Looksmart 10-Q 2004 Q3 Quarterly report

U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

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

For the Quarterly Period Ended September 30, 2004

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)

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

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

As of November 1, 2004, there were 113,184,323 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, 2004 and December 31, 2003	3
	Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the three and nine months ended September 30, 2004 and 2003	4
	Condensed Consolidated Statements of Cash Flows for the nine months ended September, 2004 and 2003	6
	Notes to Condensed Consolidated Financial Statements	7
ITEM 2:	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
	Factors Affecting Operating Results	29
ITEM 3:	Quantitative and Qualitative Disclosures About Market Risk	38
ITEM 4:	Controls and Procedures	38
PART II OTHER INFORMATION
ITEM 1:	Legal Proceedings	38
ITEM 2:	Unregistered Sales of Equity Securities and Use of Proceeds	39
ITEM 6:	Exhibits	39
ITEM 7:	Signature	39
EXHIBIT INDEX		40

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PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

LOOKSMART, LTD.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

(Unaudited)

	September 30, 2004			December 31, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	50,590		$	63,866
Short-term investments		3,683			6,068
Trade accounts receivable, net of allowance for doubtful accounts of $1,193 at September 30, 2004 and $2,504 at December 31, 2003		4,787			22,265
Prepaid expenses		1,220			2,308
Other current assets		453			372
Total current assets		60,733			94,879
Property and equipment, net		6,660			8,444
Other assets		3,708			6,124
Long term investments		11,331			—
Intangible assets, net		7,970			5,713
Goodwill		14,422			10,932
Total assets	$	104,824		$	126,092
LIABILITIES & STOCKHOLDERS’ EQUITY
Current liabilities:
Long term debt, current portion	$	47		$	101
Trade accounts payable		1,075			3,600
Other accrued liabilities		8,853			27,125
Deferred revenue and customer deposits		2,641			5,362
Total current liabilities		12,616			36,188
Long term debt		249			283
Other long term liabilities		5,172			3,324
Total liabilities		18,037			39,795
Commitments and contingencies (Note 6)
Stockholders’ equity:
Common stock, $.001 par value; Authorized: 200,000 at September 30, 2004 and December 31, 2003; Issued and Outstanding: 113,358, and 107,808 at September 30, 2004 and December 31, 2003		112			106
Additional paid-in capital		270,563			261,792
Other equity		833			773
Accumulated deficit		(184,721	)		(176,374	)
Total stockholders’ equity		86,787			86,297
Total liabilities and stockholders’ equity	$	104,824		$	126,092

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,
	2004			2003			2004			2003
Revenues:
Listings	$	17,490		$	30,068		$	60,283		$	85,833
Licensing		—			3,594			188			11,298
Total revenues		17,490			33,662			60,471			97,131
Cost of revenues		9,563			17,885			34,389			51,461
Gross profit		7,927			15,777			26,082			45,670
Operating expenses:
Sales and marketing		1,495			3,597			6,044			11,118
Product development		5,033			7,274			18,315			20,337
General and administrative		1,958			2,558			7,321			8,589
Restructuring costs		98			—			4,152			—
Total operating expenses		8,584			13,429			35,832			40,044
Income (loss) from operations		(657	)		2,348			(9,750	)		5,626
Non-operating income (expense):
Interest and other non-operating income (expense), net		327			(14	)		474			(1,025	)
Share of joint venture loss		(100	)		—			(100	)		(563	)
Income (loss) from continuing operations before income taxes and extraordinary gain		(430	)		2,334			(9,376	)		4,038
Income tax expense		(117	)		(236	)		(117	)		(809	)
Income (loss) from continuing operations before extraordinary gain		(547	)		2,098			(9,493	)		3,229
Gain (loss) from discontinued operations, net of tax		562			(240	)		1,146			727
Income (loss) before extraordinary gain		15			1,858			(8,347	)		3,956
Extraordinary gain from the purchase of BTLS joint venture entities, net of tax		—			—			—			202
Net income (loss)		15			1,858			(8,347	)		4,158
Other comprehensive income (loss):
Change in unrealized gain on investments		61			1			62			1
Change in translation adjustment		(37	)		(103	)		(54	)		112
Comprehensive income (loss)	$	39		$	1,756		$	(8,339	)	$	4,271

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), CONTINUED

(In thousands, except per share data)

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Income (loss) per share:
Basic net income (loss) per share:
Income (loss) from continuing operations	$	(0.00	)	$	0.02		$	(0.09	)	$	0.03
Gain (loss) from discontinued operations		0.00			(0.00	)		0.01			0.01
Extraordinary gain from the purchase of BTLS joint venture entities		—			—			—			0.00
Net income (loss)	$	0.00		$	0.02		$	(0.08	)	$	0.04
Diluted net income (loss) per share:
Income (loss) from continuing operations	$	(0.00	)	$	0.02		$	(0.09	)	$	0.03
Gain (loss) from discontinued operations		0.00			(0.00	)		0.01			0.01
Extraordinary gain from the purchase of BTLS Joint Venture entities		—			—			—			0.00
Net income (loss)	$	0.00		$	0.02		$	(0.08	)	$	0.04
Weighted average shares outstanding used in per share calculation—basic		112,530			104,730			110,661			102,596
Weighted average shares outstanding used in per share calculation—diluted		113,508			113,375			110,661			110,208

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,
	2004			2003
Cash flows from operating activities:
Net income (loss)	$	(8,347	)	$	4,158
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Share of joint venture loss		100			563
Depreciation and amortization		6,049			5,833
Stock based compensation		38			2,715
Gain from sale of assets and other non-cash charges		(636	)		(19	)
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		17,478			(5,417	)
Prepaid expenses		1,088			(933	)
Other assets		930			973
Trade accounts payable		(2,525	)		(1,597	)
Other accrued liabilities		(16,521	)		6,993
Deferred revenue and customer deposits		(2,721	)		(2,377	)
Net cash (used in) provided by operating activities		(5,067	)		10,690
Cash flows from investing activities:
Acquisitions		(2,116	)		(612	)
Proceeds from sale of short-term investments		2,385			—
Purchases of short-term investments		—			(1,575	)
Purchases of long-term investments		(11,331	)		—
Funding to joint venture		—			(500	)
Payments for property, equipment and capitalized software development		(2,222	)		(4,726	)
Proceeds from the sale of property and equipment		82			1
Proceeds from sale of discontinued operations		1,484			—
Net cash used in investing activities		(11,718	)		(7,412	)
Cash flows from financing activities:
Repayment of notes		(84	)		(1,161	)
Proceeds from issuance of common stock		3,647			6,190
Net cash provided by financing activities		3,563			5,029
Effect of exchange rate changes on cash		(54	)		112
Increase (decrease) in cash and cash equivalents		(13,276	)		8,419
Cash and cash equivalents, beginning of period		63,866			47,696
Cash and cash equivalents, end of period	$	50,590		$	56,115
Supplemental disclosure of non-cash investing activities:
Issuance of common stock as consideration in acquisitions	$	5,077		$	1,646

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

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

Reclassifications

Certain prior years’ balances have been reclassified to conform to the current year’s presentation. In the first nine months of 2003, payments to distribution partners for referral of customers to our LookListings program were reflected as sales and marketing expense. These costs have been reclassified and are reflected in cost of revenue. The amount reclassified in the first three and nine months of 2003 was $1.5 million and $4.0 million, respectively.

Concentration of Credit Risk and Business Risk

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

The Company derived approximately 18% and 16% of its listings revenues in the three and nine months ended September 30, 2004, respectively, from its relationship with Interchange Corporation.

The Company derived approximately 15% of its listings revenues in nine months ended September 30, 2004 from its relationship with Mamma.com.

The Company derived 16% of its listings revenue in the nine months ended September 30, 2004, and 68% an 66% of its listings revenues in the three and nine months ended September 30, 2003, respectively, from its relationship with Microsoft.

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

Software Revenue Recognition

Beginning in the second quarter of 2004, the Company began recognizing revenue from the sale of software products relating to the acquisition of Net Nanny. Software revenue is recognized upon shipment, provided pervasive evidence of arrangement exists, price is fixed and determinable, collection is determined to be probable and no significant obligations remain on our part. Revenue from distributors is

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subject to agreements allowing certain rights of return. Accordingly, recognized revenue is reduced by estimated future returns at the time the related revenue is recorded. The estimates for returns are adjusted periodically based upon historical rates of returns, inventory levels in the distribution channel and other related factors. The Company records software licensing revenue, primarily royalties, when partners ship products incorporating Looksmart software, provided collection of such revenue is deemed probable.

See our Form 10-K for a complete discussion of the Company’s revenue recognition policies.

Traffic Acquisition Costs

The Company enters into agreements of varying duration with third party affiliates that integrate the Company’s pay-for-performance search service into their Web sites. There are generally three economic structures of the affiliate agreements: guaranteed fixed payments which often carry reciprocal performance guarantees from the affiliate, variable payments based on a percentage of the Company’s revenue or based on a certain metric, such as number of searches or paid clicks, or a combination of the two.

The Company expenses, as cost of revenues, traffic acquisition costs under two methods; agreements with fixed payments are expensed pro-rata over the term the fixed payment covers, and agreements based on a percentage of revenue, number of paid introductions, number of searches, or other metric are expensed based on the volume of the underlying activity or revenue multiplied by the agreed-upon price or rate.

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

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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 employee compensation (in thousands, except per share data):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Income (loss) as reported	$	15		$	1,858		$	(8,347	)	$	4,158
Add: Stock-based employee compensation expense included in reported net income (loss), net of related tax effects		(34	)		1,561			38			2,715
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of tax		(483	)		(4,734	)		(3,939	)		(13,696	)
Pro forma net loss	$	(502	)	$	(1,315	)	$	(12,248	)	$	(6,823	)
Basic net income (loss) per share:
As reported	$	0.00		$	0.02		$	(0.08	)	$	0.04
Pro forma		(0.00	)		(0.01	)		(0.11	)		(0.06	)
Diluted net income (loss) per share:
As reported	$	0.00		$	0.02		$	(0.08	)	$	0.04
Pro forma		(0.00	)		(0.01	)		(0.11	)		(0.06	)

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

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

Segment Information

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

With the exception of accounts receivable, deferred revenue and goodwill, information (for the purposes of making decisions about allocating resources) available to the chief operating decision makers of the Company, the Chief Executive Officer and the Chief Financial Officer, did not include allocations of assets and liabilities or operating costs to the Company’s segments in 2003. As of September 30, 2004 and December 31, 2003, all of the Company’s accounts receivable, intangible assets, goodwill and deferred revenue related to the listings segment.

Recently Issued Accounting Pronouncements

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

In December 2003, the SEC issued Staff Accounting Bulletin No. 104 (“SAB 104”), “Revenue Recognition”, which supercedes Staff Accounting Bulletin No. 101 (“SAB 101”), “Revenue Recognition in

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Financial Statements.” The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, which was superceded as a result of the issuance of Emerging Issues Task Force 00-21 (“EITF 00-21”), “Accounting for Revenue Arrangements with Multiple Deliverables.” SAB 104 also incorporated certain sections of the SEC’s “Revenue Recognition in Financial Statements—Frequently Asked Questions and Answers” document. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The adoption of SAB 104 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In March 2004, the FASB approved the consensus reached on the Emerging Issues Task Force (“EITF”) Issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance for identifying impaired investments and new disclosure requirement for investments that are deemed to be temporarily impaired. The accounting provisions of EITF 03-1 were effective for all reporting periods beginning after June 15, 2004, while the disclosure requirements were effective only for annual periods ending after June 15, 2004. In September 2004, the EITF delayed the effective date for the recognition and measurement guidance previously discussed under EITF Issue No. 03-1. The Company will evaluate the impact of EITF No. 03-1 once final guidance is issued.

In March 2004, the FASB issued a proposed Statement, “Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95,” that addresses the accounting for share-based payment transactions in which a Company receives employee services in exchange for either equity instruments of the Company or liabilities that are based on the fair value of the Company’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed statement would eliminate the ability to account for share-based compensation transactions using the intrinsic method that the Company currently uses and generally would require that such transactions be accounted for using a fair-value-based method and recognized as expense in the consolidated statement of operations. The effective date of the proposed standard is for periods beginning after June 15, 2005. It is expected that the final standard will be issued before December 31, 2004 and should it be finalized in its current form, it will have a significant impact on the consolidated statement of operations as the Company will be required to expense the fair value of stock option grants and stock purchases under employee stock purchase plan.

In April 2004, the Emerging Issues Task Force (“EITF”) issued Statement No. 03-06 “Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings Per Share” (“EITF 03-06”). EITF 03-06 addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 became effective during the quarter ended June 30, 2004, the adoption of which did not have an impact on the calculation of earnings per share of the Company.

In June 2004, the Financial Accounting Standards Board (“FASB”) issued Emerging Issues Task Force Issue No. 02-14 (“EITF 02-14”), “Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock.” EITF 02-14 addresses whether the equity method of accounting applies when an investor does not have an investment in voting common stock of an investee but exercises significant influence through other means. EITF 02-14 states that an investor should only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influence over the operating and financial policies of the investee. The accounting provisions of EITF 02-14 are effective for reporting periods beginning after September 15, 2004. The Company does not expect the adoption of EITF 02-14 to have a material impact on the consolidated financial position, results of operations or cash flows.

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In July 2004, the EITF issued a draft abstract for EITF Issue No. 04-08, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share” (“EITF 04-08”). EITF 04-08 reflects the Task Force’s tentative conclusion that contingently convertible debt should be included in diluted earnings per share computations regardless of whether the market price trigger has been met. If adopted, the consensus reached by the Task Force in this Issue will be effective for reporting periods ending after December 15, 2004. Prior period earnings per share amounts presented for comparative purposes would be required to be restated to conform to this consensus. The Company does not expect the adoption of EITF 04-08 to have a material impact on the consolidated financial position, results of operations or cash flows.

2. Acquisitions

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

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

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

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

Accounts receivable, net of reserves	$	171
Inventory		34
Purchased technology		510
Goodwill		3,490
Other intangible assets		940
Total assets acquired		5,145
Less: current liability assumed		34
Net assets acquired	$	5,111

During the quarter ended September 30, 2004, the Company acquired the assets of Furl.net, which consisted primarily of intangible assets related to technology, customer lists, trade name and employees. The asset acquisition did not have a significant impact on total assets of the Company.

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3. Unaudited Interim Financial Information

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

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

4. Goodwill and Intangible Assets

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

	September 30, 2004		December 31, 2003
Goodwill	$	14,422	$	10,932
Intangible assets	$	13,342	$	9,763
Less accumulated amortization		5,372		4,050
Intangible assets, net	$	7,970	$	5,713

Intangible asset amortization expense was $0.6 million and $1.3 million for the three and nine months ended September 30, 2004, respectively, and $0.4 and $1.4 for the three and nine months ended September 30, 2003, respectively, and are 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
2004	$	607
2005		2,430
2006		1,825
2007		1,553
2008		1,183
Thereafter		372

5. Other Accrued Liabilities:

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

	September 30, 2004		December 31, 2003
Accrued compensation and related expenses	$	1,452	$	3,798
Restructuring accrual related to severance costs and current portion of lease obligations		1,351		1,653
Accrued distribution and partner costs		3,373		17,288
Other		2,677		4,386
	$	8,853	$	27,125

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6. Commitments and Contingencies

Operating Leases

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

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

	Operating Leases		Operating Leases, Net of Sublease Income
Year:
2004 remaining amount	$	1,164	$	1,044
2005		4,588		4,090
2006		4,622		4,553
2007		4,689		4,689
2008		4,751		4,751
Thereafter		4,412		4,412
Total	$	24,226	$	23,539

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

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

Guarantees and Indemnities

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

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Legal Proceedings

In August 2004, Mario Cisneros and Michael Voight filed a private attorney general lawsuit on behalf of a proposed class in Superior Court in San Francisco County. The complaint names thirteen search engines or web publishers as defendants (including the Company) and alleges unfair business practices, unlawful business practices and other causes of action in connection with the display of advertisements from internet gambling companies. The complaint seeks restitution, unspecified compensatory damages, declaratory and injunctive relief, and attorneys’ fees. The plaintiff has filed a motion for preliminary injunction and served discovery requests. The Company has not yet responded to the complaint, the motion for preliminary injunction, or the discovery requests, as the court has not required any response from the Company, pending a case management conference scheduled for December 2004. At this point in time, the Company does not have sufficient information to assess the validity of the complaint or the amount of potential damages.

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

JV Funding

Pursuant to the settlement agreement with British Telecommunications (“BT”) for the dissolution of the joint venture, LookSmart and BT are jointly liable for the costs incurred to shut down operations of the joint venture. The Company does not expect to incur significant additional expenses to shut down the joint venture. In the third quarter of 2004, we recorded an adjustment to the receivable from the Joint Venture of $0.1 million based on revised estimates of net realizable value of $0.3 million.

7. 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,
	2004		2003		2004			2003
Numerator – basic and diluted:
Net income (loss) as reported	$	15	$	1,858	$	(8,347	)	$	4,158
Denominator
Weighted average common shares outstanding:
Shares used to compute basic EPS		112,530		104,730		110,661			102,596
Dilutive common equivalent shares:
Options		978		7,839		—			6,807
Warrants		—		9		—			8
Escrow Shares		—		797		—			797
Shares used to compute diluted EPS		113,508		113,375		110,661			110,208
Net income (loss) per share:
Basic	$	0.00	$	0.02	$	(0.08	)	$	0.04
Diluted	$	0.00	$	0.02	$	(0.08	)	$	0.04

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

	Three Months Ended September 30,		Nine Months Ended September 30,
	2004	2003	2004	2003
Options	3,542	164	3,100	527
Warrants	65	22	55	28
Total antidilutive shares	3,607	186	3,155	555

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8. Related Party Transactions:

In 2002, the Company loaned Dianne Dubois, the Company’s former Chief Financial Officer, $0.3 million. The loan was interest-free and subject to forgiveness ratably over a period of four years, subject to certain performance measures being met. In addition, the Company has agreed to pay taxes due related to forgiveness of the loan and imputed interest. The amount of imputed interest and tax adjustments charged to operations were $1,000 and $1,000, respectively, for the three months ended September 30, 2004, respectively, and $7,000 and $7,000 for the nine months ended September 30, 2004. The amount forgiven, imputed interest and tax adjustments were $0, $3,000 and $10,000 for the three months ended September 30, 2003 and $16,000, $11,000 and $45,000 for the nine months ended September 30, 2003. Due to the resignation of the Chief Financial Officer in 2003, the outstanding unforgiven balance of $0.2 million was repaid in August 2004.

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

9. Restructuring Costs

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

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

In the second quarter of 2004, the Company announced that it eliminated an additional 14 positions in the United States, which included a reduction in the Company’s sales force of 3 positions, a reduction in the Company’s general and administrative departments of 4 positions and a reduction in the Company’s product development department of 7 positions. This reduction resulted in a $0.4 million restructuring charge recognized in the second quarter of 2004 and $0.1 million restructuring charge recognized in the third quarter of 2004. Substantially all severance costs were paid by the end of the third quarter of 2004.

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These costs were classified as restructuring charges on the Statement of Operations and Comprehensive Income (Loss), and included in Operating Expenses. As of September 30, 2004 the restructuring liability was $6.1 million. Of this amount, $1.4 million was included in other accrued liabilities and $4.7 million was included in other long-term liabilities on the Consolidated Balance Sheet.

A reconciliation of the liability for the restructuring charge at December 31, 2003 to the liability as of September 30, 2004 is as follows (in thousands):

	Employee Severance Costs			Lease Restructuring Costs			Total
Total 2003 restructuring charges	$	977		$	3,161		$	4,138
Reclassification of deferred rent		—			165			165
Balance at December 31, 2003		977			3,326			4,303
Adjustments to accrual during the period ended June 30, 2004		76			—			76
Additional restructuring costs		963			3,160			4,123
Reclassification of deferred rent		—			192			192
Balance at March 30, 2004		2,016			6,678			8,694
Amortization of lease restructuring costs		—			(413	)		(413	)
Cash payments		(1,692	)		—			(1,692	)
Balance at June 30, 2004	$	324		$	6,265		$	6,589
Additional restructuring costs		98			—			98
Reclassification of deferred rent		—			3			3
		422			6,268			6,690
Amortization of lease restructuring costs		—			(307	)		(307	)
Cash payments		(261	)		—			(261	)
Balance at September 30, 2004	$	161		$	5,961		$	6,122

10. 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 beginning on March 1, 2003.

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11. Gain on Discontinued Operations

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

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

I Pretax net income from discontinued operations for nine months ended September 30, 2004 includes approximately $0.4 million related to the reduction of the allowance for bad debts in the second quarter of 2004, as substantially all accounts have been collected in certain locations, and approximately $1.0 million related to the disposition and write down of certain international assets and the reduction of estimated liabilities in the third quarter of 2004, offset by expenses related to the operations of the entities during the periods.

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

	Three Months Ended September 30,					Nine Months Ended September 30,
	2004		2003			2004		2003
Revenue	$	—	$	6,638		$	6,036	$	14,978
Pretax net income (loss) (excluding gain on disposal)		562	$	(193	)		123		802
Tax impact		—		(47	)		—		(75	)
Gain on disposal		—		—			1,023		—
Net gain (loss) from discontinued operations	$	562	$	(240	)	$	1,146	$	727

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, including expected increase in proprietary traffic ability to control and/or reduce operating expenses, anticipated gross margins and operating results, cost savings, product development efforts, general outlook of our business and industry, future profits or losses, opportunities abroad, competitive position, integration of our search services into recent acquired products to differentiate us from our competitors, stock compensation and adequate liquidity to fund our operations and meet our other cash

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requirements, are inherently uncertain as they are based on our expectations and assumptions concerning future events. These forward-looking statements are subject to numerous known and unknown risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including our ability to regain net profitability in future quarters, our ability to expand and diversify our network of distribution partners, the success of our listings business and all other risks described below in the section entitled “Factors Affecting Operating Results” and elsewhere in this report. All forward-looking statements in this document are made as of the date hereof, based on information available to us as of the date hereof, and we assume no obligation to update any forward-looking statements.

BUSINESS OVERVIEW

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

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

CRITICAL ACCOUNTING ESTIMATES

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

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

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

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

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

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

We recognize software revenue in accordance with current generally accepted accounting principles that have been prescribed for the software industry. Revenue recognition requirements in the software industry are very complex and are subject to change. In applying our revenue recognition policy we must determine which portions of our revenue are recognized currently and which portions must be deferred. In order to determine current and deferred revenue, we make judgments and estimates with regard to future deliverable products and services. Our assumptions and judgments regarding future products and services could differ from actual events, thus materially impacting our financial position and results of operations.

Software revenue is recognized upon shipment, provided pervasive evidence of arrangement exists, price is fixed and determinable, collection is determined to be probable and no significant obligations remain on our part. Revenue from distributors is subject to agreements allowing certain rights of return. Accordingly, recognized revenue is reduced by estimated future returns at the time the related revenue is recorded. The estimates for returns are adjusted periodically based upon historical rates of returns, inventory levels in the distribution channel and other related factors. We record software licensing revenue, primarily royalties, when partners ship products incorporating Looksmart software, provided collection of such revenue is deemed probable.

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

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

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

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

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

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

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

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

Allowance for Doubtful Accounts. The Company maintains an allowance for doubtful accounts for estimated losses resulting from the failure of our customers to make required payments. This valuation allowance is reviewed on a periodic basis to determine whether a provision or reversal is required. The review is based on factors including the application of historical collection rates to current receivables. The Company will record a reversal of its allowance for doubtful accounts if there is a significant improvement in collection rates or economic conditions are more favorable than the Company has anticipated. Additional

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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

Overview of the Three and Nine Months Ended September 30, 2004

During the third quarter of 2004, we focused on the following primary operating priorities:

• Grow our paid listings business. Our core and ongoing business (excluding MSN and discontinued operations) continued to grow slightly from second quarter of 2004 to third quarter of 2004 and by 82% from third quarter of 2003 to third quarter of 2004. In the third quarter of 2004 we continued to add 8 new distribution partners, totaling 30 new distribution partners in 2004.

• Differentiate ourselves from our competitors. During the third quarter, we acquired the assets of Furl.net, a web-based archiving service. In addition, we launched an updated version of our family friendly safe search product, including a free downloadable toolbar. Both the software upgrade and the acquisition further improve our ability to differentiate our offerings to our partners and are expected to result in increases in proprietary traffic over the next year.

• Improve our traffic quality and optimize high quality partners.During the third quarter, we continued to focus on improving our overall traffic quality. We initiated an optimization program to increase the traffic from partners with the highest quality traffic and decrease both traffic and revenue share from the partner with lower quality traffic. This resulted in an overall decrease in traffic acquisition costs of 2% compared the second quarter of 2004.

Revenues

	Three Months Ended September 30,						Percent Change		Nine Months Ended September 30,						Percent Change
	2004			2003					2004			2003
Listings	$	17,490		$	30,068		(42	)%	$	60,283		$	85,833		(30	)%
Percentage of total revenues		100	%		89	%				100	%		88	%
Licensing		—			3,594		(100	)%		188			11,298		(98	)%
Percentage of total revenues		0	%		11	%				0	%		12	%
Total revenues	$	17,490		$	33,662		(48	)%	$	60,471		$	97,131		(38	)%

Listings.Listings revenues in the three and nine months ended September 30, 2004 decreased compared to the three and nine months ended September 30, 2003 due primarily to the winding down of our relationship with Microsoft, which began in January of 2004. This decrease was partially offset by an 82% increase in our core, non-Microsoft, revenue, primarily due to the addition of new distribution partners in the first nine months of 2004 compared to the same period in 2003.

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We began recording revenue from the sale of software in the second quarter of 2004. This revenue is included in listings revenue and was less than 5% of total revenue for the three and nine months ended September 30, 2004.

We expect our core listings revenue and software revenue to increase throughout the remainder of 2004 as we add more distribution partners and proprietary traffic to our network. Revenue from continuing operations for 2004 is expected to be between $78.5 million and $80.5 million.

Licensing. In 2003, we exclusively licensed our database content to Microsoft and customized it for their use. We derived all of our licensing revenue from our agreement with Microsoft, which expired on January 15, 2004. We do not expect additional licensing revenue in 2004.

Cost of Revenues

	Three Months Ended September 30,						Percent Change		Nine Months Ended September 30,						Percent Change
	2004			2003					2004			2003
Traffic acquisition costs	$	8,133		$	16,172		(50	)%	$	30,248		$	46,494		(35	)%
Percentage of listings revenues		47	%		54	%				50	%		54	%
Other costs		1,430			1,713		(17	)%		4,141			4,967		(17	)%
Percentage of total revenues		8	%		5	%				7	%		5	%
Total cost of revenues	$	9,563		$	17,885		(47	)%	$	34,389		$	51,461		(33	)%

Cost of revenue consists of traffic acquisition costs, connectivity costs, personnel costs of our sales operations employees, including stock-based compensation, equipment depreciation, expenses relating to hosting advertising operations, commissions paid to advertising agencies and amortization of certain intangible assets.

The decrease in traffic acquisition costs in the three and nine months ended September 30, 2004 compared to the three and nine months ended September 30, 2003 was primarily attributable to the loss of major partners, including Microsoft, Inktomi and Sprinks. The decrease in traffic acquisition costs as a percent of listings revenue in the three and nine months ended September 30, 2004 compared to the three and nine months ended September 30, 2003 was partially attributed to a reduction in international traffic and traffic optimization efforts. In the third quarter of 2004, we made adjustments to our distribution network to remove international traffic from our US domestic network. Accordingly, we reduced our partner payment accrual by $0.4 million related to the international and blocked users established in the prior quarter. We established our accrual based on our best estimate of the impact of this change in business practice. Without this benefit, traffic acquisition costs would have been 49% and 51% in the three and nine months ended September 30, 2004. This reduction from the same period in 2003 reflects our continued efforts to improve our traffic quality and optimizing traffic flow from our partners.

We expect traffic acquisition costs as a percent of listings revenue of approximately 51-53% in the fourth quarter of 2004.

Operating Expenses

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

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

	Three Months Ended September 30,						Percent Change		Nine Months Ended September 30,						Percent Change
	2004			2003					2004			2003
Stock compensation related to variable options	$	(15	)	$	420				$	(17	)	$	696
Bad debt provision/(reversal)		(97	)		(315	)				73			(638	)
Other sales and marketing expenses		1,607			3,492					5,988			11,060
Sales and marketing	$	1,495		$	3,597		(58	)%	$	6,044		$	11,118		(46	)%
Percentage of total revenues		9	%		11	%				10	%		11	%

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

In the third quarter of 2004, we reduced our bad debt allowance by $0.1 million. This reduction reflects an improvement in the historical collection rate applied to our oldest receivables and the overall improvement in DSO to 25 days for the quarter ended September 30, 2004. Bad debt expense for the nine months ended September 30, 2004 reflects the improvement in the third quarter offset by expenses incurred during the first two quarters of the year. We do not expect significant bad debt expense during the fourth quarter of 2004 as we continue to focus on improving our collections.

In the first nine months of 2003, the Company reduced a total of $0.6 million of the allowance for bad debts. The reduction was due to the improvement in the Company’s rate of collections and applying these rates to the amounts outstanding at the end of the periods, net of cash collected subsequent to the end of the periods.

The decline in other sales and marketing expenses was primarily attributable to a reduction of salaries, wages and benefits of $1.9 million in the three months ended September 30, 2004 compared to the three months ended September 30, 2003 and $4.8 million in the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003, resulting from the Company’s restructuring activities. In addition, marketing expenses declined $0.1 million in the three months ended September 30, 2004 compared to the three months ended September 30, 2003 and $0.4 million in the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003. This reduction was due to the Company’s overall cost reductions efforts. We expect sales and marketing expenses to increase slightly in the fourth quarter of 2004.

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

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

	Three Months Ended September 30,						Percent Change		Nine Months Ended September 30,						Percent Change
	2004			2003					2004			2003
Stock compensation related to variable options	$	(33	)	$	930				$	(20	)	$	1,548
Capitalized software development costs		(151	)		(478	)				6			(1,857	)
Other product development expenses		5,217			6,822					18,329			20,646
Total product development expenses	$	5,033		$	7,274		(31	)%	$	18,315		$	20,337		(10	)%
Percentage of total revenues		29	%		22	%				30	%		21	%

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

Capitalized software development costs include the cost to develop software for internal use, excluding costs associated with research and development, training and testing. The decrease in the amount capitalized for the three months ended September 30, 2004 compared to the three months ended September 30, 2003 was primarily related to a reduction in the number of engineers assigned to capitalizable projects. In the second quarter of 2004, we wrote off $0.8 million in software previously capitalized for projects that were cancelled as they related to projects that were not aligned with our operating plan. We do not anticipate additional write offs during 2004.

The decrease in other product development expenses in the three and nine months ended September 30, 2004 compared to the three and nine months ended September 30, 2003 was due primarily to a reduction in salaries and benefits of $1.7 million and $3.2 million, respectively, due to the restructuring activities starting in the fourth quarter of 2003, offset by $0.1 million and $1.0 million in retention bonuses paid to key employees for the three and nine months ended September 30, 2004, respectively. We expect other product development expenses to remain relatively flat in the fourth quarter of 2004.

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.

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

	Three Months Ended September 30,						Percent Change		Nine Months Ended September 30,						Percent Change
	2004			2003					2004			2003
Stock compensation related to variable options	$	5		$	183				$	5		$	307
Other general and administrative expenses		1,953			2,375					7,316			8,282
Total general and administrative expenses	$	1,958		$	2,558		(23	)%	$	7,321		$	8,589		(15	)%
Percentage of total revenues		11	%		8	%				12	%		9	%

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

Other general and administrative expense decreased in the three months ended September 30, 2004 compared to the three months ended September 30, 2003 primarily due to a decrease in salaries of $0.4 million due to the restructuring activities starting in the fourth quarter of 2003. The decrease in other general and administrative expenses in the nine months ended September 30, 2004 compared to September 30, 2003 was due to a decrease in salaries and benefits of $0.7 million and a decrease in professional services of $0.7 million, primarily related to legal settlement expenses in the first half of 2003, partially offset by non-restructuring separation payments of $0.5 million and $0.3 million loss on sale of fixed assets, both of which occurred in the first quarter of 2004. We expect other general and administrative expenses to remain relatively flat in the fourth quarter of 2004. However, we may be required to incur additional professional fees in 2004 related to compliance with the Sarbanes-Oxley Act.

Restructuring Costs

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

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

In the second quarter of 2004, the Company announced that it eliminated an additional 14 positions in the United States, which included a reduction in the Company’s sales force of 3 positions, a reduction in the Company’s general and administrative departments of 4 positions and a reduction in the Company’s product development department of 7 positions. This reduction resulted in a $0.4 million restructuring charge recognized in the second quarter of 2004 and $0.1 million in the third quarter of 2004. All severance costs will be paid by the end of the fourth quarter of 2004.

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

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

Non-Operating Expenses

Interest and Other Non-Operating income (expense), net.Interest and other non-operating income (expense) increased significantly in 2004 compared to 2003 due to foreign currency transaction gains related to third quarter transfers of cash from our discontinued foreign entities and the reduction of expenses related to the BTLS joint jenture.

Share of Joint Venture Loss.In 2003, share of joint venture loss included LookSmart’s 50% share of the loss of BT LookSmart. We do not expect significant additional gains or losses from the joint venture in the future. In the third quarter of 2004, we recorded a valuation adjustment to the net receivable from the joint venture of $0.1 million based on revised estimates of net realizable value.

Income Tax Expense

The reduction in our income tax expense was due to the net loss incurred in the three and nine months ended September 30, 2004 compared to net income in the three and nine months ended September 30, 2003. The charge in the third quarter of 2004 related to revisions of our estimated 2004 federal and state taxes, including the California Alternative Minimum Tax.

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

Extraordinary Gain on Acquisition of BT LookSmart Entities

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

Gain on Discontinued Operations

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

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

Pretax net income from discontinued operations for nine months ended September 30, 2004 includes approximately $0.4 million related to the reduction of the allowance for bad debts in the second quarter of 2004, as substantially all accounts have been collected in certain locations, and approximately $1.0 million related to the disposition and write down of certain international assets and the reduction of estimated liabilities in the third quarter of 2004, offset by expenses related to the operations of the entities during the periods.

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

	Three Months Ended September 30,					Nine Months Ended September 30,
	2004		2003			2004		2003
Revenue	$	—	$	6,638		$	6,036	$	14,978
Pretax net income (loss) (excluding gain on disposal)		562	$	(193	)		123		802
Tax impact		—		(47	)		—		(75	)
Gain on disposal		—		—			1,023		—
Net gain from discontinued operations	$	562	$	(240	)	$	1,146	$	727

Liquidity and Capital Resources

(in thousands)	Nine Months Ended September 30, 2004			Nine Months Ended September 30, 2003
Cash flows provided by (used in) operating activities	$	(5,067	)	$	10,690
Cash flows used in investing activities		(11,718	)		(7,412	)
Cash flows provided by financing activities		3,563			5,029

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

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

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

The decrease in cash generated in operating activities in the first nine months of 2004 compared to the first nine months of 2003 was primarily due to the net loss and a decrease in accrued liabilities of $23.5 million, offset by a decrease in accounts receivable of $22.9 million and decreases non-cash related expenses of $3.3 million. Accounts receivable decreased in the first nine months of 2004 due to lower revenue compared to 2003 and improvement in collections.

Net cash used in investing activities in the first nine months of 2004 and 2003 included purchases of equipment and capitalization of costs related to internally developed software of $2.2 million and $4.7 million, respectively, and the payments made for acquisitions of $2.1 million. This was partially offset by proceeds from the sale of discontinued operations of $1.5 million. Cash used in investing activities in nine months ended September 30, 2004 included the purchase of long term investments of $11.3 million, offset by sales of short term investments of $2.4 million. Cash used in the nine months ended September 30, 2003 included purchases of short-term investments of $1.6 million.

In the nine months ended September 30, 2004 and 2003, net cash provided by financing activities was primarily due to proceeds from the exercise of employee stock options of $3.6 million and $6.2 million, respectively. Cash used by financing activities in the nine months ended September 30, 2003 also included the repayment of notes payable of $1.2 million.

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

Off-Balance Sheet Arrangements

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

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 various operating leases covering facilities in San Francisco, New York and Los Angeles and various international offices.

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

Guarantees Under Letters of Credit—We have obtained standby letters of credit from time to time as security for certain liabilities. At September 30, 2004, outstanding letters of credit related to security of

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building leases and security for payroll processing totaled $2.0 million. In comparison with what we disclosed in our Annual Report on Form 10-K for fiscal 2003, we believe that there have been no significant changes except as noted above.

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. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations.

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

Microsoft accounted for approximately 64% of our listings revenues and all of our licensing revenue in 2003. The loss of substantially all of our Microsoft revenues in the first half of 2004 materially and adversely affected our financial results. We had a net loss of $8.3 million in the first nine months of 2004 and as of September 30, 2004, our accumulated deficit was $184.7 million. We may be unable to achieve operating profitability in the foreseeable future and, if we regain operating profitability, we may be unable to maintain it.

Our ability to achieve and maintain operating profitability in future quarters will depend largely on our ability to generate additional revenues and contain our expenses. In order to generate additional revenues, we will need to expand our network of distribution partners, expand our proprietary traffic sources, and expand our advertiser base. We may be unable to do so because of increased competition from other search services, because of the other risks identified in this report, or for unforeseen reasons. Also, we may be unable to contain our costs due to the need to make revenue sharing payments to our distribution partners, to invest in product development and search technologies, and enhance our search services. Because of the foregoing factors, and others outlined in this report, we may be unable to achieve and maintain operating profitability in the future.

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

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

Our five largest network partners accounted for approximately 48% of our revenues in the first nine months of 2004. If any of our key distribution contracts expire or terminate, we would need to find alternative sources of click traffic or otherwise replace the lost paid clicks. Although alternate sources of click traffic are currently available in the market, the search market is consolidating and there is fierce competition among search providers to sign agreements with traffic providers. Some of our competitors are able to offer higher revenue share payments to traffic sources than we offer. We face the risk that we might be unable to negotiate and sign agreements with such providers on favorable terms, if at all. If we are unsuccessful in maintaining and expanding our distribution network, then our ability to generate revenues would be seriously harmed.

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

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

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 gain or loss of key distribution partners, or changes in the implementation of search results on partner web sites,

• changes in the number of advertisers who purchase our listings, or the amount of spending per customer,

• 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,

• systems downtime on our web site or the web sites of our distribution partners, or

• 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.

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

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

Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. If we cannot provide reliable financial reports or prevent fraud, our brand and operating results could be harmed.

We have largely completed documenting our internal controls and are completing our internal control testing. We have discovered, and may in the future discover, gaps and deficiencies in our internal controls over financial reporting, including our controls over revenue accounting, accounts payable, billing and reporting, and financial analysis of business results. We have implemented controls to address some of these gaps and deficiencies and are in the process of remediating the remaining gaps and deficiencies that

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we have identified. We are subject to the risk that we may not identify all the gaps and deficiencies in our internal financial controls in a timely manner and, as a result, may report a material weakness in our future periodic reports. Further, our remediation efforts may not be sufficient to cure the gaps and deficiencies we have identified. Any failure to identify areas that require remediation, or any failure to implement required new or improved controls, could harm our operating results or cause us to fail to meet our reporting obligations. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock.

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

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

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

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

We are exposed to the risk of fraudulent clicks on our listings. We have occasionally reduced invoices or refunded revenue to our customers due to click-through fraud, and we expect to do so in the future. Click-through fraud occurs when a person or robot software clicks on a listing for some reason other than to view the underlying content. If we are unable to stop this fraudulent activity, these refunds may increase. If we find new evidence of past fraudulent clicks we may have to issue refunds retroactively of amounts previously paid by our advertisers, yet we may still have to pay revenue share to our network partners. This would negatively affect our profitability, and these types of fraudulent activities could hurt our brand. If fraudulent clicks are not detected, the affected advertisers may experience a reduced return on their investment in our listings because the fraudulent clicks will not lead to actual sales for the advertisers. This could lead the advertisers to become dissatisfied with our listings, which could lead to loss of advertisers and revenue.

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

There has been ongoing public debate whether stock options granted to employees should be treated as a compensation expense and, if so, how to properly value such charges. On March 31, 2004, the Financial Accounting Standard Board (FASB) issued an Exposure Draft, Share-Based Payment: an amendment of FASB Statements No. 123 and 95, which would require a company to recognize, as an expense, the fair value of stock options and other stock-based compensation to employees beginning after June 15, 2005 and subsequent reporting periods. Currently, we do not recognize compensation expense for stock options, other than amortization of deferred compensation related to options assumed in purchase business combinations and options accounted for under the variable method. If we elect or are required to record an expense for our stock-based compensation plans using the fair value method as described in the Exposure Draft, we could have on-going accounting charges significantly greater than those we have recorded under our current method of accounting for stock options.

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

Companies in the Internet, technology and media industries own large numbers of patents, copyrights, trademarks and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. As we face increasing competition, the possibility of intellectual property rights claims against us grows. These claims might, for example, be made for trademark, copyright or patent infringement, defamation, negligence, personal injury, breach of contract, unfair advertising, unfair competition, invasion of privacy or other claims. Allegations are made against us from time to time concerning these types of matters, and we have been subject to two purported class action lawsuits in connection with our listings services. Our technologies may not be able to withstand any third-party claims or rights against their use. In addition, we are obligated under some agreements to indemnify our partners in the event that they are subject to claims that our services infringe on the rights of others.

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

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

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

• profitably establish and expand our listings product offerings,

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

• expand and maintain our network of distribution relationships, thereby increasing the volume of clicks to our listings product, and

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

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

The search industry has recently experienced rapid consolidation, particularly with the acquisitions of companies offering algorithmic search indices and paid inclusion programs. In March 2003, Yahoo acquired Inktomi, which offers a paid inclusion program for its algorithmic search index. In April 2003, Overture Services acquired AltaVista and the web search unit of FAST Search & Transfer, each of which also offers a paid inclusion program and algorithmic search indices. In October 2003, Yahoo acquired Overture Services and Google announced its acquisition of Sprinks from About.com. Industry

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consolidation may result in larger competitors with a greater focus on algorithmic search, sponsored listings or paid inclusion products. If these industry trends continue, or if we are unable to compete in the sponsored listings and paid inclusion industries, our financial results may suffer.

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

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

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

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

• 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 or the inclusion/removal of our stock from certain stock market indices used to drive investment choices,

• 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 November 1, 2004, the CDIs registered for trading on the Australian Stock Exchange were exchangeable into an aggregate of approximately 14.1 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.

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

We may need additional capital in the future to support our operations and, if such additional financing is not available to us, our 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.

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

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

We use proprietary and licensed software to crawl the web and index web pages, create and edit listings, compile and distribute our search results, track paid clicks, and detect click fraud. 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:

• customization of our search results for distribution to particular partners,

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

• substantial increases in the number of listings in our search databases, or

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

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

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

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

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

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

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

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

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

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

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

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We have acquired businesses and technologies in recent years, including the acquisition of certain assets from BioNet Systems, LLC in the second quarter of 2004 and from Furl.net in the third quarter of 2004. Integration of acquired companies and technologies into LookSmart is likely to be expensive, time-consuming and strain our managerial resources. We may not be successful in integrating any acquired businesses or technologies and these transactions may not achieve anticipated business benefits. We intend to license to end users certain software we acquired from BioNet Systems, LLC, but we may lack the managerial and technical resources necessary to implement a software licensing business model in a timely manner. Unlicensed copying and use of such software in the United Sates and abroad will represent a loss of revenue to us. Furthermore, end users may not license our products at projected rates.

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

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

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

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

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

We derive a portion of our revenues from the sale of listings to companies that represent credit risks. Some of our customers have gone out of business, have limited operating histories or are operating at a loss. Moreover, many of these companies have limited cash reserves and limited access to additional capital. We have in some cases experienced difficulties collecting outstanding accounts receivable. Our allowance for doubtful accounts receivable as of September 30, 2004 was $1.2 million, or 20% of our gross 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.

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

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

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government agency were to require changes in the labeling, delivery or content of our listings, or if we are subject to civil penalties or injunctions regarding these issues, it may reduce the desirability of our services or the types of advertisements that we can run, and our business could be materially and adversely harmed.

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

Internet user privacy has become an issue both in the United States and abroad. The United States Congress is considering new legislation to regulate Internet privacy, and 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.

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

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

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

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

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

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

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

ITEM 4. CONTROLS AND PROCEDURES

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

(b)Changes in internal controls. During the last fiscal quarter, we identified gaps and deficiencies in our internal controls over financial reporting, including our controls over revenue accounting, accounts payable, billing and reporting, and financial analysis of business results. We have implemented controls to address some of these gaps and deficiencies and are in the process of remediating the remaining gaps and deficiencies that we have identified.

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

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In August 2004, Mario Cisneros and Michael Voight filed a private attorney general lawsuit on behalf of a proposed class in Superior Court in San Francisco County. The complaint names thirteen search engines or web publishers as defendants (including the Company) and alleges unfair business practices, unlawful business practices and other causes of action in connection with the display of advertisements from internet gambling companies. The complaint seeks restitution, unspecified compensatory damages, declaratory and injunctive relief, and attorneys’ fees. The plaintiff has filed a motion for preliminary injunction and served discovery requests. The Company has not yet responded to the complaint, the motion for preliminary injunction, or the discovery requests, as the court has not required any response from the Company, pending a case management conference scheduled for December 2004. At this point in time, the Company does not have sufficient information to assess the validity of the complaint or the amount of potential damages.

We are not a party to any other material legal proceedings.

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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On July 29, 2004, the Company issued 536,049 shares of common stock to Furl LLC in connection with the acquisition of Furl.net business and assets. There were no underwriters employed in connection with the foregoing transaction. The issuance of securities described above was deemed to be exempt from registration under the Securities Act in reliance on Section 4(2) of the Securities Act as a transaction by an issuer not involving a public offering. Furl acquired the securities for investment only and not in connection with any distribution thereof and appropriate legends were affixed to the share certificate issued in such transaction. Furl either received adequate information about the Registrant or had access, through employment or other relationships, to such information.

ITEM 6. EXHIBITS

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

SIGNATURES

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

	LOOKSMART, LTD.
Date: November 9, 2004	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(2)	Bylaws
4.1(1)	Form of Specimen Stock Certificate
4.2(6)	Forms of Stock Option Agreement used by the Registrant in connection with grants of stock options to employees, directors and other service providers in connection with the Amended and Restated 1998 Stock Plan
10.1(1)	Form of Indemnification Agreement entered into between the Registrant and each of its directors and officers
10.2(1)	Amended and Restated 1998 Stock Plan
10.3(1)	1999 Employee Stock Purchase Plan
10.7(3)	Zeal Media, Inc. 1999 Stock Plan
10.8(4)	Wisenut, Inc. 1999 Stock Incentive Plan
10.12(1)	Lease Agreement with Rosenberg SOMA Investments III, LLC for property located at 625 Second Street, San Francisco, California, dated May 5, 1999
10.16(1)	Summary Plan Description of 401(k) Plan
10.45(5)	Employment offer letter between the Registrant and its chief executive officer dated as of September 24, 2004
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 Quarterly Report on Form 10-Q filed with the SEC on August 14, 2000.

(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 Registration Statement on Form S-8 filed with the SEC on April 18, 2002.

(5) Filed in connection with the Company’s Current Report on Form 8-K filed with the SEC on October 18, 2004.

(6) Filed in connection with the Company’s Current Report on Form 8-K filed with the SEC on October 22, 2004.

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