Forward-Looking Statements

The following discussion should be read in conjunction with the Unaudited Condensed 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. Discussions containing forward-looking statements may be found in the material set forth under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and in other sections of this report. All forward-looking statements, including, but not limited to, projections, expectations or estimates concerning our business, including demand for our products and services, mix of revenue sources, 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, competitive position, share-based compensation, and adequate liquidity to fund our operations and meet our other cash requirements, are inherently uncertain as they are based on our expectations and assumptions concerning future events. These forward-looking statements are subject to numerous known and unknown risks and uncertainties. You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including but not limited to, the possibility that we may fail to maintain or grow our listings advertiser base and/or distribution network, that existing and potential distribution partners may opt to work with, or favor the products of, competitors if our competitors offer more favorable products or pricing terms, that we may be unable to grow our online search advertising revenue and/or find alternative sources of revenue, that we may be unable to attain or maintain customer acceptance of our publisher solutions products, that changes in the distribution network composition may lead to decreases in query volumes, that we may be unable to maintain or improve our query volume, match rate, number of paid clicks, average revenue per click, conversion rate or other ad network metrics, that we may be unable to achieve or maintain profitability, that we may be unable to retain our existing credit facilities or obtain new credit facilities, that we may be unable to attract and retain key personnel, that we may have unexpected increases in costs and expenses, or that one or more of the other risks described below in the section entitled "Risk Factors" and elsewhere in this report may occur.

All forward-looking statements in this report are made as of the date hereof, based on information available to us as of the date hereof, and except as required by applicable law, we assume no obligation to update any forward-looking statements.

Business Overview

LookSmart is a search advertising network solutions company that provides relevant solutions for search advertisers and publishers. LookSmart was organized in 1996 and is incorporated in the State of Delaware.

LookSmart offers search advertisers targeted, pay-per-click (PPC) search, and contextual search advertising via a monitored search advertising distribution network (referred to as the "AdCenter" platform). The Company's extensive search advertising distribution network includes publishers and search partners within certain vertical market segments in the United States and certain other countries. The Company's application programming interface (API) allows search advertisers and their advertising agencies to connect any type of marketing or reporting software with minimal effort, for easier access, management, and optimization of search advertising campaigns. The advertiser network service offering provided 94% and 90% of total revenues in the quarters ended September 30, 2009 and 2008, respectively, and 92% and 91% of total revenues for the nine months ended September 30, 2009 and 2008, respectively.

LookSmart also offers publishers licensed private-label search advertiser network solutions based on its AdCenter platform technology ("Publisher Solutions"). Publisher Solutions consist of hosted auction-based ad serving with an ad backfill capability that allows search engines, networks, media companies, social networking sites, retail sites, directories, Internet Service Providers ("ISPs") and portals to manage their advertiser relationships, distribution channels and accounts. The publisher solutions service offering has provided 6%, and 10% of total revenues in the quarters ended September 30, 2009 and 2008, respectively, and 8% and 9% of total revenues for the nine months ended September 30, 2009 and 2008, respectively. Publisher Solutions revenue decreases for the three and nine months ended September 30, 2009 as compared to the same periods in 2008 is attributed to reduced revenue from one major publisher client, resulting from significantly lower transaction volume on their advertising network, combined with a contractual reduction of the revenue share percentage in the final year of the contract.

In 2007, our management made the decision to exit certain consumer products activities and to sell or otherwise dispose of the various consumer related websites and assets associated with those activities. In the first quarter of 2008, our management made the decision to exit its remaining consumer products activities and to sell or otherwise dispose of the remaining consumer assets. During 2008, we sold the intellectual property rights to the "Wisenut" trademark and related domain names and decided to wind down the Furl operations. In the first quarter of 2009, the Furl assets were sold for an insignificant amount. The results of operations of consumer product activities, including related gains (losses), have been classified as discontinued operations for all periods presented in the accompanying Unaudited Condensed Consolidated Statements of Operations (see Note 3). At September 30, 2009, the Company continues to own the Wisenut search engine technology, intellectual property rights in such technology and other assets.

Critical Accounting Policies and Estimates

Our financial condition and results of operations are based upon certain critical accounting policies, which include estimates, assumptions, and judgments on the part of management. We base our estimates on various factors and information which may include, but are not limited to, history and prior experience, experience of other enterprises in the same industry, new related events, current economic conditions and information from third party professionals that is believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenue and expenses during the period presented. Actual results may differ from those estimates. In management's opinion, all adjustments necessary for a fair statement are reflected in the interim periods presented. All adjustments are of a normal or recurring nature.

The following discussion highlights those policies and the underlying estimates and assumptions, which we consider critical to an understanding of the financial information in this report.

Fair Value Measurements

Our estimates of fair value for assets and liabilities is based on a framework that establishes a hierarchy of the inputs used in valuation and gives the highest priority to quoted prices in active markets and requires that observable inputs be used in the valuations when available. The disclosure of fair value estimates is based on whether the significant inputs into the valuation are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect our significant market assumptions. The three levels of the hierarchy are as follows:

Level 1:    Unadjusted quoted market prices for identical assets or liabilities in
            active markets that we have the ability to access.

Level 2:    Quoted prices for similar assets or liabilities in active markets;
            quoted prices for identical or similar assets in inactive markets; or
            valuations based on models where the significant inputs are observable
            (e.g., interest rates, yield curves, default rates, etc.) or can be
            corroborated by observable market data.

Level 3:    Valuations based on models where significant inputs are not observable.
            The unobservable inputs reflect our assumptions about the assumptions
            that market participants would use.

Investments

We invest our excess cash primarily in debt instruments of high-quality corporate and government issuers. All highly liquid instruments with maturities at the date of purchase greater than ninety days are considered investments. All instruments with maturities greater than one year from the balance sheet date are considered long-term investments unless management intends to liquidate such securities in the current operating cycle. Such securities are classified as short-term investments. These securities are classified as available-for-sale and carried at fair value.

Changes in value of these investments are primarily related to changes in interest rates and are considered to be temporary in nature. Except for declines in fair value that are not considered temporary, net unrealized gains or losses on these investments are reported as a component of accumulated other comprehensive income (loss) in stockholders' equity. We recognize realized gains and losses upon sale of investments using the specific identification method.

Revenue Recognition

Our online search advertising revenue is primarily composed of per-click fees that we charge customers. The per-click fee charged for keyword-targeted listings is calculated based on the results of online bidding for keywords or page content, up to a maximum cost per keyword or page content set by the customer. Revenue also includes revenue share from licensing of private-labeled versions of our products.

Revenues associated with online advertising products, including Advertiser Networks, are generally recognized once collectability is established, delivery of services has occurred, all performance obligations have been satisfied, and no refund obligations exist. We pay distribution network partners based on clicks on the advertiser's ad that are displayed on the websites of these distribution network partners. These payments are called traffic acquisition costs ("TAC") and are included in cost of revenues. The revenue derived from these arrangements that involve traffic supplied by distribution network partners is reported gross of the payment to the distribution network partners. This revenue is reported gross due to the fact that we are the primary obligor to the advertisers who are the customers of the advertising service.

We also enter into agreements to provide private-labeled versions of our products, including licenses to the AdCenter. These license arrangements include multiple elements: revenue-sharing based on the publisher's customer's monthly revenue generated through the AdCenter application; upfront fees; and other license fees. We recognize upfront fees over the term of the arrangement or the expected period of performance, other license fees over the term of the license, and revenue-sharing portions over the period in which such revenue is earned. In all cases, revenue is recognized only when the price is fixed or determinable, persuasive evidence of an arrangement exists, the service is performed, and collectability of the resulting receivable is reasonably assured.

We provide a provision against revenue for estimated reductions resulting from billing adjustments and customer refunds. The amounts of these provisions are evaluated periodically based upon customer experience and historical trends.

Deferred revenue is recorded when payments are received in advance of performance in underlying agreements. Customer deposits are recorded when customers make prepayments for online advertising.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses resulting from customers failing to make required payments. This valuation allowance is reviewed on a periodic basis to determine whether an additional provision or reversal is required. The review is based on factors including the application of historical collection rates to current receivables and whether economic conditions are more or less favorable than we anticipated. We will record a reduction of our allowance for doubtful accounts if there is a significant improvement in collection rates or economic conditions are more favorable than we anticipated. Additional allowances for doubtful accounts may be required if there is deterioration in past due balances, if economic conditions are less favorable than we 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.

Valuation of Goodwill and Intangible Assets

Goodwill and other intangibles with indefinite useful lives are not amortized but tested for impairment annually or more frequently when events or circumstances indicates that the carrying value of a reporting unit more likely than not exceeds its fair value. Our annual goodwill impairment testing date is December 31 of each year. In addition, we periodically re-assess the valuation and asset lives of intangible assets with definite lives to conform to changes in management's estimates of future performance.

We have recorded goodwill and intangible assets in connection with our business acquisitions. Management exercises judgment in the assessment of the related useful lives, fair value and recoverability of these assets. As of September 30, 2009 and December 31, 2008, we have no recorded goodwill. The majority of intangible assets are amortized over two to seven years, the period of expected benefit.

Intangible assets with definite lives are amortized over their estimated useful life and reviewed for impairment annually or more frequently when events or circumstances indicates that the carrying value of a reporting unit more likely than not exceeds its fair value. We amortize acquired intangible assets with definite lives over periods from two to seven years and the amortization expense is primarily classified as cost of revenue in our Unaudited Condensed Consolidated Statements of Operations.

Impairment of Long-Lived Assets

We review long-lived assets held or used in operations, including property and equipment, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable. Subject assets are tested for impairment at the lowest level of operations that generates cash flows that are largely independent of the cash flows from those of other groups of asset and liabilities. We have determined that the equity of our single reporting unit to be the lowest level of operation at which independent cash flows could be identified. An impairment loss is recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Impairment, if any, is measured as the amount by which the carrying amount of a long-lived asset exceeds its fair value. Assets to be disposed of are reported at the lower of carrying amount or fair value less cost to dispose.

In the second quarter of 2009, purchased technology of $0.3 million was impaired by approximately $0.2 million because an associated initiative was discontinued. Any adjustment to the estimated impairment based on additional information providing a more accurate measurement will be recognized in subsequent reporting periods.

The Company tested its long-lived assets used in operations for impairment as of December 31, 2008 and determined they were not impaired.

Income Taxes

We account for income taxes using the liability method. Under the liability method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. Due to our history of losses and the uncertainty of net operating loss utilization, we have established a valuation allowance for the full amount of our deferred tax assets. We record liabilities, where appropriate, for all uncertain income tax positions. We recognize potential accrued interest and penalties related to unrecognized tax benefits within operations as income tax expense.

Internal Use Software Development Costs

We capitalize 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 developing internal-use computer software.

Management exercises judgment in determining when costs related to a project may be capitalized, in assessing the ongoing value of the capitalized costs, and in determining the amortization period for the capitalized costs. We expect to continue to invest in internally developed software and to capitalize such costs.

Restructuring Charges

We have recorded restructuring accruals related to closing of certain leased facilities, as well as severance costs related to workforce reductions. Management's judgment is required when estimating when the redundant facilities will be subleased and at what rate they will be subleased.

Share-Based Compensation

We recognize share-based compensation costs for all share-based payment transactions with employees, including grants of employee stock options and employee stock purchases related to the Employee Stock Purchase Plan, over the requisite service period based on their relative fair values. We estimate the fair value of share-based payment awards on the grant date using the Black-Scholes method. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods.

We elected to adopt the alternative transition method for calculating the tax effects of share-based compensation to establish the beginning balance of the additional paid-in capital pool ("APIC pool") related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC pool and cash flows of the tax effects of employee share-based compensation awards.

Recent Accounting Pronouncements

For a description of recent accounting pronouncements, see Note 1 (Summary of Significant Accounting Policies) in the Notes to the Unaudited Condensed Consolidated Financial Statements.

Results of Operations

Overview of the Three and Nine months Ended September 30, 2009

The following table sets forth selected information concerning our results of
operations as a percentage of consolidated net revenue for the periods
indicated:



                                                 Three Months Ended            Nine Months Ended
                                                    September 30,                September 30,
                                                 2009           2008          2009           2008
Revenue                                           100.0 %       100.0 %        100.0 %       100.0 %
Cost of revenue                                    69.0 %        59.9 %         63.4 %        59.4 %

Gross profit                                       31.0 %        40.1 %         36.6 %        40.6 %
Operating expenses:
Sales and marketing                                11.8 %        16.0 %         11.1 %        13.3 %
Product development                                19.3 %        18.6 %         19.3 %        17.2 %
General and administrative                         14.1 %        16.9 %         19.1 %        15.6 %
Restructuring charge                                2.4 %         1.4 %          1.3 %         0.2 %
Impairment charge                                   0.0 %         0.0 %          0.5 %         0.0 %

Total operating expenses                           47.6 %        52.9 %         51.3 %        46.3 %

Loss from operations                              (16.6 )%      (12.8 )%       (14.7 )%       (5.7 )%
Non-operating income, net                           0.1 %         1.6 %          0.2 %         1.8 %

Loss from continuing operations before
income taxes                                      (16.5 )%      (11.2 )%       (14.5 )%       (3.9 )%
Income tax expense (benefit)                        0.0 %         0.0 %          0.0 %         0.0 %

Loss from continuing operations                   (16.5 )%      (11.2 )%       (14.5 )%       (3.9 )%
Income (loss) from discontinued operations,
net of tax                                          1.1 %         0.0 %          1.0 %        (0.9 )%

Net loss                                          (15.4 )%      (11.2 )%       (13.5 )%       (4.8 )%

Revenues

Revenue is derived from the Company's two service offerings or "products":
Advertiser Networks and Publisher Solutions. Total revenue and revenue from
Advertiser Networks and Publisher Solutions for each of the three and nine
months ended September 30, 2009 and 2008 were as follows (in thousands):



                                          Three Months Ended September 30,
                                   % of                    % of         Dollar
                         2009     Revenue        2008     Revenue       Change        % Change
 Advertiser Networks   $ 11,799        94 %    $ 13,901        90 %    $  (2,102 )         (15 )%
 Publisher Solutions        744         6 %       1,522        10 %         (778 )         (51 )%

 Total revenue         $ 12,543       100 %    $ 15,423       100 %    $  (2,880 )         (19 )%


                                           Nine Months Ended September 30,
                                   % of                    % of         Dollar
                         2009     Revenue        2008     Revenue       Change        % Change
 Advertiser Networks   $ 35,825        92 %    $ 45,441        91 %    $  (9,616 )         (21 )%
 Publisher Solutions      3,195         8 %       4,618         9 %       (1,423 )         (31 )%

 Total revenue         $ 39,020       100 %    $ 50,059       100 %    $ (11,039 )         (22 )%

We recognized $12.5 and $39.0 million of total revenue during the three and nine months ended September 30, 2009, respectively. Total revenue for the three and nine months ended September 30, 2009 was down 19% and 22%, respectively, from the $15.4 million and $50.1 million recognized during the comparable three and nine months ended September 30, 2008. We attribute the $2.9 million decrease in the three months ended September 30, 2009 primarily to a 29% decrease in average revenue-per-click (RPC), partially offset by a 19% increase in paid clicks, combined with lower Publisher Solutions revenue from a single significant customer compared to the same period in 2008. For the nine months ended September 30, 2009, revenues were lower by $11.0 million compared to the nine months ended September 30, 2008, due mostly to a 31% decrease in RPC, partially offset by a 15% increase in paid clicks, and lower Publisher Solutions revenue from a single significant customer. Our RPC has decreased as a result of continued pressure on search advertising demand and pricing.

We continue to be dependent upon a few customers for a significant percentage of our revenue. For each of the three months ended September 30, 2009 and 2008, two customers combined to account for 25% and 32% of revenue, respectively. For each of the nine months ended September 30, 2009 and 2008, two customers accounted for a combined 27% and 26%, respectively.

One of these two customers, IAC Search and Media ("IAC"), notified us in May 2009 that it does not intend to renew the May 2005 AdCenter License, Hosting and Support Agreement, which provides for certain Publisher Solutions services when it expires on December 31, 2009. The decrease in Publisher Solutions revenue from IAC has accelerated since the May 2009 notification from $1.4 million and $4.0 million, respectively, for the three and nine months ended September 30, 2008, to $0.6 million and $2.6 million, respectively, for the three and nine months ended September 30, 2009. Advertiser Network revenue derived from IAC, which is covered under separate distribution agreements, was $1.3 million and $4.1 million, respectively, for the three and nine months ended September 30, 2009, and $1.5 million and $3.3 million for the three and nine months ended September 30, 2008. IAC has not indicated to us an intent to terminate these separate distribution agreements.

We recognized Advertiser Networks revenue of $11.8 million and $35.8 million, respectively, during the three and nine months ended September 30, 2009, down 15% and 21%, respectively, from the $13.9 million and $45.4 million, respectively, recognized during the three and nine months ended September 30, 2008. Revenue from Advertiser Networks decreased in the third quarter of 2009 by $2.1 million and $9.6 million in the first nine months of 2009 compared to the same respective periods in 2008.

The Advertiser Network saw growth in total paid clicks for both the three and the nine months ended September 30, 2009. Total paid clicks for the three months ending September 30, 2009 increased 19% to 219 million, compared to 184 million for the third quarter of 2008. During the same period, average RPC decreased from $0.076 to $0.054 compared to the previous year's quarter. Paid clicks totaled 610 million for the nine months ended September 30, 2009, compared to 531 million for the same period of 2008. The 15% increase in paid clicks was offset by a decrease in revenue per click from $0.086 to $0.059 over the same time period.

We recognized Publisher Solutions revenue of $0.7 million during the three months ended September 30, 2009, a 51% decrease from the $1.5 million recognized during the three months ended September 30, 2008. IAC represented $0.6 million, or 74%, of Publisher Solutions revenue during the three months ended September 30, 2009. For the nine months ended September 30, 2009, we recognized $3.2 million of Publisher Solutions revenue, a decrease of 31%, or approximately $1.4 million, from the $4.6 million recognized in the same period of the prior year. IAC represented $2.6 million, or 82%, of Publisher Solutions revenue for the nine months ended September 30, 2009. The decrease in Publisher Solutions . . .