REACHLOCAL INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.

[March 15, 2012]

REACHLOCAL INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.

(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion together with Part II, Item 6, "Selected Financial Data" and our consolidated financial statements and the related notes included elsewhere in this Annual Report. This discussion contains forward-looking statements about our business and operations. Our actual results may differ materially from those we currently anticipate as a result of many factors, including those we describe in Part I, Item 1A, "Risk Factors" and elsewhere in this Annual Report. See Part I, "Cautionary Notice Regarding Forward-Looking Statements." Overview Our mission is to help small and medium-sized businesses, or SMBs, acquire, maintain and retain customers via the Internet. We offer a comprehensive suite of online marketing and reporting solutions, including search engine marketing, Web presence and social media marketing, display advertising, remarketing, online marketing analytics and other related products and services, each targeted to the SMB market. We deliver these solutions to SMBs through a combination of our proprietary platform, the RL Platform, and our direct, "feet-on-the-street" sales force of Internet Marketing Consultants, or IMCs, and select third-party agencies and resellers.

We use our RL Platform to create advertising campaigns for SMBs to target potential customers in their geographic area, optimize those campaigns in real time and track tangible results. Through a single Internet advertising budget, we enable our clients to reach local customers across the Internet, including through all of the major search engines and leading general interest and vertically focused online publishers. In 2010, we expanded the RL Platform to include ReachCast, our full-service Web presence and social media solution.

Empowered by the RL Platform, our IMCs, which are based in or near the cities in which our clients operate, establish a direct consultative relationship with our clients and provide our solutions to achieve their marketing objectives.

We generate revenue by providing online advertising solutions for our clients through our portfolio of online marketing and advertising solutions. We sell our search engine marketing product, ReachSearch, our display advertising product, ReachDisplay, and our remarketing product, based on a package pricing model in which our clients commit to a fixed fee that includes the media; the optimization, reporting and tracking technologies of the RL Platform; and the personnel dedicated to support and manage their campaigns. While we do not commit to a specific set of results, we work with our clients to meet their marketing objectives. For our ReachSearch product, we believe clients evaluate performance based on the number and quality of leads (phone, email and other) received. For our ReachDisplay and remarketing products, we believe clients focus on the numbers of customers reached and the accuracy of targeting achieved through the campaign. Each of these products includes access to multiple publishers, some of which are not directly available to SMBs, as well as access to our proprietary optimization and tracking technologies that dynamically adjust the publishers to which we allocate clients' media spend in order to meet their performance objectives. For these reasons, while we rely on third-party publishers for the substantial majority of the media we purchase on behalf of our clients, we are not simply a reseller of media; rather, we market our products as a complete package of media optimized for the client. We also generate revenue from digital marketing solutions for our clients that do not include the purchase of third-party media, including our campaign performance tracking product, TotalTrack, our assisted chat product, TotalLiveChat and ReachCast. Generally our products are sold to our clients in a single budget to simplify the purchasing process.

Nearly all of our cost of revenue is for the purchase of media and nearly all of the media we purchase is from Google, Bing and Yahoo!. A substantial majority of the media we purchase is from Google. We generally purchase this media in an auction marketplace. We believe that our technology enables us to purchase this media efficiently and, as a result, allows us to fulfill our clients' expected level of performance. However, an increase in the cost of media in these marketplaces without a corresponding increase in our media buying efficiency could result in an increase in our cost of revenue as a percentage of revenue even if our business expands. In addition, such an increase could result in an increase in the prices we must charge our clients or a decrease in our ability to fulfill our clients' service expectations at the existing package price.

While we enter into rebate and incentive programs with some publishers, these incentive programs are subject to change or cancellation with little notice, and, on occasion, these incentives have been cancelled, reduced or have required us to comply with rules that reduce the benefit of the incentives from what we previously received. For further information, see the section titled "Risk Factors-We purchase most of our media from Google, and our business could be adversely affected if Google takes actions that are adverse to our interests." We first offered our products and services solely through third-party agencies and resellers that, in turn, offered them to their end advertiser clients. In 2007, we began to allocate resources to focus on sales to national or regional businesses with multiple locations, such as franchisors, which we refer to as national brands. Because the sale to agencies, resellers and national brands involves negotiations with businesses that generally represent an aggregated group of SMB advertisers, we group them together as our National Brands, Agencies and Resellers channel. In 2006, we made the strategic decision to invest in creating a direct local sales force and began selling our products and services through our IMCs. We refer to sales through our IMCs as our Direct Local channel. Sales in the Direct Local channel accounted for 78% of our revenue in 2011 and 75% of our revenue in 2010. Our ongoing investment in increasing the number of our IMCs has been the principal engine for our growth, and it is our largest operating expense.

PAGE 29 -------------------------------------------------------------------------------- In December 2006, we entered our first market outside of North America through a joint venture in Australia. On September 11, 2009, we acquired the remaining interest in our Australian joint venture. In connection with the ReachLocal Australia acquisition, we recognized a non-cash gain of $16.2 million in 2009.

We now own all our international operations and currently have sales operations in Australia, Germany, the United Kingdom,Canada, and Netherlands. At December 31, 2011, 197 of our 796 total IMCs were located outside of North America.

On February 22, 2010, we acquired SMB:LIVE, which included the team and core technology for our ReachCast solution launched later that year, for consideration of up to approximately $8.5 million in cash and stock.

We were formed in 2003 and remained a development-stage company until the end of 2004. Prior to 2007, we financed our operations and capital expenditures through private sales of preferred stock. Since 2007, we have financed our operations, our expansion of our IMC sales force and the extension of our Direct Local channel into new territories through cash provided by operations. Deferred revenue arising from prepayment by the majority of our Direct Local clients and vendor trade financing are major components of our cash flow from operations.

Although we expect that cash flow from operations, existing cash balances and proceeds from our 2010 initial public offering will be sufficient to continue funding our expansion activities, these investments, including investments in developing new products and services for our clients and potential additional acquisitions, could require us to seek additional equity or debt financing, and that financing may not be available on terms favorable to us or at all. In addition, expansion in the number of IMCs and rapid expansion of new products and services for our clients could require significant capital and entail non-capitalized expenses that could diminish our income from operations.

Business Model and Operating Metrics Our Direct Local channel has grown more rapidly than our other channels. As a percentage of total revenue, Direct Local revenue increased to 78% in 2011 from 75% in 2010. Growth in Direct Local revenue is primarily driven by increases in the quality, tenure and productivity of IMCs employed by the Company.

Typically, each month we hire 40-60 IMCs worldwide, with the hiring weighted towards the first ten months of the year. We refer to IMCs with 12 months or less of experience as Underclassmen. With each new class of Underclassmen, we track how they are performing relative to a standard level of revenue growth and other performance metrics for each month after their training. Understanding the performance of past and current Underclassmen allows us to adjust our investment in additional Underclassmen in the event we detect significant changes in their productivity.

We believe the key factors that affect the productivity of our IMCs are: • IMC Tenure. As IMCs mature, they, on average, grow their advertiser base or sell additional products to existing advertisers, resulting in greater revenue productivity. In particular, Upperclassmen, those IMCs with more than 12 months of employment, are more productive than Underclassmen. As more and more IMCs mature and become Upperclassmen, as Upperclassmen become a higher percent of total IMCs, and as existing Upperclassmen mature, we expect overall IMC productivity to increase.

• Macroeconomic and Business Conditions. Macroeconomic conditions directly impact the amount of money SMBs allocate to market their business. Commencing in mid-2008, IMC productivity was significantly impacted by the economic recession as some of our SMB clients were forced to close or temporarily suspend their operations, while others curtailed their marketing expenditures in light of a contraction in consumer spending. At the end of 2009 and throughout 2011, our IMC productivity remained higher than those levels experienced at the end of 2008. However, we believe the economic conditions remain challenging, particularly in North America. This has impacted new advertiser acquisition more than sales to existing advertisers. In addition, our IMCs' productivity is affected by the amount of competition and online advertising consumption by SMBs. For example, our international IMCs have on average been more productive, which we attribute to lower levels of competition and online advertising consumption by SMBs in those markets.

• Number of Products. We believe that expanding our comprehensive suite of online marketing and reporting products and services will allow us to generate more revenue from each SMB relationship. Prior to 2009, we primarily offered a single product, ReachSearch. Since then, we launched our ReachDisplay and remarketing products in 2009, our TotalLiveChat and ReachCast products in 2010, and our search retargeting and international ReachCast products in 2011.

• IMC Capacity. We continually endeavor to enhance the productivity of our IMCs.

Our business model therefore contemplates additional investments in technology and support personnel to assist our IMCs in managing and maintaining existing clients in order to increase their capacity to acquire new clients. For example, we have invested in expanding our existing customer support team to include campaign performance personnel, who have assumed many of the day-to-day campaign management obligations of our IMCs, and are providing account managers to help our more successful Upperclassmen continue to focus on new client acquisition.

PAGE 30-------------------------------------------------------------------------------- • Client Tenure. One of the most time-consuming activities for our IMCs is the process of prospecting, arranging a time to visit and obtaining the first order for our products and services from a new client. A key factor in IMC productivity is therefore the success of our efforts to continue to sell our products and services to existing clients, which requires significantly less of an IMC's time. We believe that a measure of the success of these efforts is the percentage of our revenue generated by sales to clients with different tenures. For this purpose, on an annual basis, we divide our clients into three groups to measure their revenue contribution: • Trial Period Clients. We characterize a client's initial four months as the "trial period" because that is generally the minimum term for a new client's first agreement, and we believe that four months is the shortest period in which performance of an advertising campaign can be fully assessed.

• First-Year Post-Trial Clients. We characterize a client that continues to advertise through us after its four-month trial period and for up to one year after its trial period as a First-Year Post-Trial Client.

• Long-Term Clients. We characterize clients that continue to advertise through us for more than one year after their trial period as Long-Term Clients.

The chart below presents the percentage of total revenues represented by our trial period, first-year post-trial, and long-term clients for the years ended December 31, 2009 to 2011.

[[Image Removed]] We regularly review a number of other financial and operating metrics to evaluate our business, determine the allocation of resources and make decisions regarding business strategies. The following table shows certain key operating metrics for the three years ended December 31, 2011, 2010 and 2009.

December 31, 2011 2010 2009 Number of IMCs (at period end): Upperclassmen 372 286 235 Underclassmen 424 379 280 Total 796 665 515 Underclassmen Expense (in thousands) (1) $ 44,488 $ 36,073 $ 26,824 Active Advertisers (at period end) (2) 19,100 16,900 14,700 Active Campaigns (at period end) (3) 27,500 22,700 18,600 (1) See Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP Financial Measures" for our definition of Underclassmen Expense.

(2) See Part II, Item 6, "Selected Financial Data" for our definition of Active Advertisers.

(3) See Part II, Item 6, "Selected Financial Data" for our definition of Active Campaigns.

PAGE 31--------------------------------------------------------------------------------Number of IMCs Our ongoing investment in increasing the number of our IMCs has been the principal engine for our growth. Typically, each month we hire 40-60 IMCs worldwide, with the hiring weighted towards the first ten months of the year. We refer to IMCs with 12 months or less of experience as Underclassmen. In particular, our revenue growth is driven by the increase in the number of our Upperclassmen, who are significantly more productive than our Underclassmen. As such, we believe that our ability to grow our business is highly dependent on our ability to grow the number of our Upperclassmen. Beyond our hiring practices, which determine the number of IMCs to be hired as well as the rate at which we hire them, the increase in the number of Upperclassmen depends primarily on the productivity of Underclassmen, as the majority of Underclassmen attrition has been involuntary and is based on performance relative to a standard level of revenue growth and other performance metrics determined by us.

We do not expect all Underclassmen to become Upperclassmen, and our investment decisions anticipate the cost of attrition. Our revenue growth is also driven by the increase in the number of our international IMCs as our international IMCs are on average more productive than our IMCs in North America, which we attribute to lower levels of competition and online advertising consumption by SMBs in those markets. The increase in the number of international IMCs was a result of our international expansion.

Underclassmen Expense Underclassmen do not in the aggregate make a positive contribution to operating income. Our largest operating expenses include the hiring, training and retention of Underclassmen in support of our goal of developing more Upperclassmen.

Underclassmen Expense is a number we calculate to approximate our investment in Underclassmen and is comprised of the selling and marketing expenses we allocate to Underclassmen during a reporting period. The amount includes the direct salaries and allocated benefits of the Underclassmen (excluding commissions), training and sales organization expenses, including depreciation, allocated based on relative headcount and marketing expenses allocated based on relative revenue. While we believe that Underclassmen Expense provides useful information regarding our approximate investment in Underclassmen, the methodology we use to arrive at our estimated Underclassmen Expense was developed internally by management, is not a concept or method recognized by GAAP and other companies may use different methodologies to calculate or approximate measures similar to Underclassmen Expense. Accordingly, our calculation of Underclassmen Expense may not be comparable to similar measures used by other companies.

We determine the amount to invest in Underclassmen Expense based on our objectives for development of the business and the key factors affecting IMC productivity described above. The increase in Underclassmen Expense in 2011 as compared to the preceding year was primarily attributable to our international expansion.

Active Advertisers and Active Campaigns We track the number of Active Advertisers and Active Campaigns to evaluate the growth, scale and diversification of our business. We also use these metrics to determine the needs and capacity of our sales forces, our support organization and other personnel and resources. Active Advertisers and Active Campaigns increased in 2011 due to an increase in the number of IMCs selling our products.

Basis of Presentation Sources of Revenue We derive our revenue principally from the provision and sale of online advertising to our clients. Revenue includes the sale of our ReachSearch, ReachDisplay, remarketing and other products based on a package pricing model in which our clients commit to a fixed fee that includes the media, the optimization, reporting and tracking technologies of the RL Platform, and the personnel dedicated to support and manage their campaigns; the sale of our ReachCast, TotalTrack, TotalLiveChat, and other products and services; and set-up, management and service fees associated with these products and other services. We distribute our products and services directly through our sales force of IMCs, who are focused on serving SMBs in their local markets through an in-person, consultative process, which we refer to as our Direct Local channel, as well as a separate sales force targeting our National Brands, Agencies and Resellers channel. The sales cycle for sales to SMBs ranges from one day to over a month. Sales to our National Brands, Agencies and Resellers clients generally require several months.

We typically enter into multi-month agreements for the delivery of our ReachSearch, ReachDisplay and ReachCast products. Under our agreements, our SMB clients typically pay, in advance, a fixed fee on a monthly basis, which includes all charges for the included technology and media services, management, third-party content and other costs and fees. We record these prepayments as deferred revenue and only record revenue for income statement purposes as we purchase media and perform other services on behalf of clients. Generally, when at least 85% of requisite purchases and other services have occurred and an additional campaign cycle remains under the agreement, we make an additional billing or automatic collection for the next campaign cycle.

Our National Brands, Agencies and Resellers clients enter into agreements of various lengths or that are indefinite. Our National Brands, Agencies and Resellers clients either pay in a manner similar to Direct Local clients or are extended credit privileges with payment generally due in 30 to 60 days. There were $3.3 million of accounts receivables related to our National Brands, Agencies and Resellers at December 31, 2011.

PAGE 32 --------------------------------------------------------------------------------Cost of Revenue Cost of revenue consists primarily of the costs of online media acquired from third-party publishers. Media cost is classified as cost of revenue in the corresponding period in which revenue is recognized. From time to time, publishers offer the Company rebates based upon various factors and operating rules, including the amount of media purchased. We record these rebates in the period in which they are earned as a reduction to cost of revenue and the corresponding payable to the applicable publisher, or as an other receivable, as appropriate. Cost of revenue also includes third-party telephone and information services costs, data center and third-party hosting costs, credit card processing fees, third-party content and other direct costs.

In addition, cost of revenue includes costs to initiate, operate and manage clients' campaigns, other than costs associated with the Company's sales force, which are reflected as selling and marketing expenses. Cost of revenue includes salaries, benefits, bonuses and stock-based compensation for the related staff, including the cost of Web Presence Professionals who are the principal service providers for the Company's ReachCast product, and allocated overhead such as depreciation expense, rent and utilities, as well as an allocable portion of our technical operations costs.

Operating Expenses Selling and Marketing. Selling and marketing expenses consist primarily of personnel and related expenses for our selling and marketing staff, including salaries and wages, commissions, benefits, bonuses and stock-based compensation; travel and business costs; training, recruitment, marketing and promotional events; advertising; other brand building and product marketing expenses; and occupancy, technology and other direct overhead costs. A portion of the compensation for IMCs, sales management and other employees in the sales organization is based on commissions. In addition, the cost of agency commissions is included in selling and marketing expenses.

Product and Technology. Product and technology expenses consist primarily of personnel and related expenses for our product development and technology staff, including salaries, benefits, bonuses and stock-based compensation, and the cost of certain third-party service providers and other expenses, including occupancy, technology and other direct overhead costs. Technology operations costs, including related personnel and third-party costs, are included in product and technology expenses. We capitalize a portion of costs for software development and, accordingly, include amortization of those costs as product and technology expenses as the RL Platform addresses all aspects of our activities, including supporting the IMC selling and consultation process, online publisher integration, efficiencies and optimization, providing insight to our clients into the results and effects of their online advertising campaigns and supporting all of the financial and other back-office functions of our business.

Product and technology expenses also include the amortization of the technology obtained in acquisitions and expenses of the deferred payment obligations related to product and technology personnel.

General and Administrative. General and administrative expenses consist primarily of personnel and related expenses for executive, legal, finance, human resources and corporate communications, including wages, benefits, bonuses and stock-based compensation, professional fees, insurance premiums and other expenses, including occupancy, technology and other direct overhead, public company costs and other corporate expenses.

Discontinued Operations. As a result of the winding down of the operations of Bizzy, we have reclassified and presented all related historical financial information as "discontinued operations" in the Consolidated Balances Sheets, Consolidated Statements of Operations and Consolidated Statements of Cash Flows.

In addition, all Bizzy related activities have been excluded from the following discussions, unless specifically referenced.

Critical Accounting Policies and Estimates The preparation of our consolidated financial statements in conformity with U.S.

generally accepted accounting principles, or GAAP, requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses. We continually evaluate our estimates, judgments and assumptions based on available information and experience. Because the use of estimates is inherent in the financial reporting process, actual results could differ from those estimates.

Revenue Recognition We recognize revenue for our services when all of the following criteria are satisfied: • persuasive evidence of an arrangement exists; • services have been performed; PAGE 33-------------------------------------------------------------------------------- • the selling price is fixed or determinable; and • collectability is reasonably assured.

Generally, we recognize revenue as the cost for the third-party media is incurred, which is upon delivery of the advertising on behalf of our clients. We recognize revenue for our ReachSearch product as clicks are recorded on sponsored links on the various search engines and for our ReachDisplay product when the display advertisements record impressions or as otherwise provided in our agreement with the applicable publisher. The Company recognizes revenue for its ReachCast product on a straight line basis over the applicable service period for each campaign. We recognize revenue when we charge set-up, management or other fees on a straight line basis over the term of the related campaign contract or the completion of any obligation for services, if shorter. When we receive advance payments from our clients, we record these amounts as deferred revenue until the revenue is recognized. When we extend credit, we record a receivable when the revenue is recognized.

Our Direct Local clients, which represented 78% of revenue for 2011, generally prepay for services either by credit card, electronic debit, or check prior to the commencement of each approximately 30-day cycle of a campaign.

When we sell through agencies, we either receive payment in advance of services or in some cases we extend credit. We pay each agency an agreed-upon commission based on the revenue we earn or cash we receive. Some agency clients who have been extended credit may offset the amount otherwise due to us by any commissions they have earned. We evaluate whether it is appropriate to record the gross amount of campaign revenue or the net amount earned after commissions.

As we are the primary party obligated in the arrangement, subject to the credit risk and with discretion over both price and media, we recognize the gross amount of such sales as revenue and any commissions are recognized as a selling and marketing expense.

We also have a small number of resellers that integrate our product offerings and services, including ReachSearch, ReachDisplay, remarketing and TotalTrack, into their product offerings. In each case, the resellers integrate with our RL Platform through a custom API. Resellers are responsible for the price and specifications of the integrated product offered to their clients. Resellers pay us in arrears, net of commissions and other adjustments. We recognize revenue generated under reseller agreements net of the agreed-upon commissions and other adjustments earned or retained by the reseller, as we believe that the reseller has retained sufficient control and bears sufficient risks to be considered the primary obligor in those arrangements.

When we offer future incentives to our clients in exchange for minimum commitments, we estimate the amount of the future incentives that will be earned by our clients and defer a portion of the otherwise recognizable revenue. Our estimate is based upon a statistical analysis of previous campaigns for which such incentives were offered. Should a client not meet its minimum commitment and therefore no longer qualify for the incentive, we recognize the revenue previously deferred related to the estimated incentive. Our estimates are based upon historical actual results and unexpected changes in client purchasing patterns could render our estimates inaccurate.

Stock-based Compensation We account for stock-based compensation based on fair value. We follow the attribution method that requires companies to reduce current stock-based compensation expenses by the effect of anticipated forfeitures. We estimate forfeitures based upon our historical experience, which has resulted in a small expected forfeiture rate.

The fair value of each award is estimated on the date of the grant and amortized over the requisite service period, which is the vesting period.

We use the Black-Scholes option pricing model to estimate the fair value of stock-based payment awards on the date of grant. Determining the fair value of stock-based awards at the grant date under this model requires judgment, including estimating our value per share of common stock, volatility, expected term and risk-free interest rate. The assumptions used in calculating the fair value of stock-based awards represent our best estimates based on management judgment and subjective future expectations. These estimates involve inherent uncertainties. If any of the assumptions used in the Black-Scholes model significantly changes, stock-based compensation for future awards may differ materially from the awards granted previously.

Prior to our initial public offering in May 2010, the fair values of the common stock underlying stock options granted were estimated by our board of directors, which intended all options granted to be exercisable at a price per share not less than the per share fair market value of our common stock underlying those options on the date of grant. In the absence of a public trading market, our board of directors considered numerous objective and subjective factors to determine its best estimate of the fair market value of our common stock as of the date of each option grant, including but not limited to, the following factors: • transactions in our common stock; • third-party valuations of our common stock; • the rights, preferences and privileges of our preferred stock relative to the common stock; PAGE 34-------------------------------------------------------------------------------- • our performance and stage of development; and • the likelihood of achieving a liquidity event for the shares of common stock underlying these stock options, such as an initial public offering or sale of our company, given prevailing market conditions.

After our initial public offering, the fair values of our common stock underlying stock options granted have been based on the market price of our common stock.

We granted stock options with the following exercise prices during 2011: Estimated Fair Value Per Number of Shares Underlying Intrinsic Value Underlying Exercise Price Share as of Per Share at Date Grant Dates Options Per Share Grant Date of Grant February 2011 244,650 $ 20.98 $ 20.98 $ - February 2011 700,000 $ 22.46 $ 20.98 $ - April 2011 236,100 $ 25.51 $ 25.51 $ - June 2011 56,045 $ 17.32 $ 17.32 $ - August 2011 229,650 $ 16.70 $ 16.70 $ - November 2011 246,800 $ 7.56 $ 7.56 $ - We estimate the fair value of each option award on the date of grant using the Black-Scholes option pricing model. We determined weighted average valuation assumptions as follows: • Volatility. As we have a limited trading history for our common stock, the expected stock price volatility for our common stock was estimated by taking the median historic price volatility for industry peers based on daily price observations over a period equivalent to the expected term of the stock option grants. Industry peers consist of several public companies in the technology industry similar in size, stage of life cycle and financial leverage. We did not rely on implied volatilities of traded options in our industry peers' common stock because the volume of activity was relatively low.

• Expected term. The expected term was estimated using the simplified method allowed under SEC Staff Accounting Bulletin No. 107, Share-Based Payment. We use this method because we have limited historical data to estimate future terms and we are unable to obtain objective, measurable and comparative historical data of comparable companies.

• Risk free interest rate. The risk free interest rate is based on the yields of U.S. Treasury securities with maturities similar to the expected term of the options for each option group.

• Dividend yield. We have never declared or paid any cash dividends and do not presently plan to pay cash dividends in the foreseeable future. Consequently, we used an expected dividend yield of zero.

The following table summarizes the assumptions relating to our stock options granted during 2011: Expected dividend yield 0 % Risk free interest rate 1.88 % Expected life, in years 4.75 Expected volatility 57 % In addition, we estimate the forfeiture rate using our historical experience with forfeitures. We review the estimated forfeiture rates each period end and make changes as factors affecting the forfeiture rate calculations and assumptions change.

Using the Black-Scholes option pricing model, we recorded non-cash stock-based compensation expenses related to employee stock options granted of approximately $7.7 million and $5.1 million during 2011 and 2010, respectively, which includes $1.1 million and $1.2 million of SMB:LIVE deferred stock compensation during 2011 and 2010, respectively. At December 31, 2011, we had unrecorded compensation costs of $18.3 million related to unvested stock options and deferred stock consideration. The unrecognized compensation expense is expected to be recognized over a weighted average period of 1.4 years.

During 2011, we also issued 94,000 restricted stock units with a vesting period of 4 years. During 2011 and 2010, we recorded non-cash stock-based compensation expense of approximately $0.7 million and $0.6 million related to restricted stock units, respectively. At December 31, 2011, we had $2.0 million of unrecognized compensation expense related to unvested restricted stock units.

Changes in assumptions could impact the amount of restricted stock compensation expense.

PAGE 35--------------------------------------------------------------------------------Software Development Costs We capitalize our costs to develop internal-use software when management has determined the development efforts will result in new or additional functionality or results in new products. Costs incurred prior to meeting these criteria and costs associated with ongoing maintenance are expensed as incurred.

We track our costs by project and by each release and objectively determine which projects resulted in additional functionality or new products for which we can improve our offerings and market presence. Our developers, engineers and quality assurance staff currently record their time spent on various projects on a weekly basis so we may determine the approximate amount of costs that should be capitalized. Our senior management team reviews these estimates to determine the appropriate level of capitalization. We monitor our existing capitalized software and reduce its carrying value as the result of releases that render previous features or functions obsolete or otherwise reduce the value of previously capitalized costs.

Costs capitalized as software development costs are amortized on a straight-line basis over the estimated useful life of the software of three years.

Amortization of those costs is included in product and technology expenses as the RL Platform addresses all aspects of our activities, including supporting the IMC selling and consultation process, online publisher integration, efficiencies and optimization, providing insight to our clients into the results and effects of their online advertising campaigns and supporting all of the financial and other back office functions of our business.

Income Taxes We use the liability method of accounting for income taxes. Significant judgment is required in determining the consolidated provision for income taxes and evaluating our tax positions. In the ordinary course of business, there are many transactions and calculations for which the ultimate tax settlement is uncertain. As a result, we recognize tax liabilities based on estimates of whether additional taxes and interest will be due. These tax liabilities are recognized when, despite our belief that our tax return positions are supportable, we believe that it is more likely than not that those positions may not be fully sustained upon review by tax authorities.

For the periods presented, income tax expense represents minimum income taxes imposed by state, foreign and local tax jurisdictions applicable to our activities. We are otherwise generating net operating losses in the various tax jurisdictions in which we operate. We believe that it is likely that taxes imposed by state, local and foreign jurisdictions will increase in magnitude, particularly to the extent we become profitable in certain foreign jurisdictions before the time we obtain profitability on a consolidated basis.

Due to a history of losses, we have provided a valuation allowance against our deferred tax assets as more fully described in Note 10 of the consolidated financial statements. The ability to utilize these losses, any future losses and any other tax credits or attributes may be restricted or eliminated by changes in our ownership, including potentially as a result of our public offering, changes in legislation and other rules affecting the ability to offset future taxable income with losses from prior periods. Future determinations on the need for a valuation allowance on our net deferred tax assets will be made on a quarterly basis, and our assessment at December 31, 2011 reflects a continued need for a valuation allowance.

U.S. income and foreign withholding taxes have not been recognized on the excess of the amount for financial reporting over the tax basis of investments in foreign subsidiaries that are essentially permanent in duration. This amount becomes taxable upon a repatriation of assets from the subsidiary or a sale or liquidation of the subsidiary. The amount of such temporary differences totaled $18.7 million as of December 31, 2011, which included $16.2 million of non-cash gain discussed below. Determination of the amount of any unrecognized deferred income tax liability on this temporary difference is not practicable because of the complexities of the hypothetical calculation.

As a result of the acquisition of the portion of ReachLocal Australia that we did not previously own, in 2010 we recognized a non-cash gain of $16.2 million.

We did not record an income tax provision on the gain since management intends to hold its investment in ReachLocal Australia indefinitely.

As a result of the acquisition of SMB:LIVE on February 22, 2010, we recorded a one-time discrete deferred tax benefit of $0.7 million from intangible assets recorded on the date of acquisition.

We are required to file income tax returns in the United States and various foreign jurisdictions, which requires us to interpret the applicable tax laws and regulations in effect in such jurisdictions. Such returns are, and from time to time, have been subject to audit by the various federal, state and foreign taxing authorities, which may disagree with our tax positions. We believe that our accruals for tax liabilities are adequate for all open audit years based on our assessment of many factors, including past experience and interpretations of tax law. We review and update our estimates in light of changing facts and circumstances, such as the closing of a tax audit, the lapse of a statute of limitations or a material change in estimate. To the extent that the final tax outcome of these matters differs from our expectations, such differences will impact income tax expense in the period in which such determination is made.

PAGE 36 --------------------------------------------------------------------------------Goodwill Total goodwill of $41.8 million as of December 31, 2011 and $34.1 million as of December 31, 2010 is related to our acquired businesses. We operate in one reportable segment, in accordance with ASC 280, Segment Reporting, and have identified two reporting units-North America and Australia-for purposes of evaluating goodwill. These reporting units each constitute a business or group of businesses for which discrete financial information is available and is regularly reviewed by segment management. North America assigned goodwill is $9.4 million in 2011 and $1.7 million in 2010. Australia assigned goodwill is $32.4 million for 2011 and 2010. We review the carrying amounts of goodwill for possible impairment whenever events or changes in circumstance indicate that the related carrying amount may not be recoverable. We perform our annual assessment of goodwill impairment as of the first day of each fourth quarter.

For the year ended December 31, 2011, we adopted the amended guidance for assessing qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, in accordance with ASC 350-20, Intangibles - Goodwill and Other. Entities are provided with the option of first performing a qualitative assessment on any of its reporting units to determine whether further quantitative impairment testing is necessary. An entity may also bypass the qualitative assessment for any reporting unit in any period and proceed directly to the quantitative impairment test.If an entity determines that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing a two-step impairment test is necessary. The first step of the impairment test involves comparing the estimated fair values of each of our reporting units with their respective carrying amounts, including goodwill. If the estimated fair value of a reporting unit exceeds its carrying amount, including goodwill, goodwill is considered not to be impaired and no additional steps are necessary. If, however, the estimated fair value of the reporting unit is less than its carrying amount, including goodwill, then the second step is performed to compare the carrying amount of the goodwill with its implied fair value. If the carrying amount of goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess. We estimate fair value utilizing the projected discounted cash flow method and discount rate determined by management to commensurate the risk inherent in our business model.

We performed our annual assessment of goodwill impairment as of the first day of the fourth quarter of 2011 and 2010, and determined that it was more likely than not that there was no impairment of goodwill. Accordingly, no impairment of goodwill was recorded as of December 31, 2011 and 2010.

Long-Lived Assets and Intangible Assets We report finite-lived, acquisition-related intangible assets at fair value, net of accumulated amortization. Identifiable intangible assets are amortized on a straight-line basis over their estimated useful lives of three years.

Straight-line amortization is used because no other pattern over which the economic benefits will be consumed can be reliably determined.

Management reviews the carrying values of long-lived assets, including intangible assets, for possible impairment whenever events or changes in circumstance indicate that the related carrying amount may not be recoverable.

In our analysis of other finite lived amortizable intangible assets, we apply the guidance of ASC 350-20, Intangibles - Goodwill and Other, in determining whether any impairment conditions exist. An impairment loss is recognized to the extent that the carrying amount exceeds the asset's fair value. Intangible assets are attributable to the various developed technologies and client relationships of the businesses we have acquired. Long-lived assets to be disposed of are reported at the lower of carrying amount or estimated fair value less cost to sell.

At December 31, 2011 and 2010, we had $2.0 million and $1.7 million, respectively, of intangible assets resulting from acquisitions. In accounting for the 2009 ReachLocal Australia acquisition, we recorded other intangible assets related to pre-existing client relationships of $2.3 million. At December 31, 2011 and 2010, we had $0.5 million and $1.3 million, respectively, of intangible assets resulting from the ReachLocal Australia acquisition. In accounting for the 2010 acquisition of SMB:LIVE, we recorded other intangible assets related to purchased technology of $2.3 million. At December 31, 2011 and 2010, we had $0.9 million and $1.7 million, respectively, of intangible assets resulting from the SMB: LIVE acquisition.

During 2011, we recorded a $0.8 million impairment charge to intangible assets related to customer relationships acquired in the DealOn acquistion. This impairment is recorded in Cost of Revenue and results from a diminution in value attributable to an adjustment in our business strategy for ReachDeals and the elimination of our dedicated deal sales force. Management had determined that there was no impairment of long-lived assets as of December 31, 2010.

PAGE 37 --------------------------------------------------------------------------------Results of Operations Comparison of the Years Ended December 31, 2011, 2010 and 2009 Year Ended December 31, 2011 2010 2009 (in thousands, except per share data) Revenue $ 375,241 $ 291,689 $ 203,117 Cost of revenue (1) 190,559 159,018 112,218 Operating expenses: Selling and marketing (1) 139,929 108,529 76,089 Product and technology (1) 15,602 9,957 4,657 General and administrative (1) 33,313 23,629 15,529 Total operating expenses 188,844 142,115 96,275 Loss from operations (4,162 ) (9,444 ) (5,376 ) Gain on acquisitions of ReachLocal Australia - - 16,223 Other income (expense), net 928 601 (7 ) Income (loss) before provision (benefit) for income taxes (3,234 ) (8,843 ) 10,840 Provision (benefit) for income taxes 735 (540 ) 217 Income (loss) from continuing operations, net of income taxes (3,969 ) (8,303 ) 10,623 Loss from discontinued operations, net of income taxes (6,215 ) (2,844 ) (601 ) Net income (loss) (10,184 ) (11,147 ) 10,022 Undistributed income attributable to preferred stockholders - - 8,638 Net income (loss) available to common stockholders $ (10,184 ) $ (11,147 ) $ 1,384 Net income (loss) available to common stockholders: Net income (loss) from continuing operations, net of income taxes $ (3,969 ) $ (8,303 ) $ 1,985 Loss from discontinued operations, net of income taxes (6,215 ) (2,844 ) (601 ) Net income (loss) $ (10,184 ) $ (11,147 ) $ 1,384 Net income (loss) per share available to common stockholders, basic: Net income (loss) per share from continuing operations, basic $ (0.14 ) $ (0.42 ) $ 0.32 Net loss per share from discontinued operations, basic (0.21 ) (0.14 ) (0.10 ) Net income (loss) per share, basic $ (0.35 ) $ (0.56 ) $ 0.22 Net income (loss) per share available to common stockholders, diluted: Net income (loss) per share from continuing operations, diluted $ (0.14 ) $ (0.42 ) $ 0.25 Net loss per share from discontinued operations, diluted (0.21 ) (0.14 ) (0.07 ) Net income (loss) per share, diluted $ (0.35 ) $ (0.56 ) $ 0.18 Weighted average common shares used in the computation of net income (loss) per share available to common stockholders: Basic 28,974 19,867 6,283 Diluted 28,974 19,867 7,901 The following earnings per share information is presented as if all preferred shares were converted into common stock as of the beginning of the period presented.

Pro-forma net income (loss) per share, as if converted: Net income (loss) per share from continuing operations, basic $ (0.14 ) $ (0.32 ) $ 0.46 Net loss per share from discontinued operations, basic (0.21 ) (0.11 ) (0.03 ) Net income (loss) per share, basic $ (0.35 ) $ (0.42 ) $ 0.44 PAGE 38-------------------------------------------------------------------------------- Year Ended December 31, 2011 2010 2009 Net income (loss) per share from continuing operations, diluted $ (0.14 ) $ (0.32 ) $ 0.43 Net loss per share from discontinued operations, diluted (0.21 ) (0.11 ) (0.02 ) Net income (loss) per share, diluted $ (0.35 ) $ (0.42 ) $ 0.41 Pro-forma weighted average common shares used in computation of net income (loss) per share, as if converted: Basic 28,974 26,286 22,995 Diluted 28,974 26,286 24,613 -------------------------------------------------------------------------------- (1) Stock-based compensation, net of capitalization, and depreciation and amortization included in the above line-items (in thousands): Year Ended December 31, 2011 2010 2009 Stock-based compensation: Cost of revenue $ 200 $ 244 $ 86 Selling and marketing 1,402 1,202 566 Product and technology 1,387 1,104 117 General and administrative 5,392 3,123 2,145 $ 8,381 $ 5,673 $ 2,914 Depreciation and amortization: Cost of revenue $ 645 $ 364 $ 261 Selling and marketing 1,443 1,038 889 Product and technology 6,764 3,822 1,741 General and administrative 1,422 1,078 430 $ 10,274 $ 6,302 $ 3,321 Revenue Year Ended December 31, 2011-2010 2010-2009 2011 2010 2009 % Change % Change (in thousands) Direct Local $ 291,444 $ 217,846 $ 141,492 33.8 % 54.0 % National Brands, Agencies and Resellers 83,797 73,843 61,625 13.5 % 19.8 Total revenue $ 375,241 $ 291,689 $ 203,117 28.6 % 43.6 % At period end: Number of IMCs: Upperclassmen 372 286 235 30.1 % 21.7 % Underclassmen 424 379 280 11.9 % 35.4 Total 796 665 515 19.7 % 29.1 % Active Advertisers (at period end) 19,100 16,900 14,700 13.0 % 15.0 % Active Campaigns (at period end) 27,500 22,700 18,600 21.1 % 22.0 % The increase in Direct Local revenue of $73.6 million in 2011 compared to 2010 was largely attributable to the increase in productivity of our IMCs as a result of the increases in the number of Upperclassmen, the tenure of our Upperclassmen, and the number of international IMCs as a percentage of our total IMCs as our international IMCs are on average more productive, which we attribute to lower levels of competition and online advertising consumption by SMBs in those markets.

PAGE 39-------------------------------------------------------------------------------- The increase in National Brands, Agencies and Resellers revenue of $10.0 million in 2011 compared to 2010 was primarily due to $10.4 million in higher revenue from our domestic and international National Brands clients during 2011, and $1.2 million from our international Agencies and Resellers, which we attribute to greater success in these portions of the channel. This increase was offset in part by a decrease of $1.7 million in revenue from North American Agencies and Resellers during 2011, which was due to a decrease in spending from advertisers who advertised with us in both 2010 and 2011, and a decrease in the number of agencies advertising with us, partially offset by an increase in revenue from new agencies.

The increase in Direct Local revenue of $76.4 million in 2010 compared to 2009 reflected an incremental $24.4 million of Direct Local revenue attributable to ReachLocal Australia, which we began to consolidate after our September 2009 acquisition of the portion of ReachLocal Australia that we did not already own.

Excluding the impact of the ReachLocal Australia acquisition, the incremental revenue contributed by our Upperclassmen IMCs who were already Upperclassmen at the end of 2009 contributed the largest portion of the revenue growth in 2010.

The increased contribution of our new Upperclassmen-that is, IMCs who were Underclassmen at the end of 2009 and subsequently became Upperclassmen in 2010-represented the next largest portion of revenue growth, followed by the revenue contributed by our new Underclassmen hired in 2010.

The increase in National Brands, Agencies and Resellers revenue of $12.2 million in 2010 compared to 2009 was primarily due to an $8.5 million increase in revenue from our National Brands clients. The increase in National Brands client revenue was primarily due to the growth in the number of National Brands clients, both domestically and internationally, and to a lesser extent increased revenues from National Brands clients which were already clients in 2009. The growth in Agencies and Resellers revenues resulted from the addition of new Agencies during 2010.

Cost of Revenue Year Ended December 31, Year Ended December 31, 2011-2010 2010-2009 2011 2010 2009 % Change % Change 2011 2010 2009 (in thousands) (as a percentage of revenue) Cost of revenue $ 190,559 $ 159,018 $ 112,218 19.8 % 41.7 % 50.8 % 54.5 % 55.2 % The decrease in our cost of revenue as a percentage of revenue in 2011 compared to 2010 was primarily due to changes in geographic, product and service mix, including increased international sales and sales of ReachCast and ReachDisplay, improved media buying efficiencies introduced in late 2010 related to our core products, an increase in publisher and vendor rebates, and economies of scale in our operations and service infrastructure. Publisher rebates as a percentage of revenue increased to 3.2% of revenue in 2011 from 1.9% in 2010, due to more favorable rebate terms, primarily from our reseller agreements with Google.

The decrease in our cost of revenue as a percentage of revenue in 2010 compared to 2009 was primarily due to an increase in publisher rebates, the effect of changes in geographic, product and service mix and increased media buying efficiency. These decreases were partially offset by higher costs associated with the expansion of the campaign performance group as part of our strategy to enhance the productivity of our IMCs and improve customer satisfaction and the initial build-out of our Web Presence Professionals group in advance of the launch of our ReachCast product in the fourth quarter of 2010. Publisher rebates as a percentage of revenue increased to 1.9% of revenue in 2010, from 1.2% in 2009, due to an increase in rebates from existing and new publishers in North America, other than Google, and the full year inclusion of publisher rebates, predominantly from Google related to ReachLocal Australia.

Our cost of revenue as a percentage of revenue will be affected in the future by the mix and relative amount of media we purchase to fulfill service requirements, the availability and amount of publisher rebates, the mix of products and services we offer, our media buying efficiency, and the costs of support and delivery.

Operating Expenses We have significantly increased the scale of our operations. We intend to continue to increase our operating scale by increasing our sales force, product offerings and the infrastructure to support them. In managing our business for increased scale, we expect each category of operating expenses to increase. We are not a mature business where operating expense expansion can be tied to current revenue and revenue growth with a goal of meeting a particular immediate operating income target. Rather, we are intentionally incurring expenses to support our long-term growth plans, acknowledging that these investments may put pressure on near term periodic operating results and increase our operating expenses as a percentage of revenue.

PAGE 40 -------------------------------------------------------------------------------- Selling and Marketing Year Ended December 31, Year Ended December 31, 2011-2010 2010-2009 2011 2010 2009 % Change % Change 2011 2010 2009 (in thousands) (as a percentage of revenue) Salaries, benefits and other costs $ 98,784 $ 74,195 $ 50,380 33.1 % 47.3 % 26.3 % 25.4 % 24.8 % Commission expense 41,145 34,334 25,709 19.8 % 33.6 % 11.0 11.8 12.7 Total selling and marketing $ 139,929 $ 108,529 $ 76,089 28.9 % 42.6 % 37.3 % 37.2 % 37.5 % Underclassmen Expense included above, excluding commissions $ 44,488 $ 36,073 $ 26,824 23.3 % 34.5 % The increase in selling and marketing salaries, benefits and other costs in absolute dollars in 2011 compared to 2010 was primarily due to an increase in our IMC headcount and related recruiting, training and facilities costs. The increase as a percentage of revenue in 2011 compared to 2010 was due primarily to the entrance into new international markets, partially offset by economies of scale in our established markets.

The increase in commission expense in absolute dollars for 2011 compared to 2010 was due to increased sales. As a percentage of revenue, commission expense decreased due to a higher percentage of revenue from our Direct Local channel, for which we pay lower commission rates. We do not expect continued decreases in commission expense as a percentage of revenue due to an expected higher percentage of Upperclassmen, who generally earn higher commission rates based on increased productivity.

The increase in Underclassmen Expense in 2011 compared to 2010 was primarily due to increased IMC hiring, particularly in international markets. As we continue to invest in additional Underclassmen and retain additional Upperclassmen, selling and marketing expenses will continue to increase in absolute dollars.

The increase in absolute dollars of salaries, benefits and other costs in selling and marketing expenses in 2010 compared to 2009 was primarily due to an increase in our IMC headcount and related recruiting, training, and facilities costs.

The increase in commission expense in absolute dollars in 2010 compared to 2009 was due to increases in our revenue. As a percentage of revenue, commission expense decreased due to a higher percentage of Direct Local channel revenue, including the additional Direct Local revenue from ReachLocal Australia, for which we pay lower commission rates.

The increase in Underclassmen Expense in absolute dollars in 2010 compared to 2009 was primarily due to increased IMC hiring in 2010, as well as the inclusion of Australia's Underclassmen starting on September 11, 2009.

Product and Technology Year Ended December 31, Year Ended December 31, 2011-2010 2010-2009 2011 2010 2009 % Change % Change 2011 2010 2009 (in thousands) (as a percentage of revenue) Product and technology expenses $ 15,602 $ 9,957 $ 4,657 56.7 % 113.8 % 4.2 % 3.4 % 2.3 % Capitalized software development costs from product and technology resources 6,776 6,884 3,276 (1.6 )% 110.1 % 1.8 2.4 1.6 Total product and technology costs expensed and capitalized $ 22,378 $ 16,841 $ 7,933 32.9 % 112.3 % 6.0 % 5.8 % 3.9 % PAGE 41-------------------------------------------------------------------------------- The increase in product and technology expenses in both absolute dollars and as a percentage of revenue in 2011 compared to 2010 was primarily attributable to $3.5 million of increased salaries and compensation expense as a result of increased headcount related to the ongoing development of the RL Platform, including ReachCast, and $2.1 million of increased amortization expense related to previously capitalized software development costs.

Capitalized software development costs were essentially flat between 2011 and 2010.

The increase in product and technology expenses in both absolute dollars and as a percentage of revenue in 2010 compared to 2009 was primarily attributable to a $2.7 million increase in compensation for additional headcount, which includes $1.7 million of compensation expense related to SMB:LIVE, for which no comparative amounts existed in 2009. The remaining increase was due to a $1.8 million increase in amortization of capitalized software and intangibles; and $0.8 million increase in facilities and software maintenance costs and consulting fees primarily related to the acquisition of SMB:LIVE for which no comparative amounts existed in 2009.

The increase in the amount of software development costs capitalized both in absolute dollars and as a percentage of revenue in 2010 compared to 2009 was a result of investment in the development of ReachCast, which commenced in the first quarter of 2010 with the acquisition of SMB:LIVE, and additional product enhancements to the RL Platform.

General and Administrative Year Ended December 31, Year Ended December 31, 2011-2010 2010-2009 2011 2010 2009 % Change % Change 2011 2010 2009 (in thousands) (as a percentage of revenue) General and administrative $ 33,313 $ 23,629 $ 15,529 41.0 % 52.2 % 8.9 % 8.1 % 7.6 % The increase in general and administrative expenses in absolute dollars and as a percentage of revenue in 2011 compared to 2010 was primarily due to $2.9 million of increased employee costs to support the growth of the business, $2.3 million of increased tax, consulting and legal professional fees, including costs to support our Sarbanes-Oxley compliance efforts and our international expansion initiatives, $2.3 million of increased stock-based compensation expense, and $1.8 million of increased facilities and related costs supporting the growth of the business and the requirements associated with being a public company.

The increase in general and administrative expenses in both absolute dollars and percentage of revenue in 2010 compared to 2009 was primarily due to an increase of $3.9 million in expense for additional administrative headcount and professional service fees necessary for our transition to being a public company. In addition, the incremental general and administrative expenses of ReachLocal Australia and SMB:LIVE added $2.5 million of general and administrative expenses. We also accrued $0.8 million of incremental expenses in connection with the settlement of a class action lawsuit.

We expect general and administrative expenses to increase in absolute dollars as we continue to add administrative personnel and incur additional professional fees and other expenses resulting from continued growth and the compliance requirements associated with being a public company.

Gain on Acquisition of ReachLocal Australia Our purchase of the equity interests in ReachLocal Australia that we did not previously own on September 11, 2009 required that we recognize a gain associated with the proportionate fair value of the assets acquired and liabilities assumed to the carrying value of the shares we already owned. Prior to the acquisition, our interest in ReachLocal Australia had a carrying value of zero as a result of our share of the losses recognized under the equity method of accounting. On the date of the acquisition, our investment was adjusted to fair value, resulting in the one-time non-cash gain of $16.2 million.

Other Income (Expense), Net The increases in other income in both absolute dollars and as a percentage of revenue in 2011 and 2010 as compared to the prior-year periods were attributable to an increase in interest income resulting from higher invested balances.

PAGE 42 --------------------------------------------------------------------------------Provision (Benefit) for Income Taxes The income tax provision of $0.7 million for 2011 relates to federal, state, local and foreign income taxes. The income tax benefit of $0.5 million for 2010 was primarily attributable to the acquisition of SMB:LIVE, in which we recorded a one-time discrete deferred tax benefit of $0.7 million, which was partially offset by state, local and foreign income taxes of $0.2 million.

Loss from Discontinued Operations On November 1, 2011, we announced that we would wind down the operations of Bizzy due to insufficient consumer adoption of the Bizzy recommendation engine and determined that Bizzy would be considered a discontinued operation as of the third quarter of 2011. In connection with this decision, we recorded a charge of $4.0 million in 2011 to reflect the impairment of capitalized software development costs, personnel and severance costs, operating losses, facilities and other costs.

Non-GAAP Financial Measures In addition to our GAAP results discussed above, we believe Adjusted EBITDA and Underclassmen Expense are useful to investors in evaluating our operating performance. For the twelve months ended December 31, 2011, 2010 and 2009 our Adjusted EBITDA and Underclassmen Expense were as follows: Year Ended December 31, 2011 2010 2009 (in thousands) Non-GAAP Financial Measures (unaudited): Adjusted EBITDA (1) $ 15,915 $ 3,133 $ 1,920 Underclassmen Expense (2) $ 44,488 $ 36,073 $ 26,824 (1) Adjusted EBITDA. We define Adjusted EBITDA as net income (loss) from continuing operations before interest, income taxes, depreciation and amortization expenses, excluding, when applicable, stock-based compensation, the effects of accounting for business combinations (including any impairment of acquired intangibles and, in the case of the acquisition of SMB:LIVE, the deferred cash consideration), and amounts included in other non-operating income or expense.

(2) Underclassmen Expense. We define Underclassmen Expense as our investment in Underclassmen, which is comprised of the selling and marketing expenses we allocate to Underclassmen during a reporting period. The amount includes the direct salaries and allocated benefits of the Underclassmen (excluding commissions), training and sales organization expenses including depreciation allocated based on relative headcount and marketing expenses allocated based on relative revenue. While we believe that Underclassmen Expense provides useful information regarding our approximated investment in Underclassmen, the methodology we use to arrive at our estimated Underclassmen Expense was developed internally by the company, is not a concept or method recognized by GAAP and other companies may use different methodologies to calculate or approximate measures similar to Underclassmen Expense. Accordingly, our calculation of Underclassmen Expense may not be comparable to similar measures used by other companies.

Our management uses Adjusted EBITDA because (i) it is a key basis upon which our management assesses our operating performance; (ii) it may be a factor in the evaluation of the performance of our management in determining compensation; (iii) we use it, in conjunction with GAAP measures such as revenue and income (loss) from operations, for operational decision-making purposes; and (iv) we believe it is one of the primary metrics investors use in evaluating Internet marketing companies.

Our management believes that Adjusted EBITDA permits an assessment of our operating performance, in addition to our performance based on our GAAP results that is useful in assessing the progress of the business. By excluding (i) the effects of accounting for business combinations and associated acquisition and integration costs, which obscure the measurable performance of the business operations; (ii) depreciation and amortization and other non-operating income and expense, each of which may vary from period to period without any correlation to underlying operating performance; and (iii) stock-based compensation, which is a non-cash expense, we believe that we are able to gain a fuller view of the operating performance of the business. We provide information relating to our Adjusted EBITDA so that investors have the same data that we employ in assessing our overall operations. We believe that trends in our Adjusted EBITDA are a valuable indicator of operating performance on a consolidated basis and of our ability to produce operating cash flow to fund working capital needs, capital expenditures and investments in Underclassmen.

PAGE 43 -------------------------------------------------------------------------------- In addition, our management believes that Adjusted EBITDA and similar measures are widely used by investors, securities analysts, ratings agencies and other interested parties in our industry as a measure of financial performance and debt-service capabilities. Our use of Adjusted EBITDA has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are: • Adjusted EBITDA does not reflect our cash expenditures for capital equipment or other contractual commitments; • Although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect capital expenditure requirements for such replacements; • Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; • Adjusted EBITDA does not consider the potentially dilutive impact of issuing equity-based compensation to our management team and employees; • Adjusted EBITDA does not reflect the potentially significant interest expense or the cash requirements necessary to service interest or principal payments on indebtedness we may incur in the future; • Adjusted EBITDA does not reflect income and expense items that relate to our financing and investing activities, any of which could significantly affect our results of operations or be a significant use of cash; • Adjusted EBITDA does not reflect certain tax payments that may represent a reduction in cash available to us; and • Other companies, including companies in our industry, calculate Adjusted EBITDA measures differently, which reduces its usefulness as a comparative measure.

Adjusted EBITDA is not intended to replace operating income (loss), net income (loss) and other measures of financial performance reported in accordance with GAAP. Rather, Adjusted EBITDA is a measure of operating performance that you may consider in addition to those measures. Because of these limitations, Adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results, including cash flows provided by operating activities, and using total Adjusted EBITDA as a supplemental financial measure.

The following table presents a reconciliation of Adjusted EBITDA to our loss from operations for each of the periods indicated: Year Ended December 31, 2011 2010 2009 (in thousands) Loss from operations $ (4,162 ) $ (9,444 )) $ (5,376 ) Add: Stock-based compensation, net 8,381 5,673 2,914 Depreciation and amortization 10,274 6,302 3,321 Acquisition and integration costs 1,422 602 389 Amortization of step-down in deferred revenue on acquisition of ReachLocal Australia, net of tax - - 672 Adjusted EBITDA $ 15,915 $ 3,133 $ 1,920 Liquidity and Capital Resources Year Ended December 31, 2011 2010 2009 Consolidated Statements of Cash Flow Data: (in thousands) Net cash provided by operating activities, continuing operations $ 20,861 $ 19,805 $ 14,718 Net cash used in investing activities, continuing operations $ (11,708 ) $ (16,924 ) $ (15,882 ) Net cash used by discontinued operations $ (3,012 ) $ (3,533 ) $ (1,390 ) Net cash provided by (used in) financing activities $ (973 ) $ 44,097 $ (979 ) At December 31, 2011, we had cash and cash equivalents of $84.5 million and short-term investments of $0.6 million. Cash and cash equivalents consist of cash, money market accounts and certificates of deposit. Short term investments consist of certificates of deposit with original maturities in excess of three months but less than 12 months. To date, we have experienced no loss of our invested cash, cash equivalents or short-term investments. We cannot, however, provide any assurances that access to our invested cash, cash equivalents and short-term investments will not be impacted by adverse conditions in the financial markets. At December 31, 2011, we had no long-term indebtedness for borrowed money and are not subject to any restrictive bank covenants. At December 31, 2011, we had $1.3 million in restricted certificates of deposit to secure letters of credit issued to landlords and others.

PAGE 44 -------------------------------------------------------------------------------- At December 31, 2011, we did not have contractual or purchase commitments for capital expenditures that were not reflected on our balance sheet as a liability. At December 31, 2010, our contractual or purchase commitments for capital expenditures that were not reflected on our balance sheet as a liability were less than $0.4 million, such amounts representing unfilled purchase orders of computer equipment. In addition, at December 31, 2011, we had significant internal product and technology resources working on projects that met the criteria for capitalization as software development costs and others that did not, although none of the projects in process were long-term projects (greater than one year). The amount capitalized for such projects in future periods will be evaluated by management and will impact the portion of costs for those internal resources that reduces net cash provided by operating activities and the portion of such costs that reduces net cash provided by investing activities. Funding for the committed capital expenditures, including software development costs, is expected to be provided by operating cash flow.

We have financed our operations, our expansion of our IMC salesforce and the extension of our Direct Local channel into new territories through cash provided by operations. Deferred revenue arising from prepayment by the great majority of our clients and vendor trade financing, principally for the purchase of media, are major components of our cash flow from operations, and the cash provided by deferred revenue and accounts payable has increased as our business has continued to grow. In general, to the extent our revenue from our Direct Local channel continues to grow, we would expect both the amount of deferred revenue from customer prepayments and the amount of vendor financing for purchased media to increase, which, subject to offset from changes in other operating costs, cash demands or vendor terms, would result in an increase in net cash provided by operations. Should revenue from the Direct Local channel decrease, the amount of deferred revenue and vendor financing would likely decrease, which, subject to changes in other accounts, would cause net cash provided by operations to be reduced.

Although we expect that cash flow from operations, existing cash balances and proceeds from our initial public offering will be sufficient to continue funding our expansion activities, these investments, including investments in developing new products and services for our clients, could require us to seek additional equity or debt financing, and that financing may not be available on terms favorable to us or at all. In addition, expansion in the number of IMCs and rapid expansion of new products and services for our clients could require significant capital and entail non-capitalized expenses that could diminish our income from operations. Further, in light of the additional capital provided by our initial public offering and assuming a stable macroeconomic climate and continued favorable operating cash flow, we intend to continue to invest in additional Underclassmen, retain additional Upperclassmen, and develop new products.

Operating Activities Our cash flow from operating activities for 2011 resulted primarily from adjustments for non-cash expenses. Our loss from continuing operations of $4.0 million was offset by non-cash depreciation and amortization of $10.3 million, and non-cash stock-based compensation of $8.4 million. The loss was also offset by increases in accounts payable and accrued expenses of $7.1 million, reflecting a return to more normalized accounts payable levels as compared to 2010 due to the change in timing of payments to certain vendors, and $5.4 million of increases in deferred revenue and deferred payment obligations, both due to the growth of our business. The increases were partially offset by an increase in other receivables and prepaid expenses of $5.7 million, primarily related to an increase in vendor rebates of $6.3 million.

Our cash flow from operating activities for 2010 resulted primarily from changes in our operating assets and liabilities, with accounts payable and accrued liabilities increasing $11.2 million and deferred revenue and rent increasing $8.0 million, both due to the growth of our business. We had a net loss in 2010 of $8.3 million, which included non-cash depreciation and amortization of $6.3 million and non-cash stock-based compensation of $5.7 million.

Our cash flow from operating activities for 2009 resulted primarily from changes in our operating assets and liabilities, with accounts payable and accrued liabilities increasing $8.3 million and deferred revenue increasing $6.2 million. Accounts payable at December 31, 2009 includes approximately $2.1 million in deferred expenses relating to our initial public offering. Net income of $10.6 million included a non-cash gain of $16.2 million from our purchase of the remaining interest in ReachLocal Australia.

Investing Activities Our primary investing activities have consisted of purchases of property and equipment, capitalized software development costs, short-term investments, and business acquisitions. Our purchases of property and equipment and capitalized software have increased year-over-year as the business has grown, but may vary from period to period due to the timing of the expansion of our operations and our software development efforts.

On February 8, 2011, we acquired DealOn for up to approximately $9.7 million in cash and stock. On the closing date, we paid $5.8 million in cash and issued 82,878 shares of our common stock. The balance of the purchase price is estimated to total up to $1.5 million, payable in cash, and 22,095 common shares of our stock, payable in three installments, with 50% (10,649 shares of common stock), paid in February 2012, 25% payable August 2012 and 25% payable February 2013.

PAGE 45-------------------------------------------------------------------------------- In 2010, we invested $2.8 million, net of cash acquired, in the purchase of SMB:LIVE. The terms of our purchase agreement required us to make additional payments in 2011 of $0.4 million and in 2012 of $0.6 million. In 2009, we acquired the remaining interest of ReachLocal Australia and invested $8.9 million in net cash. Of this investment, $3.1 million was paid, net of cash acquired, in 2009 and the balance of $5.8 million was paid in conjunction with our initial public offering in 2010. We expect to continue to use capital for acquisitions, purchases of property and equipment and development of software.

Financing Activities Our cash flow used in financing activities for 2011 resulted primarily from settlements of repurchases of our common stock of $6.5 million. This was partially offset by $5.5 million in proceeds from the exercise of stock options.

In May 2010, we received $43.0 million in proceeds, after deducting underwriting discounts and commissions and estimated offering costs payable by us, from the sale of shares of common stock in connection with our initial public offering.

Future cash flows from financing activities may also be affected by our repurchases of our common stock. On November 4, 2011, we announced that our Board of Directors authorized the repurchase of up to $20.0 million of our outstanding common stock. At December 31, 2011, we had executed repurchases of $6.7 million of our common stock under the program. From January 1, 2012 to March 9, 2012, we executed repurchases of an additional $2.6 million of our common stock under the program. Purchases may be made from time-to-time in open market or privately negotiated transactions as determined by our management. The amount and timing of the share repurchase will depend on business and market conditions, stock price, trading restrictions, acquisition activity, and other factors. The share repurchase program does not obligate us to acquire any particular amount of common stock, and the repurchase program may be suspended or discontinued at any time at our discretion.

Balance Sheet Arrangements At December 31, 2011, we did not have any off-balance sheet arrangements.

Contractual Obligations At December 31, 2011, the remaining deferred payment obligations under the SMB:LIVE acquisition agreement included $0.6 million of deferred cash consideration and 181,224 shares of our common stock and are also based on achieving certain milestones tied to employee retention objectives through February 22, 2012, which were met and the remaining cash and stock consideration was paid. At December 31, 2011, the deferred payment obligation under the DealOn acquisition agreement included approximately $1.5 million in cash and 21,297 shares of our common stock. On February 8, 2012, we made a deferred payment in the amount of $0.5 million and issued 10,649 shares of common stock in accordance with the DealOn acquisition agreement.

We lease our primary office space in Woodland Hills, California; Plano, Texas; and other locations under various cancelable and non-cancelable operating leases that will expire between 2012 and 2021. We have no debt obligations. All property and equipment have been purchased for cash, and we have no capital lease obligations recorded in the financial statements. We have no material long-term purchase obligations outstanding with any vendors or third parties other than the SMB deferred payment obligations.

As of December 31, 2011, future minimum payments under non-cancelable operating leases are as follows (in thousands): Payments Under Operating Leases Less than 1 year $ 9,168 1-3 years 16,092 3-5 years 9,358 More than 5 years 8,028 Total future minimum payments $ 42,646 PAGE 46--------------------------------------------------------------------------------Recently Issued Accounting Standards Accounting Standards Codification ("ASC") Topic 220-10, Comprehensive Income - Presentation of Comprehensive Income, provides that an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under both options, an entity will be required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. The amendments do not affect how earnings per share is calculated or presented. ASC Topic 220-10 is effective for us as of January 1, 2012, however certain provisions of the standard relating to the presentation of reclassification adjustments out of accumulated other comprehensive income have been deferred . Although adopting the guidance will not impact our accounting for comprehensive income, it will affect our presentation of components of comprehensive income by eliminating our practice of showing these items within the Consolidated Statements of Shareowners' Equity.

ASC Topic 820-10, Fair Value Measurement - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (International Financial Reporting Standards), clarifies existing fair value measurement and disclosure requirements, amends certain fair value measurement principles and requires additional disclosures about fair value measurements.

Adoption of this provision, which is effective for us as of January 1, 2012, is not expected to have a material impact on our consolidated financial statements.

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