revenues and distribution costs as a percentage of revenue were primarily attributable to the growth in revenue, which triggered higher contractual revenue sharing costs due to the tiered structure of certain revenue sharing agreements, most notably with Microsoft. We expect distribution costs as a percent of revenue to be approximately 53-55% in the fourth quarter of 2003 and in 2004, assuming no significant changes to our current distribution levels. If we enter into or exit agreements with additional significant distribution partners, average distribution costs as a percentage of revenue may increase.

Operating Expenses

For purposes of managing our resources, we do not track operating expenses by reportable segment, but treat these as shared overhead of our reportable segments.

Due to the termination of our distribution and licensing agreement with Microsoft on January 15, 2004, we intend to restructure our operations over the next two quarters, which will significantly reduce our operating costs.

Sales and Marketing. Sales and marketing expenses include salaries, commissions, stock-based compensation and other costs of employment for the Company’s sales force, sales administration and customer service staff, payments to distribution partners for directing online users to LookSmart search results and referring Small Business customers when LookSmart branding is used, overhead, facilities, allocation of depreciation and the provision for and reversals of reserves for doubtful trade receivables. Sales and marketing expenses also include the costs of advertising, trade shows and public relations activities. Sales and marketing expenses changed as follows (dollar figures are in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
Amortization of deferred stock compensation	$	4		$	226		$	39		$	738
Stock compensation related to variable options		420			(64	)		695			54
Bad debt expense		64			—			58			580
Other sales and marketing expense		5,519			4,202			16,844			14,428
Total sales and marketing expense	$	6,007		$	4,364		$	17,636		$	15,800
As % of revenue		15	%		18	%		16	%		24	%

Amortization of deferred stock compensation is related to stock granted to employees at less than market value. This expense will continue to decline in 2003 as it becomes fully amortized.

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

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Bad debt expense for the three months ended September 30, 2003 increased $0.1 million from the third quarter of 2002 and bad debt expense for the nine months ended September 30, 2003 decreased $0.5 million from the nine months ended September 30, 2002. In the third quarter of 2003, the Company recorded a bad debt expense of $0.1 million, which related primarily to the accounts receivable of the United Kingdom subsidiary. The decrease in the year-to-date expense was due to the improvement in the Company’s rate of collections and the application of the improved collection rates to the Company’s domestic accounts receivable.

Other sales and marketing expenses for the three and nine months ended September 30, 2003, increased 31% and 17% from the three and nine months ended September 30, 2002. This increase was due primarily to additional costs related to our United Kingdom and Japanese subsidiaries. We expect these costs to remain relatively constant for the remainder of the year.

Product Development.Product development costs include all costs related to the development and engineering of new products and continued development of our search databases and customer account features. These costs include salaries and associated costs of employment, including stock-based compensation, overhead, facilities and amortization of intangible assets. Costs related to the development of software for internal use in the business, including salaries and associated costs of employment are capitalized. Software licensing and computer equipment depreciation related to supporting product development functions are also included in product development expenses. Product development expenses were as follows (dollar figures are in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
Amortization of deferred stock compensation	$	32		$	255		$	120		$	778
Stock compensation related to variable options		930			(71	)		1,552			77
Other product development expense		7,434			4,924			21,665			16,433
Total product development expense	$	8,396		$	5,108		$	23,337		$	17,288
As % of revenue		21	%		21	%		21	%		27	%

Amortization of deferred stock compensation is related to stock granted to employees at less than market value. This expense will continue to decline in 2003 as it becomes fully amortized.

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

The increase in other product development expenses of 51% and 32% for the three and nine months ended September 30, 2003 compared to 2002 was due to $0.9 million and $2.1 million of additional salary and benefit expense and temporary staff expenses incurred in the three and nine months ended September 30, 2003, a reduction in total capitalized costs of $0.5 million and $0.4 million for the three and nine months ended September 30, 2003 compared to the same periods in 2002, and $0.1 million and $0.6 million for the three and nine months ended September 30, 2003 in additional costs associated with our United Kingdom and Japanese subsidiaries. We expect these costs to remain relatively constant for the remainder of the year.

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General and Administrative. General and administrative expenses include overhead costs such as executive management, human resources, finance, legal and facilities personnel. These costs include salaries and associated costs of employment, including stock-based compensation, overhead, facilities and allocation of depreciation. General and administrative expenses also include legal, tax and accounting consulting and professional service fees. General and administrative expenses were as follows (dollar figures are in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
Amortization of deferred stock compensation	$	—		$	20		$	7		$	89
Stock compensation related to variable options		182			(52	)		309			34
Other general and administrative expense		3,211			2,826			9,683			7,661
Total general and administrative expense	$	3,393		$	2,794		$	9,999		$	7,784
As % of revenue		8	%		12	%		9	%		12	%

Amortization of deferred stock compensation is related to stock granted to employees at less than market value.

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

Other general and administrative expense increased 14% and 26% in the three and nine months ended September 30, 2003 compared to 2002, respectively. The increase in expenses for the three months ended September 30, 2003 compared to the three months ended September 30, 2002 was primarily due to additional costs associated with our United Kingdom and Japanese subsidiaries. The remaining increase for the nine months ended September 30, 2003 compared to the nine months ended September 30, 2002 was primarily due to an increase of $0.3 million of additional fees related to tax consulting, audit fees and consulting fees related to compliance with the Sarbanes-Oxley Act in addition to $0.6 million related to the proposed settlement of pending litigation related to our small business product. We expect other general and administrative costs to remain relatively constant for the remainder of the year.

Non-Operating Expenses

Interest and Other Non-Operating Income (expenses), net.Interest and other non-operating income (expense), net was an expense of $0.3 million and $0.3 million for the three and nine months ended September 30, 2003, respectively, compared to expense of $1.2 million and $2.8 million for the three and nine months ended September 30, 2002, respectively. This decrease was primarily the result of the settlement of the Company’s loan with Transceptgate, a subsidiary of BT in December 2002.

Share of Joint Venture Loss.Share of joint venture loss includes LookSmart’s 50% share of the loss of BT LookSmart. The Company recorded $0.0 and $0.6 million of equity losses for the three and nine months ended September 30, 2003, respectively, compared to $0.9 million and $2.8 million in expense recorded in the three and nine months ended September 30, 2002, respectively. In December 2002, LookSmart entered into a settlement agreement with BT to terminate the joint venture. The decrease in the equity losses compared to the prior year was a result of the joint venture winding down operations. The joint venture investment balance at September 30, 2003 approximates the expected distribution of joint venture assets. We do not expect significant gains or losses from the joint venture in the future.

Income Tax Benefit (Expense)

The provision for income taxes was $0.3 million and $0.9 million for the three and nine months ended September 30, 2003 compared to a benefit of $1,000 and expense of $23,000 for the three and nine months ended September 30, 2002. Our effective tax rate was 13% and 18% for the three and nine months ended September 30, 2003, respectively, and was due primarily to statutory tax rates associated with doing business in countries where there are no historical losses to offset current income and

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federal alternative minimum taxes. The Company did not incur tax expense on 2002 U.S. net income due to loss carryforwards and tax credits. Income tax expense for the three and nine months ended September 30, 2002 was primarily associated with our Australian operations. The effective tax rate in the upcoming quarters and for the year ending December 31, 2003 may vary due to a variety of factors, including but not limited to the relative income contribution by tax jurisdiction, changes in statutory tax rates, the amount of tax exempt interest income generated during the year, the ability to utilize foreign tax credits and foreign net operating losses, and any non-deductible items related to acquisitions or other non-recurring charges.

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 and discontinued operations of Futurecorp. As required by SFAS No. 144, the Company reported the results of operations of this component as a loss from discontinued operations of $1.0 million in 2002, which includes a $1.0 million loss on disposal. Revenue included in the loss on disposal was $0 and $0.6 million in the nine months ended September 30, 2003 and 2002, respectively. Pretax net loss reported in discontinued operations was $0 and $63,000 in the nine months ended September 30, 2003 and 2002, respectively.

Extraordinary Gain on Acquisition of BT LookSmart Entities

In February 2000, LookSmart entered into a joint venture agreement with British Telecommunications (BT). LookSmart and BT took an equal equity interest in the joint venture, BT LookSmart, which provided localized directory services in Europe and Asia. We accounted for our investment in the joint venture using the equity method of accounting. Our share of the joint venture’s net loss is reported as non-operating income or expense.

In December 2002, LookSmart entered into a settlement agreement with BT to terminate the joint venture. LookSmart and BT are jointly liable for the estimated settlement costs of $2.3 million expected to be incurred during the dissolution of the joint venture. These estimated costs were recorded in the fourth quarter of 2002 by the joint venture.

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

Liquidity and Capital Resources

The Company invests cash pending use in investment grade debt and equity instruments with maturities of less than one year, with the intent to make such funds available for operating purposes. As of September 30, 2003, the Company had $61.3 million of unrestricted cash, cash equivalents and short-term investments.

Operating activities provided $10.7 million of cash in the nine months ended September 30, 2003 compared to $8.2 million in the nine months ended September 30, 2002. The improvement in cash provided by operating activities is primarily attributable to increased revenue in the nine months ended September 30, 2003 compared to the same period in 2002.

Net cash used in investing activities was $7.4 million in the nine months ended September 30, 2003, compared to cash provided by investing activities of $9.8 million in the nine months ended September 30, 2002. For the nine months ended September 30, 2002, the Company sold short-term investments of $13.1 million compared to purchases of $1.6 million for the nine months ended September 30, 2003. Additionally, investment activity increased during the nine months ended September 30, 2003 associated with the acquisition of property and equipment and capitalized software from $4.2 million in 2002 to $4.7 million in 2003. We expect to invest a total of approximately $1 million in capital expenditures in fourth quarter of 2003.

Net cash provided by financing activities was $5.0 million for the nine months ended September 30, 2003, compared to $2.5 million for the nine months ended September 30, 2002. The cash provided by financing activities in both periods was due primarily to proceeds received from the issuance of common stock in connection with employee stock option exercises.

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

Off-Balance Sheet Arrangements

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

Contractual Obligations and Commercial Commitments

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

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

Operating Lease Obligations—We have operating leases covering facilities in San Francisco, New York and Los Angeles and various international offices. We also have some minor operating leases relating to equipment.

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

Guarantees Under Letters of Credit—We have obtained standby letters of credit from time to time as security for certain liabilities. At September 30, 2003, outstanding letters of credit related to security of building leases of $1.6 million.

Recently Issued Accounting Pronouncements

See Note 1 in the Notes to 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 likely will not be able to maintain profitability in 2004, which could result in a decline in our stock price

After the fourth quarter of 2003, we likely will not be able to maintain profitability. On October 6, 2003, we announced that Microsoft will not renew its distribution and licensing agreement with us after it expires on January 15, 2004. Our business and financial results will be materially and adversely affected following the end of the MSN relationship. Microsoft accounted for approximately 65% of listings revenues and all of our licensing revenue in the nine months ended September 30, 2003. Accordingly, we likely will be unable to maintain profitability in future quarters.

We reached profitability for the first time in the fourth quarter of 2002. Prior to that time, we incurred net losses in every quarter since inception, including net losses of approximately $6.6 million in the first three quarters of 2002, $59.6 million in 2001, $62.6 million in 2000 and $64.7 million in 1999. As of September 30, 2003, we had an accumulated deficit of $178.0 million.

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The extent of our net losses in 2004 will depend on our ability to preserve revenues, develop our distribution network and sources of click traffic, restructure our business in light of the loss of the Microsoft relationship, and contain our expenses. We expect to spend significant amounts to:

• maintain and expand our network of distribution partners and make revenue sharing payments to our distribution partners,

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

• develop new listings products and enhance our search services.

Because of the foregoing factors, and others outlined in this report, we will likely be unable to maintain profitability on a quarterly or annual basis in 2004.

We may lose customers and our revenue per click may fall as a result of the expiration of the Microsoft agreement in January 2004, which would cause a decline in our revenues

We may lose additional advertisers from our advertiser base and our average revenue per click may fall as a result of the loss of Microsoft as a distribution partner after January 15, 2004. Most of our advertising contracts are short-term in nature and are terminable on short notice. It is difficult to predict whether, and to what extent, we will lose advertisers or advertisers will pay reduced revenues per click after the Microsoft agreement ends. If enough of our advertisers terminate their advertising contracts with us, or if our revenue per click falls significantly, then our listings revenues and results of operations would be materially and adversely affected.

We rely primarily on our network of distribution partners to generate paid clicks; if we were unable to maintain or expand this network after January 2004, our ability to generate revenues would be seriously harmed

Our ability to generate paid clicks depends on the distribution of our listings through our network of portals, ISPs and media companies. Because our revenues depend on clicks on our paid listings, growth in our listings business depends on the volume of traffic on our distribution network. Microsoft accounted for approximately 75% of our paid clicks and 66% of our listings revenues in the third quarter of 2003. Our distribution agreement with Microsoft expires on January 15, 2004. After that time, even if we find alternative distribution partners, our volume of traffic will likely decline significantly. We face competition for traffic sources from other paid listing providers, some of whom have greater technical and capital resources than we do. 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 would be seriously harmed.

Our revenues are concentrated in the listings segment and our growth prospects depend on the success of our listings business; if we were unable to find alternative sources of revenue in this segment or contain our costs, our results of operations and financial conditions would suffer

To maintain profitability through the fourth quarter of 2003, and to regain profitability after the end of the Microsoft relationship in January 2004, we will need to continue expanding our listings business or significantly reduce our operating costs. Listings accounted for $36.7 million or 91.1% of our revenues in the third quarter of 2003. Our success will depend upon the extent to which advertisers choose to use and partners choose to distribute our listings products. Some of our products will require both modification of existing software and systems and the creation or acquisition of new software and systems. We may lack the managerial, editorial and technical resources necessary to expand our product offerings in a timely manner. Even if we expand our product offerings, customers may not adopt our products at projected rates. For these and other reasons, these initiatives may not generate sufficient revenues to reach our profitability goals. If we are unable to generate significant additional revenues from our listings business or significantly reduce our operating costs, our results of operations and financial condition will suffer.

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

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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.

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

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

• changes in our distribution network, particularly the loss of Microsoft as a distribution partner after January 15, 2004, changes to the terms of our distribution agreements, or changes by our distribution partners in their web sites that affect the number of clicks on our search results,

• changes in the number of advertisers who purchase our listings, or the number of listings purchased by our large business customers,

• the revenue-per-click we receive from advertisers, or other factors that affect the demand for, and prevailing prices of, Internet advertising and marketing services,

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

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

• technical difficulties and systems downtime or failures, whether caused by us, third party service providers or hackers, and whether occurring on our web site or the web sites of our distribution partners,

• the effect of variable accounting for stock options, which requires that we book an operating expense in connection with some of our outstanding stock options at the end of each quarter, depending on the closing price of our common stock on the last trading day of the quarter and the number of stock options subject to variable accounting, or

• the timing of our delivery of URL listings under our contract with Microsoft, which will terminate on January 15, 2004. We recognize quarterly licensing revenues under this contract based on the number of URL listings added to our database during the quarter relative to the total number of URL listings we 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 expenses 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.

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, 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, unfair competition or other theories based on our listings and services. In addition, we are obligated under some agreements to indemnify our partners in the event that they are subject to claims that our listings or services infringe on the rights of others. 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.

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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.

We face growing competitive pressures in the search marketing industry which, if this trend towards increasing competitive pressures were to continue, could materially and adversely affect our financial results

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

• profitably establish and expand our listings product offerings,

• compete with our competitors, some of whom have greater capital or technical resources than we do,

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

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

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

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

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

We derive a significant portion of our revenues from the sale of listings to companies that represent credit risks. Some of our customers have gone out of business, have limited operating histories or are operating at a loss. Moreover, many of these companies have limited cash reserves and limited access to additional capital. We have in some cases experienced

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difficulties collecting outstanding accounts receivable and our allowance for doubtful accounts receivable as of September 30, 2003 was $2.4 million or 10% of our total accounts receivable. We may continue to have these difficulties in the future, and if a significant part of our customer base experiences financial difficulties or is unable or unwilling to pay our search marketing fees for any reason, our business will suffer.

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

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

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

• quarterly fluctuations in our operating results,

• the termination or expiration of our distribution agreements,

• our potential failure to meet our forecasts or analyst expectations on a quarterly basis,

• changes in ratings or financial estimates by analysts,

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

• the sales of substantial amounts of our common stock in the public market by participants in our pre-IPO equity financings or by 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 October 31, 2003, the CDIs registered for trading on the Australian Stock Exchange were exchangeable into an aggregate of approximately 18.8 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 or outcome of the case.

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

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

• 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,

• develop new product and service offerings,

• take advantage of favorable conditions in capital markets, or

• respond to competitive pressures.

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

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

We have developed custom, proprietary software for use by our editors to create the LookSmart directories, and we also use proprietary and licensed software to crawl the web and index web pages, search the database, distribute our search results and serve 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 search databases,

• customization of our search results 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, such as the Sponsored Listings product launched in October 2003.

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.

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

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 clicks and revenues. A system failure that prevents us from tracking paid clicks or reporting accurate information to our customers’ online accounts could adversely affect our reputation and financial results. The occurrence of a natural disaster or unanticipated problems at our principal headquarters or at a third-party facility could cause interruptions or delays in our business, loss of data or could render us unable to provide some services. Our California facilities exist on or near known earthquake fault zones and a significant earthquake could cause an interruption in our services. We do not have back-up sites for our main customer operations center and editorial department which are both located at our San Francisco, California office. An interruption in our ability to provide customer support and editorial services would adversely affect our business.

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

We have an agreement with Savvis Communications, Inc. to house equipment for web serving and networking and to provide network connectivity services. We also have an agreement with AboveNet Commuincations, Inc. to house equipment for networking and to provide network connectivity services. Our network connectivity and network hardware infrastructure are fully redundant at separate locations. However, we do not presently maintain fully redundant click tracking, customer account and web serving systems at separate locations. Accordingly, our operations depend on Savvis and AboveNet to protect the systems in 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.

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

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

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.

We may incur unforeseen expenses and liabilities in connection with the dissolution of BT LookSmart

In the fourth quarter of 2002, we and BT agreed to close our joint venture, BT LookSmart. We are in the process of dissolving the joint venture and may incur unforeseen expenses in connection with the dissolution. Also, we have assumed the operations of BT LookSmart in the United Kingdom and Japan and we may incur costs in excess of the amounts we forecasted in connection with the operation of those businesses.

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

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

We have acquired businesses and technologies, including the acquisition of WiseNut, Inc. in the second quarter of 2002 and the acquisition of the intellectual property assets of Grub, Inc. in the first quarter of 2003. 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 business prospects depend on the continued growth in the use of the Internet; if such growth in usage were to subside or stop completely, our business could be materially and adversely impacted

Our business is dependent upon continued growth in the use of the Internet as a medium for search marketing 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;

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• inconsistent quality of service,

• government regulation, such as tax or privacy laws, and

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

If these or other 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 handling or use of personal information. Any laws imposed to protect the privacy of Internet users may affect the way in which we collect and use personal information. We could incur additional expenses if new laws or court judgments, in the United States or abroad, regarding the use of personal information are introduced or if any agency chooses to investigate our privacy practices.

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

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

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

The Federal Trade Commission, in response to a petition from a private organization, reviewed the way in which search engines disclose paid placement or paid inclusion practices to Internet users. Recently, the FTC staff issued guidance on the matter in the form of letters to the petitioner and to members of the industry, including LookSmart. The letters stated the staff’s position on what disclosures are necessary to avoid misleading users about the possible effects of paid placement or paid inclusion listings on the search results. This guidance may differ from the existing practices of some in the industry, including our practices and those of some of our distribution partners. The FTC has not yet taken any enforcement action to date against us or any of our distribution partners. If the FTC were to require changes in the labeling or other disclosure of our listings, it may reduce the desirability of our services, and our business and the business of some of our distribution partners could be harmed. We and some of our distribution partners have recently adjusted the disclosures on our search results pages on a voluntary basis, or are likely to do so in the future, and such disclosures may reduce the desirability of our listings, which could adversely affect our business.

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

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

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

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

ITEM 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 of restricted cash. The Company had no derivative financial instruments as of September 30, 2003 or 2002. The Company invests 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 and issuer is limited.

Foreign Currency Risk. International revenues from the Company’s foreign subsidiaries were 17% and 3% of total revenues in the quarters ended September 30, 2003 and 2002, and were derived from our Australian, United Kingdom and Japanese 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, particularly the exchange rates between the Australian dollar, the United Kingdom Pound, the Japanese Yen and the United States dollar. The effect of foreign exchange rate fluctuations on the Company for quarters ended September 30, 2003 and 2002 were not material.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures.Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

Changes in internal control over financial reporting.There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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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 in April 2002. The complaint sought restitution, unspecified compensatory damages, injunctive relief and attorneys’ fees. In July 2002, Curt Kramer, an express listing customer, filed a proposed class action lawsuit in Superior Court in San Francisco County alleging claims that were substantially similar to those alleged by Legal Staffing Partners. In October 2002, the two plaintiffs agreed to withdraw their complaints and file a single consolidated amended complaint containing substantially the same allegations as the prior two complaints. In November 2002, the Company filed a motion to dismiss the claims in the amended complaint. The court denied the motion in January 2003. The Company filed an answer to the amended complaint in January 2003. Plaintiffs have served document and deposition requests, but no other discovery is being sought at this time. In June 2003, the Company reached a tentative agreement to settle the matter and in October 2003 the Superior Court approved the settlement.

The Company is not a party to any other material legal proceedings.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

Please see the exhibit list following the signature of this report.

(b) Form 8-K

The Company furnished a Current Report on Form 8-K on July 29, 2003 (second quarter 2003 financial results) and filed Current Reports on Form 8-K on October 6, 2003 (Microsoft non-renewal) and October 28, 2003 (third quarter 2003 financial results).

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, 2003

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

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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.
10.7(3)	Zeal Media, Inc. 1999 Stock Plan
10.8(5)	Wisenut, Inc. 1999 Stock Incentive Plan
10.12(1)	Lease Agreement with Rosenberg SOMA Investments III, LLC for property located at 625 Second Street, San Francisco, California, dated May 5, 1999
10.13(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
10.21(4)	Employment Agreement with Kevin Berk dated September 29, 2000
10.22(4)	Employment Agreement with Brian Goler dated September 29, 2000
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(7)	Letter agreement between the Registrant and Robert Goldberg dated March 4, 2002
10.28(7)	Letter agreement between the Registrant and Brian Cowley dated May 30, 2002
10.29(7)	Letter agreement between the Registrant and Martin Roberts dated July 1, 2002
10.30(7)	Letter agreement between the Registrant and Jason Kellerman dated September 24, 2002
10.31(8)	Settlement Agreement between the Registrant, Transceptgate Ltd., LookSmart Barbados, Inc., BT LookSmart, Ltd. and British Telecommunications Plc., dated December 3, 2002
10.32(9)	Letter agreement between the Registrant and Peter Adams dated September 17, 2001
10.33(10)	Source Code License Agreement between the Registrant and Viator Ventures, Inc., dated October 26, 2001
10.34++(12)	Co-Location Services Agreement between the Registrant and Savvis Communications Corporation dated February 19, 2003
10.35(11)	Settlement Agreement and Release between the Registrant and Dianne Dubois dated May 27, 2003
31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(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 Registration Statement on Form S-8 filed with the SEC on, December 7, 2000.

(4) Filed in connection with the Company’s Annual Report on Form 10-K filed with the SEC on March 16, 2001.

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(5) Filed in connection with the Company’s Registration Statement on Form S-8 filed with the SEC on April 18, 2002.

(6) Filed in connection with the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 14, 2002.

(7) Filed in connection with the Company’s Quarterly Report on Form 10-Q filed with the SEC on November 12, 2002.

(8) Filed in connection with the Company’s Annual Report on Form 10-K filed with the SEC on March 14, 2003.

(9) Filed in connection with the Company’s Quarterly Report on Form 10-Q filed with the SEC on May 15, 2003.

(10) Filed in connection with the Company’s Annual Report on Form 10-K/A filed with the SEC on August 5, 2003.

(11) Filed in connection with the Company’s Quarterly Report on Form 10-Q filed with the SEC on August 14, 2003.

(12) Filed in connection with the Company’s Quarterly Report on Form 10-Q/A filed with the SEC on November 7, 2003.

(+) Confidential treatment has been granted with respect to portions of the exhibit.

(++) Confidential treatment has been requested with respect to portions of the exhibit.

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