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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark one)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2007
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number: 000-51002
ZIPREALTY, INC.
(Exact name of registrant as specified in its charter)
     
DELAWARE   94-3319956
(State of incorporation)   (IRS employer identification number)
     
2000 POWELL STREET, SUITE 300    
EMERYVILLE, CA   94608
(Address of principal executive offices)   (Zip Code)
(510) 735-2600
(Registrant’s telephone number)
     Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer o      Accelerated Filer þ      Non-Accelerated Filer o
     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
     We had 23,369,138 shares of common stock outstanding at November 1, 2007.
 
 

 


 

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 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32.1
 EXHIBIT 32.2

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Statement regarding forward-looking statements
     This report includes forward-looking statements. All statements other than statements of historical facts contained in this report, including statements regarding our future financial position, business strategy and plans and objectives of management for future operations, are forward-looking statements. The words “believe,” “may,” “will,” “should,” “could,” “estimate,” “continue,” “anticipate,” “intend,” “expect,” “plan,” “potential,” “predict” and similar expressions, as they relate to us, are intended to identify forward-looking statements. Forward-looking statements contained in this report include, but are not limited to, statements relating to:
    our future financial results;
 
    our future growth and expansion into new markets;
 
    our future advertising and marketing activities; and
 
    our future investment in technology.
     We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in “Risk Factors” in Item 1A of Part II. No forward-looking statement is a guarantee of future performance and you should not place undue reliance on any forward-looking statement.
     In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this report may not occur and actual results could differ materially from those anticipated or implied in the forward-looking statements. Except as otherwise required by law, we undertake no obligation to update or revise any forward-looking statement contained in this report.
Trademarks
     “ZipRealty,” “ZipAgent,” “ZipNotify,” “Your home is where our heart is” and “Real Estate Redefined” are our registered trademarks in the United States. We also own the rights to the domain name “www.Real-Estate.com.” “REALTOR” and “REALTORS” are registered trademarks of the National Association of REALTORS® . All other trademarks, trade names and service marks appearing in this report are the property of their respective owners.
Internet site
     Our Internet address is www.ziprealty.com. We make publicly available free of charge on our Internet website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. Information contained on our website is not a part of this quarterly report on Form 10-Q.
Where you can find additional information
     You may review a copy of this quarterly report on Form 10-Q, including exhibits and any schedule filed therewith, and obtain copies of such materials at prescribed rates, at the Securities and Exchange Commission’s Public Reference Room in Room 1580, 100 F Street NE, Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission maintains a website (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding registrants, such as ZipRealty, that file electronically with the Securities and Exchange Commission.

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PART I — FINANCIAL INFORMATION
Item 1. Unaudited Condensed Consolidated Financial Statements:
ZIPREALTY, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
                 
    September 30,     December 31,  
    2007     2006  
Assets
               
Current assets
               
Cash and cash equivalents
  $ 7,740     $ 8,575  
Short-term investments
    77,672       80,233  
Accounts receivable, net of allowance of $32 and $30 at September 30, 2007 and December 31, 2006, respectively
    2,085       1,781  
Prepaid expenses and other current assets
    2,964       3,151  
Current and deferred income taxes
    24       29  
 
           
Total current assets
    90,485       93,769  
Restricted cash
    90       90  
Property and equipment, net
    5,259       4,114  
Investment in non-consolidated companies
    13       17  
Intangible assets, net
    126       149  
Other assets
    209       218  
 
           
Total assets
  $ 96,182     $ 98,357  
 
           
 
               
Liabilities and Stockholders’ Equity
               
Current liabilities
               
Accounts payable
  $ 2,810     $ 2,184  
Accrued expenses and other liabilities
    10,301       7,791  
 
           
Total current liabilities
    13,111       9,975  
Other long-term liabilities
    501       513  
 
           
Total liabilities
    13,612       10,488  
 
           
Commitments and contingencies (Note 8)
               
Stockholders’ equity
               
Common stock: $0.001 par value; 100,000 shares authorized; 23,279 and 21,627 shares issued and outstanding at September 30, 2007 and December 31, 2006, respectively
    23       22  
Additional paid-in capital
    141,876       134,813  
Common stock warrants
    1,834       5,519  
Deferred stock-based compensation
    (13 )     (71 )
Accumulated other comprehensive loss
    75       (157 )
Accumulated deficit
    (61,225 )     (52,257 )
 
           
Total stockholders’ equity
    82,570       87,869  
 
           
Total liabilities and stockholders’ equity
  $ 96,182     $ 98,357  
 
           
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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ZIPREALTY, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
                                 
    Three Months ended September 30,     Nine Months ended September 30,  
    2007     2006     2007     2006  
Net transaction revenues
  $ 27,225     $ 25,420     $ 80,406     $ 70,263  
Referral and other revenues
    804       765       2,286       2,048  
 
                       
Net revenues
    28,029       26,185       82,692       72,311  
 
                       
 
                               
Operating expenses
                               
Cost of revenues
    15,637       14,238       46,024       39,568  
Product development
    1,835       1,376       5,329       4,128  
Sales and marketing
    9,630       7,719       28,306       22,398  
General and administrative
    3,357       3,227       11,782       9,556  
Litigation
    3,550             3,550        
 
                       
Total operating expenses
    34,009       26,560       94,991       75,650  
 
                       
 
                               
Income (loss) from operations
    (5,980 )     (375 )     (12,299 )     (3,339 )
 
                       
Other income (expense), net
                               
Interest income
    1,147       1,086       3,329       2,782  
Other income (expense), net
    2       (8 )     2       (8 )
 
                       
Total other income, net
    1,149       1,078       3,331       2,774  
 
                       
Income (loss) before income taxes
    (4,831 )     703       (8,968 )     (565 )
Provision for (benefit from) income taxes
          81             (179 )
 
                       
Net income (loss)
  $ (4,831 )   $ 622     $ (8,968 )   $ (386 )
 
                       
 
                               
Net income (loss) per share:
                               
Basic
  $ (0.21 )   $ 0.03     $ (0.40 )   $ (0.02 )
Diluted
  $ (0.21 )   $ 0.03     $ (0.40 )   $ (0.02 )
Weighted average common shares outstanding:
                               
Basic
    22,629       20,410       22,421       20,356  
Diluted
    22,629       23,478       22,421       20,356  
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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ZIPREALTY, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
                 
    Nine Months ended September 30,  
    2007     2006  
Cash flows from operating activities
               
Net loss
  $ (8,968 )   $ (386 )
Adjustments to reconcile net loss to net cash provided by (used in) operating activities
               
Deferred income tax benefit
          (179 )
Depreciation and amortization
    2,118       1,744  
Stock-based compensation expense
    2,862       1,884  
Provision for doubtful accounts
    2       (4 )
Amortization of short-term investment premium (discount)
    (323 )     (2 )
Amortization of intangible assets
    23        
Loss on disposal of property and equipment
    8       15  
Equity in net loss of non-consolidated companies
    4        
Changes in operating assets and liabilities
               
Accounts receivable
    (306 )     (308 )
Prepaid expenses and other current assets
    192       421  
Other assets
    9       (180 )
Accounts payable
    626       (106 )
Accrued expenses and other liabilities
    2,510       (1,614 )
Other long-term liabilities
    (12 )     531  
 
           
Net cash provided by (used in) operating activities
    (1,255 )     1,816  
 
           
 
               
Cash flows from investing activities
               
Purchases of short-term investments
    (48,830 )     (51,102 )
Proceeds from sale and maturity of short-term investments
    51,946       54,540  
Purchases of property and equipment
    (3,241 )     (3,038 )
Purchase of intangible asset
          (150 )
Investment in non-consolidated companies
          (28 )
 
           
Net cash provided by (used in) investing activities
    (125 )     222  
 
           
 
               
Cash flows from financing activities
               
Proceeds from stock option exercises
    95       535  
Proceeds from common stock warrant exercises
    450        
 
           
Net cash provided by financing activities
    545       535  
 
           
Net increase (decrease) in cash and cash equivalents
    (835 )     2,573  
 
           
Cash and cash equivalents at beginning of period
    8,575       6,868  
 
           
Cash and cash equivalents at end of period
  $ 7,740     $ 9,441  
 
           
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BACKGROUND AND BASIS OF PRESENTATION
     The accompanying unaudited interim condensed consolidated financial statements as of September 30, 2007 and 2006 and for the three and nine months then ended have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the rules and regulations of the U.S. Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements. In the opinion of the Company’s management, the unaudited interim condensed consolidated financial statements have been prepared on the same basis as the audited financial statements, and include all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of the Company’s financial position for the periods presented. The results for the three and nine months ended September 30, 2007 are not necessarily indicative of the results to be expected for the year ending December 31, 2007, or any other period. The audited condensed consolidated balance sheet at December 31, 2006 has been derived from the audited consolidated balance sheet at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. These financial statements and notes should be read in conjunction with the audited financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2006.
     In June 2006, the Company formed two wholly owned subsidiaries, ZipRealty Title Holdings, LLC, and Highline Insurance Services, LLC. These subsidiaries were formed for the purpose of offering services relating to the purchase, sale and ownership of a home, including services related to title insurance and property and casualty insurance. In June 2006, ZipRealty Title Holdings, LLC entered into a joint venture with an independent third party title company. There were no significant operations as of September 30, 2007 for any of these entities.
     The unaudited interim condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries and reflect the elimination of intercompany accounts and transactions. Investments in business entities in which the Company does not have control, but has the ability to exercise significant influence over operating and financial policies, are accounted for using the equity method.
     The Company accounts for interests in variable interest entities (“VIEs”) in accordance with Financial Accounting Standards Board Interpretation No. 46 (“FIN 46”), as amended. The Company consolidates all VIEs for which the Company is deemed to be the primary beneficiary.
Reclassifications
     Effective January 1, 2007, for income statement presentation purposes, we have reclassified sales support and marketing expenses from general and administrative to sales and marketing (previously stated as marketing and customer acquisition). In management’s opinion, the reclassification to sales and marketing more appropriately reflects the nature of these activities, which include sales support and marketing activities of our district offices, regional services, ZipAgent and customer support services. In conjunction with this reclassification, we have also allocated headquarter occupancy costs to corporate departments based upon square footage to product development, sales and marketing and general and administrative; previously, all headquarter occupancy costs were recorded under general and administrative expenses. Comparative periods have been conformed to this presentation. The following is the change in classification of operating expenses for the three months and nine months ended September 30, 2006:
                                 
    Three Months Ended     Nine Months Ended  
    September 30, 2006     September 30, 2006  
    Previously             Previously        
    Reported     Reclassified     Reported     Reclassified  
    (in thousands)  
Cost of revenues
  $ 14,238     $ 14,238     $ 39,568     $ 39,568  
Product development
    1,284       1,376       3,838       4,128  
Sales and marketing
    3,116       7,719       9,413       22,398  
General and administrative
    7,922       3,227       22,831       9,556  
 
                       
Total operating expenses
  $ 26,560     $ 26,560     $ 75,650     $ 75,650  
 
                       

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Seasonality
     The Company’s net transaction revenues and income (loss) from operations have historically varied from quarter to quarter. Such variations are principally attributable to variations in home sales activity over the course of the calendar year. The Company has historically experienced lower net transaction revenues during the first quarter because holidays and adverse weather conditions in certain regions typically reduce the level of sales activity and listings inventories between the Thanksgiving and Presidents’ Day holidays. Net transaction revenues during the three months ended September 30, 2006 and 2005 accounted for approximately 27.4% and 30.3% of annual net transaction revenues in 2006 and 2005, respectively. Net transaction revenue during the nine months ended September 30, 2006 and 2005 accounted for approximately 75.8% and 77.0% of annual net transaction revenues in 2006 and 2005, respectively.
2. RECENT ACCOUNTING PRONOUNCEMENTS
     In February 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 159 (“SFAS 159”), Fair Value Option for Financial Assets and Financial Liabilities, which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS 159 will be effective for the Company on January 1, 2008. The Company is currently evaluating the impact of adopting SFAS 159 on its financial position, cash flows and results of operations.
3. SHORT-TERM INVESTMENTS
     At September 30, 2007, short-term investments were classified as available-for-sale securities, except for restricted cash, and are reported at fair value as follows:
                                 
            Gross     Gross        
    Gross Amortized     Unrealized     Unrealized     Estimated  
    Cost     Gains     Losses     Fair Value  
    (in thousands)  
Money market securities
  $ 4,578     $     $     $ 4,578  
Asset backed
    29,311       37       (40 )     29,308  
Mortgage backed
    11,763       60             11,823  
Corporate obligations
    23,763       11       (29 )     23,745  
US Government and agency obligations
    12,760       36             12,796  
 
                       
Total short-term investments
  $ 82,175     $ 144     $ (69 )   $ 82,250  
 
                       
         
    September 30,  
    2007  
    (in thousands)  
Recorded as:
       
Cash equivalents
  $ 4,578  
Short-term investments
    77,672  
 
     
 
  $ 82,250  
 
     
     At September 30, 2007, the fair value of the Company’s investments which had been in an unrealized loss position for over twelve months was $6.3 million and the related unrealized loss was approximately $18,000.
     The estimated fair value of short-term investments classified by date of contractual maturity at September 30, 2007 were as follows:
         
    September 30,  
    2007  
    (in thousands)  
Due within one year or less
  $ 33,949  
Due after one year through two years
    16,068  
Due after two years through four years
    32,233  
 
     
 
  $ 82,250  
 
     

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4. NET INCOME (LOSS) PER SHARE
     The following table sets forth the computation of basic and dilutive net income (loss) per share for the periods indicated:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2007     2006     2007     2006  
    (in thousands, except per share amounts)  
Numerator:
                               
Net income (loss)
  $ (4,831 )   $ 622     $ (8,968 )   $ (386 )
 
                       
Denominator:
                               
Weighted average common shares outstanding:
                               
Basic
    22,629       20,410       22,421       20,356  
Diluted
    22,629       23,478       22,421       20,356  
Net income (loss) per share:
                               
Basic
  $ (0.21 )   $ 0.03     $ (0.40 )   $ (0.02 )
Diluted
  $ (0.21 )   $ 0.03     $ (0.40 )   $ (0.02 )
     The following table sets forth potential common shares that are not included in the diluted net income (loss) per share calculation because to do so would be anti-dilutive for the periods presented:
                                 
    Three Months Ended September 30,   Nine Months Ended September 30,
    2007   2006   2007   2006
    (in thousands)
Stock options to purchase common stock
    4,203       3,052       4,426       4,363  
Warrants to purchase common stock
    2,291       3       2,743       4,603  
Nonvested common shares
    42             14        
5. STOCK-BASED COMPENSATION EXPENSE
     The impact on our results of operations of recording stock-based compensation for stock options and stock awards for the three and nine months ended September 30, 2007 and 2006 was as follows:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2007     2006     2007     2006  
    (in thousands, except per share amounts)  
Cost of revenues
  $ 130     $ 110     $ 391     $ 357  
Product development
    51       48       113       135  
Sales and marketing
    218       109       502       377  
General and administrative
    468       448       1,856       1,015  
 
                       
Total stock-based compensation expense
    867       715       2,862       1,884  
Tax effect on stock-based compensation
        (286 )         (754 )
 
                       
Net effect on net income
  $ 867     $ 429     $ 2,862     $ 1,130  
 
                       
Effect on earnings per share:
                               
Basic
  $ 0.04     $ 0.02     $ 0.13     $ 0.06  
Diluted
  $ 0.04     $ 0.02     $ 0.13     $ 0.06  
     There was no impact on cash flows from operating activities or financing activities during the three and nine months ended September 30, 2007 as a result of the adoption of SFAS 123(R). In the Company’s pro forma disclosures prior to the adoption of SFAS 123(R) the Company accounted for forfeitures upon occurrence. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised if necessary in subsequent periods if actual forfeitures differ from those estimates. The Company estimated expected forfeitures based on various factors including employee class and historical experience. As of September 30, 2007, there was $9.4 million of unrecorded total stock-based compensation, after estimated forfeitures, related to unvested stock options. That cost is expected to be recognized over a weighted average remaining recognition period of 2.9 years. As of September 30, 2007, there was $1.4 million of unrecorded stock-based compensation related to unvested restricted stock. That cost is expected to be recognized over a weighted average remaining recognition period of 3.7 years.

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Valuation assumptions
     SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service period in the Company’s financial statements. In connection with the adoption of SFAS 123(R), the Company reassessed its valuation technique and related assumptions.
     The Company estimates the fair value of stock options using the Black-Scholes option pricing model, which incorporates various assumptions including volatility, expected life and interest rates. The expected volatility is based on the historical volatility of the Company’s common stock and consideration of other relevant factors such as the volatility assumptions of guideline companies. The expected life of options granted is estimated by taking the average of the vesting term and the contractual term of the option as provided by SAB 107.
     The assumptions used for the three and nine months ended September 30, 2007 and 2006 and the resulting estimates of weighted average fair value per share of options granted during those periods are as follows:
                                 
    Three Months Ended September 30,   Nine Months Ended September 30,
    2007   2006   2007   2006
Expected volatility
    45 %     51 %     45-51 %     51-52 %
Risk-free interest rate
    4.3 %     4.8-4.9 %     4.3-4.8 %     4.3-5.0 %
Expected life (years)
    6.1       6.0-6.1       5.5-6.1       5.5-6.1  
Expected dividend yield
    0 %     0 %     0 %     0 %
Weighted-average fair value of options granted during the period
  $ 3.32     $ 3.30     $ 3.82     $ 3.90  
Stock option and stock award activity
     A summary of the Company’s stock option activity for the period indicated is as follows:
                                 
                    Weighted    
            Weighted   Average    
            Average   Remaining    
    Number of   Exercise   Contractual   Aggregate
    Shares   Price   Life (Years)   Intrinsic Value
    (in thousands)                   (in thousands)
Outstanding at January 1, 2007
    4,235     $ 7.71       8.50     $ 5,885  
Options granted
    976       7.37                  
Options exercised
    (14 )     1.51                  
Options forfeited or expired
    (347 )     9.81                  
 
                               
Outstanding at March 31, 2007
    4,850       7.51       8.56       4,929  
 
                               
Options granted
    425       7.69                  
Options exercised
    (37 )     1.36                  
Options forfeited or expired
    (1,084 )     6.64                  
 
                               
Outstanding at June 30, 2007
    4,154       7.81       8.33       4,445  
 
                               
Options granted
    543       6.68                  
Options exercised
    (20 )     1.25                  
Options forfeited or expired
    (170 )     8.85                  
 
                               
Outstanding at September 30, 2007
    4,507       7.66       8.30       2,881  
 
                               
Options exercisable at September 30, 2007
    1,909     $ 7.38       7.05     $ 2,819  
 
                               
     Options generally vest over a four-year period with one-fourth (1/4) of the shares vesting one year after the vesting commencement date, and an additional one-forty eighth (1/48) of the shares vesting on the first day of each calendar month thereafter until all such shares are exercisable. Options expire after ten years.
     Aggregate intrinsic value represents the difference between the Company’s closing stock price on the last trading day of the fiscal period, which was $6.38 on September 28, 2007, and the exercise price for the options that were in-the-money at September 30, 2007.

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The total number of in-the-money options exercisable as of September 30, 2007 was 925,000. Total intrinsic value of options exercised was $418,000 and $1,215,000 for the nine month periods ended September 30, 2007 and September 30, 2006, respectively.
     The Company settles employee stock option exercises with newly issued common shares.
     The Company’s 2004 stock plan also allows for the issuance of restricted stock. The restricted stock awards have the voting rights of common stock and the shares underlying the restricted stock awards are considered issued and outstanding. The Company expenses the cost of restricted stock awards, which is determined to be the fair market value of the shares at the date of grant, ratably over the period during which the restriction lapse. Stock-based compensation expense related to restricted stock for the three and nine month periods ended September 30, 2007 was $122,000. A summary of the Company’s nonvested restricted stock for the period indicated is as follows:
                 
            Weighted
            Average Grant Date
    Number of   Fair Value
    Shares   Per Share
    (in thousands)    
Nonvested at June 30, 2007
             
Shares granted
    225     $ 6.68  
Shares vested
             
Shares forfeited
             
 
               
Nonvested at September 30, 2007
    225     $ 6.68  
 
               
Stock option plans
     Following the Company’s initial public offering, any shares that were reserved but not issued under the 1999 Plan were made available under the 2004 Plan, and any shares that would have otherwise returned to the 1999 Plan will be made available for issuance under the 2004 Plan. The 1999 Plan will continue to govern awards granted thereunder prior to the Company’s initial public offering. Our 2004 Equity Incentive Plan, or 2004 Plan, is an omnibus stock plan which provides for the grant of stock options, restricted stock, stock appreciation rights, performance units and performance shares to the Company’s employees, directors and consultants.
     The number of shares initially reserved for issuance under the 2004 Plan is 1,000,000 plus an increase to include the following: the number of shares that have been reserved but not issued under the 1999 Plan, any shares returned to the 1999 Plan, and an annual increase added on the first day of each fiscal year beginning in 2006 equal to the least of (a) 1,666,666 shares, (b) 4% of the outstanding shares on such date, or (c) an amount determined by the BOD. Pursuant to this requirement, on January 1, 2006 and 2007 respectively, an additional 810,932 shares and 864,905 shares respectively, were added to the plan, reserved for issuance and registered for sale under Form S-8.
Other stock options
     In September 2007, the BOD approved the issuance of 180,000 shares of common stock underlying options issued outside the Company’s stock option plans. The nonstatutory stock options (“NSO”) were granted in connection with the employment of the Company’s new Senior Vice President of Sales and Operations and the new Vice President and General Counsel. Subject to customary terms of a change in control agreement, these options vest over a four-year period with one-fourth (1/4) of the shares vesting one year after the vesting commencement date and an additional one-forty eighth (1/48) of the shares vesting on the first day of each calendar month thereafter until all such shares are exercisable. Options expire after ten years.
6. INCOME TAXES
     At the end of each interim period, the Company calculates an effective tax rate based on the Company’s best estimate of the tax provision (benefit) that will be provided for the full year, stated as a percentage of estimated annual pre-tax income (loss). The tax provision (benefit) for the interim period is determined using this estimated annual effective tax rate.
     We have recorded a full valuation allowance against our deferred tax assets at September 30, 2007, due to uncertainties related to our ability to utilize our deferred tax assets, primarily consisting of net operating loss carryforwards, before they expire. We regularly review deferred tax assets for recoverability and establish a valuation allowance based on historical taxable income, projected future taxable income, and the expected timing of the reversals of existing temporary differences. If we conclude that it is more likely than not that we will realize the benefit of all or some of our deferred tax assets, we will reduce or eliminate the valuation allowance and

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will record a significant benefit to our results of operations. In the event we were to determine that we would be able to realize all of our deferred tax assets in the future, an adjustment to the valuation allowance would increase net income in the period such determination was made.
     Based on the full valuation allowance and the taxable loss for the nine months ended September 30, 2007, the Company has not recorded a tax provision or benefit.
     In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement 109 (“FIN 48”). As a result of the implementation of FIN 48, we recognized no material adjustment in the liability for unrecognized income tax benefits. We do not have any material accrued interest or penalties associated with any unrecognized tax benefits. We will account for any interest related to uncertain tax positions as interest expense, and for penalties as tax expense. Other than as discussed below, we do not believe it is reasonably possible that our unrecognized tax benefits will significantly change within the next twelve months. There were no material changes in the amount of unrecognized tax benefits as of September 30, 2007. We are subject to taxation in the US and various state jurisdictions. The tax years 2002-2006 remain open to examination by the federal and most state tax authorities.
7. COMPREHENSIVE INCOME (LOSS)
     Comprehensive income (loss) includes net income (loss) and unrealized gains (losses) on investments. Comprehensive income (loss) for the periods indicated is comprised of the following:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2007     2006     2007     2006  
    (in thousands)  
Net income (loss)
  $ (4,831 )   $ 622     $ (8,968 )   $ (386 )
Other comprehensive income (loss):
                               
Change in accumulated unrealized gain (loss) on available-for-sale securities, net of tax
    213       346       231       322  
 
                       
Comprehensive income (loss)
  $ (4,618 )   $ 968     $ (8,737 )   $ (64 )
 
                       
8. COMMITMENTS AND CONTINGENCIES
     The Company leases office space under non-cancelable operating leases with various expiration dates through May 2013.
     Future minimum lease payments under non-cancelable operating leases at September 30, 2007 are as follows, in thousands:
         
    Operating  
Year ending December 31,   Leases  
2007
  $ 597  
2008
    2,172  
2009
    1,756  
2010
    1,655  
2011
    1,656  
Thereafter
    615  
 
     
Total minimum lease payments
  $ 8,451  
 
     
Legal proceedings
     On May 4, 2007, the Company was named in a class action lawsuit filed in United States District Court for the Central District of California, Lubocki, et al v. ZipRealty, case number CV 07 2959, by four former employee agents of the Company on behalf of themselves and others similarly situated. The complaint alleged, among other things, that the Company’s policies for expense allowances and expense reimbursement in place prior to October 2005, and its policy for commission payments to agents for transactions that do not close during the period of employment, violate applicable law. The Company has reached a proposed settlement which calls for a payment of $3,550,000 and, as a result, has recorded a charge in that amount during the quarter ended September 30, 2007. The proposed settlement is expected to include a full release from any further liability on the matters raised in the complaint, and is subject to the execution of a definitive settlement agreement and court approval.

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     On May 18, 2007, the Company was named in a class action lawsuit filed in the Superior Court of California, County of Alameda, Crystal Alexander, et al. v. ZipRealty, case number RG 07326622, by one former employee agent of the Company. The complaint alleges, among other things, that the Company’s practices for compensating agents and reimbursing expenses violate applicable law regarding the payment for overtime. The Company is in the initial stages of investigation and discovery in this matter. However, at this time, management believes that its business practices at issue in this case are in compliance with applicable law, and therefore intends to vigorously defend this lawsuit.
     The Company has filed a claim for malpractice against the law firm which provided counseling in connection with certain employment matters in California Superior Court, County of San Francisco, ZipRealty Inc., v. Squire, Sanders & Dempsey, LLP, Michael W. Kelly Esq., et. al., Case No. CGC 06450765. While the Company believes it has a good case, it is too early to determine the likelihood of a recovery, or to estimate the amount of recovery, if any.
     The Company is not currently subject to any other material legal proceedings. From time to time the Company has been, and it currently is, a party to litigation and subject to claims incident to the ordinary course of the business. The amounts in dispute in these matters are not material to the Company, and management believes that the resolution of these proceedings will not have a material adverse effect on the business, financial position, results of operations or cash flows.
Indemnifications
     The Company has entered into various indemnification agreements in the ordinary course of our business. Pursuant to these agreements, the Company has agreed to indemnify, hold harmless and reimburse the indemnified parties, which include certain of the Company’s service providers as well as others, in connection with certain occurrences. In addition, the Company’s charter documents require the Company to provide indemnification rights to our directors and officers to the fullest extent permitted by the Delaware General Corporation Law, and permit the Company to provide indemnification rights to the Company’s other employees and agents, for certain events that occur while these persons are serving in these capacities. The Company has also entered into indemnification agreements with each of the Company’s directors and its officers with a title of Vice President or higher. Further, the underwriting agreement for the Company’s initial public offering requires the Company to indemnify the Company’s underwriters and certain of their affiliates and agents for certain liabilities arising from the Company’s offering and the related registration statement.
     The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unspecified. The Company is not aware of any material indemnification liabilities for actions, events or occurrences that have occurred to date. The Company maintains insurance on some of the liabilities the Company has agreed to indemnify, including liabilities incurred by the Company’s directors and officers while acting in these capacities, subject to certain exclusions and limitations of coverage.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations:
     The following discussion should be read together with our financial statements and related notes appearing elsewhere in this report. This discussion contains forward-looking statements based upon current expectations that involve numerous risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including but not limited to those set forth in “Risk Factors” in Item 1A of Part II of this report and elsewhere in this report. Except as otherwise required by law, we do not intend to update any information contained in these forward-looking statements.
OVERVIEW
General
     We are a full-service residential real estate brokerage firm, using the Internet, proprietary technology and efficient business processes to provide home buyers and sellers with high-quality service and value. Our solution includes a client-centric business approach, a sophisticated website that empowers home buyers and sellers with relevant information, a proprietary business management technology platform and significant financial savings for consumers. We share a portion of our commissions with our buyer clients in the form of a cash rebate, and typically represent our seller clients at fee levels below those offered by most traditional brokerage companies in our markets. Generally, our seller clients pay a total brokerage fee of 4.5% to 5.0% of the transaction value, of which 2.5% to 3.0% is paid to agents representing buyers.

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     Our net revenues are comprised primarily of commissions earned as agents for buyers and sellers in residential real estate transactions. We record revenues net of rebate or commission discount, if any, paid or offered to our clients. Our net revenues are principally driven by the number of transactions we close and the average net revenue per transaction. Average net revenue per transaction is a function of the home sales price and percentage commission we receive on each transaction. We also receive revenues from certain co-marketing arrangements, such as our relationship with E-LOAN, Inc., which provides the mortgage center on our website and pays us a flat monthly fee that is established on a periodic basis. Generally, non-commission revenues represent less than 5% of our net revenues during any period. We are currently exploring our options for offering other services related to the purchase, sale and ownership of a home and have begun offering property and casualty insurance (including auto insurance) services through a subsidiary.
     We were founded in 1999, currently have operations in 32 markets, and as of September 30, 2007 employed 2,539 people, of whom 2,263 were ZipAgents. During 2006, we commenced operations in Tampa in February, Orlando in April, Minneapolis/St. Paul in May, Austin in July, Palm Beach in September, and the Greater Philadelphia area in December. To date in 2007 we have commenced operations in Naples and Tucson in March, Denver in April, Jacksonville in May, Salt Lake City and Richmond in July, Virginia Beach and Charlotte in August and Raleigh-Durham in September. We have announced plans to enter Long Island and Westchester County in the fourth quarter of 2007.
Trends in our business
     Although our business has experienced significant growth since our inception in 1999, primarily as a result of increased transaction volume and increased average net revenue per transaction, recently growth rates in transaction volume have decreased based on what we believe to be a transition period in the housing market and the effects of the recent changes in the mortgage lending business. In the three months ended September 30, 2007, we generated $28.0 million in net revenues, compared to $26.2 million in the three months ended September 30, 2006. In the nine months ended September 30, 2007 we generated $82.7 million in net revenues, compared to $72.3 million in the nine months ended September 30, 2006. The number of our closed transactions increased to approximately 3,829 in the three months ended September 30, 2007 from approximately 3,467 in the three months ended September 30, 2006, while our average net revenue per transaction decreased to approximately $7,110 in the three months ended September 30, 2007 from approximately $7,332 in the three months ended September 30, 2006. The number of our closed transactions increased to approximately 10,927 in the nine months ended September 30, 2007 from approximately 9,657 in the nine months ended September 30, 2006, and our average net revenue per transaction increased to approximately $7,359 in the nine months ended September 30, 2007 from approximately $7,276 in the nine months ended September 30, 2006.
     Our transaction volume is primarily driven by the number of ZipAgents we employ, which increased to 2,263 at September 30, 2007 from 1,747 at September 30, 2006. Our average net revenue per transaction increased over this period of time in both existing and new markets, as well as in California markets and in markets outside of California. As we introduce new initiatives to improve agent productivity, we may experience a temporary decline in the total number of agents. However we expect to end 2008 with more agents than we will end with in 2007. As we add additional ZipAgents, we believe long term we will continue to increase our transaction volume and grow our business, although this may not be the case if the market continues to soften. In addition, we believe that customer acquisition is one of our core competencies, and while we anticipate that the difficulty of acquiring a sufficient number of leads online may increase over time, we expect that we can mitigate some of that impact with repeat and referral business, as well as by increasing our visibility and credibility to potential clients over time. Since our market share has averaged less than 1% over the past twelve months in our existing markets in aggregate, we believe that there is an opportunity to increase our market share, even if the overall level of sales decline due to changing consumer sentiment, interest rate increases, credit tightening, or other economic or geopolitical factors.
     As we end 2007 and develop our business plan for 2008 a key area of focus will be be on existing markets, and driving their efficiency, productivity and profits. Nevertheless, our losses are likely to continue into 2008, albeit we expect they will be reduced from that we expect to incur in 2007.

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     Since early September of 2005 we have experienced a significant increase in the available inventory of homes for sale in many of our markets, as well as an increase in the amount of time listings are taking to sell. For example, average inventories in our existing markets increased approximately 23%, and months of inventory increased approximately 64%, in the quarter ended September 30, 2007 from the quarter ended September 30, 2006. Pricing increases have also slowed, and some markets have shown declines in median selling prices over this period. According to NAR, nationally sales of existing homes fell 19.1% year-over-year in September 2007 to a seasonally adjusted annual rate of 5.04 million. In the State of California, the California Association of REALTORS reported that sales of existing homes declined 38.9% year-over-year during the month of September 2007. In our opinion, these data points suggest the housing market is in a period of transition, with more power shifting to buyers from sellers, and that the residential real estate market may continue to soften in the foreseeable future. While over the long-term we believe a more balanced market will be beneficial to our model, which relies primarily on representing buyers, during this period of transition we may continue to experience reduced growth rates and agent productivity versus our historical levels as buyers react cautiously to perceived changing market conditions.
     Over time, we have made significant adjustments to our cost structure and revenue model in order to improve the financial results of our business. We have modified the compensation and expense reimbursement structure for ZipAgents over time, and we most recently changed our commission and/or expense structure in April 2007. Currently, our ZipAgents earn a compensation package consisting of a percentage of the commissions they generate for us that ranges from 35% to 80% of our net revenues after deducting certain other items. We also provide our ZipAgents with health, retirement and other benefits, and pay for certain marketing costs and other business expenses. ZipAgents may also be granted equity incentives based on performance. We may choose or be required to make further modifications to our compensation structure in the future.
     For example, Nevada recently approved legislation that preempts the federal “outside sales exemption” from paying minimum wages in that state. That legislation took effect on November 1, 2007. Accordingly, on November 1, 2007 we begin paying ZipAgents minimum wage and, where required, overtime, to our ZipAgents in Nevada. The minimum wage payments will be offset against future commissions earned, if any.
     We have lowered our buyer rebate percentage several times to improve our revenue model. In March 2004, we reduced our buyer rebate to 20% of our commission from 25% of our commission, up to a maximum of 1% of the home sales price. The effect of the buyer rebate reduction was recognized over a phase-in period of approximately two to four months as the reduction only affected new clients immediately while existing clients continued under the prior rebate policy for transactions already in progress and for transactions opened within a short period after the reduction was announced. We implemented these buyer rebate percentage reductions for several reasons, including our determination that our growing reputation for superior service allowed us not to compete solely on price, our efforts to improve our revenue model and agent compensation model, and our desire to offer a simplified rebate structure to our clients.
     In connection with entry into the Greater Philadelphia area, we entered the New Jersey market, where the payment of cash rebates is currently not permitted by law. Consequently, in New Jersey, in lieu of offering a cash rebate to our buyers, we make a donation to a local charity through United Way equal to 20% of our commission in cash upon closing.
     We achieved profitability in the first quarter of 2005, the first time in our seasonally slow first quarter, primarily as a result of higher average net transaction revenues and increased transactional volume. We experienced a net loss in the second quarter of 2005 as a result of a one-time charge relating to the settlement of a class action lawsuit; we would have been profitable excluding the effect of this settlement. We achieved profitability in the third and fourth quarters of 2005, but because of seasonality and new market expansion as well as softening in the residential real estate market, we experienced a net loss in the first and second quarters of 2006. We achieved profitability in the third quarter of 2006, but experienced a net loss in the fourth quarter of 2006 as a result of decreased transaction volume due to our seasonally slow fourth quarter and continued market softness. We reported a loss in the first quarter of 2007 primarily due to seasonality, new market expansion and ongoing market softness. We reported losses in the second and third quarters of 2007 due to new market expansion and further market softness. The third quarter loss was also impacted by tightening in the availability of home mortgage credit and the proposed litigation settlement described in Part II, Item 1 Legal Proceedings.
     Over the past several years there has been a decline in average commissions charged in the real estate brokerage industry, in part due to companies such as ours exerting downward pressure on prices with a lower commission structure, as well as by what, in our view, appears to be an increase in consumer willingness to negotiate fees with their agents. We believe that many consumers are focusing on absolute commission dollars paid to sell their home as opposed to accepting a traditional standard market commission percentage. According to REAL Trends, while the average commission percentage decreased from 5.44% in 2000 to 5.18% in 2006, total commission revenues increased from $42.6 billion to $59.7 billion during that same period, influenced by steadily increasing

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sales volumes and higher median sales prices. In the event that commissions continue to decline, we have designed our business model around an attractive cost structure and operational efficiencies which we believe should allow us to continue to offer our services at prices less than those charged by the majority of our competitors.
     In addition, the competitive landscape in the residential real estate industry is in the midst of significant changes as new business models enter the marketplace. For example, Redfin Corporation has introduced a discount brokerage model (currently in five states and the District of Columbia) that allows clients to make offers to purchase homes and to list homes for sale directly online, while receiving a two-thirds rebate of their commission. BuySide Realty, another discount brokerage, employs agents who are paid salaries and bonuses based on customer service, not commissions, while offering a 75% rebate of their commission. RealEstate.com, which is owned by LendingTree, LLC, acts as a lead generator for real estate brokers and agents, and has opened a direct to consumer brokerage service. Trulia, Inc. operates a residential real estate search engine to connect consumers directly to listings on agent and broker web sites. These companies have limited operating histories upon which to evaluate their operations and future prospects. However, in order to be successful, our business model must remain attractive to consumers so that we can compete successfully with these newer models as they expand into our marketplaces. In addition, to remain economically viable, we will need to be able to compete effectively with these new entrants for the acquisition of agents and leads.
Market seasonality, cyclicality and financing influences
     The residential real estate brokerage market is influenced both by annual seasonality factors, as well as by overall economic cycles. While individual markets vary, transaction volume nationally tends to progressively increase from January through the summer months, then gradually slows over the last three to four months of the calendar year. Revenues in each quarter are significantly affected by activity during the prior quarter, given the typical 30- to 45-day time lag between contract execution and closing. While we believe that, until fairly recently, seasonality has been somewhat masked by our overall growth, we have been, and believe we will continue to be, influenced by overall market activity and seasonal forces. We generally experience the most significant impact in the first and fourth quarters of each year, when our revenues are typically lower relative to the second and third quarters as a result of traditionally slower home sales activity and reduced listings inventory between Thanksgiving and Presidents’ Day.
     We believe that the overall market activity, macroeconomic environment, and periodic business cycles can significantly influence the general health of the residential real estate market at any given point in time. Generally, when economic times are fair or good, the housing market tends to perform well. If the economy is weak, interest rates dramatically increase, or there are market events such as terrorist attacks or threats, the outbreak of war or geopolitical uncertainties, the housing market could be negatively impacted. Recently, changes in the mortgage market, including the subprime market, have negatively effected the buying and selling of real estate, as financing and credit standards have tightened. These factors have tended to depress the real estate activity. Also, there have been numerous reports about the effects of subprime mortgages on the general real estate market. These reports also tend to have a dampening effect on the general real estate market.
     Over the past several decades, the national residential real estate market has demonstrated significant growth, with annual existing home sales volume growing from 1.6 million in 1970 to approximately 7.1 million in 2005 and median existing home sales prices increasing every year during that period. While the volume of existing home sales has declined for at least two consecutive years only twice since 1970, namely 1979 through 1982 and 1989 through 1990, sales did fall from their 2005 peak to approximately 6.5 million in 2006 and are forecasted to fall again in 2007, and there are forecasts that predict sales will continue their decline in 2008. Sales volume changes are sensitive to, but do not always follow interest rate changes. The declines in sales volumes in the 1979 through 1982 period occurred while interest rates were at historic highs, with long-term U.S. Treasury rates exceeding 10%. However, with rates remaining at similarly high levels, sales increased during the period from 1983 through 1986. Average interest rates were lower during the second period of consecutive year declines, 1989 through 1990, than they had been in the expansion period ending in 1988.
     Many factors influence an individual’s decision to buy or sell a home, and we believe that no one factor alone determines the health of the residential real estate market. For example, a rise in interest rates, tighter lending standards and/or disruptions in the availability of mortgage funds could lead to lower demand for housing or put downward pressure on prices because, all else being equal, it should increase monthly housing payments or reduce the amount an individual can pay for a home. However, it is also our experience that lifestyle influences, such as job relocation, changes in family dynamics or a desire to change neighborhoods, significantly impact the demand for residential real estate. In addition, periods of interest rate increases are often characterized by improving economic fundamentals, which can create jobs, increase incomes and bolster consumer confidence, all of which are factors that positively influence housing demand. It is difficult to predict which influences will be strongest, and ultimately whether the housing market will be affected positively or negatively when faced with numerous influences.

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     While it is difficult to isolate the cause of recent transaction volume declines and pricing growth slowing in the residential real estate market, such softening has been occurring since the Fall of 2005 as interest rates and inventories have been increasing and credit standards, and financing have tightened. Other factors have likely contributed to the slowdown as well, such as high fuel prices, persistent press coverage about residential real estate potentially being poised for a correction, and the fact that prices had until that time been increasing at historically high rates. This rapid price appreciation, which was well ahead of household income growth, along with increasing interest rates has made housing less affordable, which has manifested itself in declining home ownership rates, which peaked in 2004. With overall transaction activity declining and sales price increases slowing, overall commissions generated in the industry could decline as well, potentially causing the roughly $59.7 billion in annual commissions generated in 2006 to decline. However, should the addressable market for our services decline somewhat in the near term due to decreasing sales volume or prices, we believe the overall size of the market on an absolute basis will remain very large, providing ample addressable opportunity for us to continue to grow our business through increasing our market share.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
     Our financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Accordingly, our actual results may differ from these estimates under different assumptions or conditions.
     Our significant accounting policies are described in Note 1 of the notes to our consolidated financial statements contained in our Form 10-K for the year ended December 31, 2006, and of those policies, we believe that the following accounting policies involve the greatest degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to understand and evaluate our financial condition and results of operations.
Income statement reclassification
     Effective January 1, 2007, for income statement presentation purposes, we have reclassified sales support and marketing expenses from general and administrative to sales and marketing (previously stated as marketing and customer acquisitions). In management’s opinion, the reclassification to sales and marketing more appropriately reflects the nature of these activities which include sales support and marketing activities of our district offices, regional services and ZipAgent and customer support services. In conjunction with this reclassification, we have also allocated headquarter occupancy costs to corporate departments based upon square footage to product development, sales and marketing and general and administrative; previously all headquarter occupancy costs were recorded under general and administrative expenses. Comparative periods have been conformed to this presentation.
Revenue recognition
     We derive the substantial majority of our revenues from commissions earned as agents for buyers and sellers in residential real estate transactions. We recognize commission revenues upon closing of a sale and purchase transaction, net of any rebate or commission discount, or transaction fee adjustment, as evidenced by the closure of the escrow or similar account and the transfer of funds to all appropriate parties. We recognize non-commission revenues from our other business relationships, such as our E-LOAN marketing relationship, as the fees are earned from the other party typically on a monthly fee basis. Revenues are recognized when there is persuasive evidence of an arrangement, the price is fixed or determinable, collectibility is reasonably assured and the transaction has been completed.
Internal-use software and website development costs
     We account for internal-use software and website development costs, including the development of our ZipAgent Platform, in accordance with the guidance set forth in Statement of Position 98-1, Accounting for the Cost of Computer Software Developed or Obtained for Internal Use and Emerging Task Force Issue No. 00-02, Accounting for Website Development Costs. We capitalize the payroll and direct payroll-related costs of employees who devote time to the development of internal-use software. We amortize these costs over their estimated useful lives, which is generally 15 to 24 months. Our judgment is required in determining the point at which various projects enter the stages at which costs may be capitalized, in assessing the ongoing value of the capitalized costs, and in determining the estimated useful lives over which the costs are amortized. The estimated life is based on management’s judgment as to the product life cycle.

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Income taxes
     Deferred tax assets and liabilities arise from the differences between the tax basis of an asset or liability and its reported amount in the financial statements as well as from net operating loss and tax credit carry forwards. Deferred tax amounts are determined by using the tax rates expected to be in effect when the taxes will actually be paid or refunds received, as provided under current tax law. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense or benefit is the tax payable or refundable, respectively, for the period plus or minus the change during the period in deferred tax assets and liabilities.
     Historically, we have recorded a valuation allowance on our deferred tax assets, the majority of which relate to net operating loss tax carryforwards generated before we achieved profitability. During the fourth quarter of 2006, the Company concluded that a full valuation allowance should be reinstated, a significant portion of which had originally been released in 2005, against its net deferred tax assets at December 31, 2006 as available evidence, including recent historical results and management’s expectations for the future, supported a more likely than not conclusion that the related deferred tax assets will not be realized.
Stock-based compensation
     SFAS 123 (Revised 2004), Share-Based Payment (“SFAS 123(R)”) requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors, including employee stock options and employee stock purchases, based on estimated fair values. Under the fair value recognition provisions for SFAS 123(R), stock-based compensation cost is estimated at the grant date based on the fair value of the awards expected to vest and recognized as expense using the straight-line method over the requisite service period of the award.
     The Company estimates the fair value of stock options using the Black-Scholes option pricing model, which incorporates various assumptions including volatility, expected life and interest rates. The expected volatility is based on the historical volatility of the Company’s common stock and consideration of other relevant factors such as the volatility assumptions of peer companies. The expected life of options is estimated by taking the average of the vesting term and the contractual term of the option as provided by SAB 107. The Company estimates expected forfeitures based on various factors including employee class and historical experience.
     The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123(R) and Emerging Task Force Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services (“EITF 96-18”).
     The accounting for and disclosure of employee and non-employee equity instruments, primarily stock options and preferred and common stock warrants, requires judgment by management on a number of assumptions, including the fair value of the underlying instrument, estimated lives of the outstanding instruments, and the instrument’s volatility. Changes in key assumptions will impact the valuation of such instruments.
Recently issued accounting pronouncement
     In February 2007, the FASB issued SFAS No. 159, Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”) which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS 159 will be effective for the Company on January 1, 2008. The Company is currently evaluating the impact of adopting SFAS 159 on its financial position, cash flows and results of operations.

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RESULTS OF OPERATIONS
     The following table summarizes our operating results for the three and nine months ended September 30, 2007 compared to the same period in the prior year:
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
Statements of operations data (unaudited)    2007     2006     2007     2006  
    (in thousands, except per share amounts)  
Net transaction revenues
  $ 27,225     $ 25,420     $ 80,406     $ 70,263  
Referral and other revenues
     804        765       2,286       2,048  
 
                       
Net revenues
    28,029       26,185       82,692       72,311  
 
                       
Operating expenses:
                               
Cost of revenues
    15,637       14,238       46,024       39,568  
Product development
    1,835       1,376       5,329       4,128  
Sales and marketing
    9,630       7,719       28,306       22,398  
General and administrative
    3,357       3,227       11,782       9,556  
Litigation
    3,550             3,550        
 
                       
Total operating expenses
    34,009       26,560       94,991       75,650  
 
                       
Income (loss) from operations
    (5,980 )     (375 )     (12,299 )     (3,339 )
 
                       
Other income (expense):
                               
Interest income
    1,147       1,086       3,329       2,782  
Other expense, net
    2       (8 )     2       (8 )
 
                       
Total other income, net
    1,149       1,078       3,331       2,774  
 
                       
Income (loss) before income taxes
    (4,831 )      703       (8,968 )     (565 )
Provision for (benefit from) income taxes
          81             (179 )
 
                       
Net income (loss)
  $ (4,831 )   $ 622     $ (8,968 )   $ (386 )
 
                       
Net income (loss) per share:
                               
Basic
  $ (0.21 )   $ 0.03     $ (0.40 )   $ (0.02 )
Diluted
  $ (0.21 )   $ 0.03     $ (0.40 )   $ (0.02 )
Weighted average common shares outstanding:
                               
Basic
    22,629       20,410       22,421       20,356  
Diluted
    22,629       23,478       22,421       20,356  
     The following table presents our operating results as a percentage of net revenues for the periods indicated:
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
Statements of operations data (unaudited)   2007     2006     2007     2006  
Net transaction revenues
    97.1 %     97.1 %     97.2 %     97.2 %
Referral and other revenues
    2.9       2.9       2.8       2.8  
 
                       
Net revenues
    100.0       100.0       100.0       100.0  
 
                       
Operating expenses:
                               
Cost of revenues
    55.8       54.4       55.7       54.7  
Product development
    6.5       5.3       6.4       5.7  
Sales and marketing
    34.4       29.5       34.2       31.0  
General and administrative
    12.0       12.3       14.2       13.2  
Litigation
    12.7             4.3        
 
                       
Total operating expenses
    121.4       101.5       114.8       104.6  
 
                       
Income (loss) from operations
    (21.4 )     (1.5 )     (14.8 )     (4.6 )
 
                       
Other income (expense):
                               
Interest income
    4.1       4.1       4.0       3.8  
Other expense, net
                       
 
                       
Total other income, net
    4.1       4.1       4.0       3.8  
 
                       
Income (loss) before income taxes
    (17.3 )     2.6       (10.8 )     (0.8 )
Provision for (benefit from) income taxes
          0.3             (0.2 )
 
                       
Net income (loss)
    (17.3 )%     2.3 %     (10.8 )%     (0.6 )%
 
                       

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Comparison of the three months ended September 30, 2007 and 2006
Net transaction revenues
     Net transaction revenues and statistical data are presented below for comparable existing and new markets (1):
                                 
    Three Months Ended              
    September 30,     Increase     Percent  
    2007     2006     (Decrease)     Change  
    (in thousands, except statistical data)  
Net transaction revenues
                               
Comparable existing markets
  $ 23,659     $ 24,594     $ (935 )     (3.8 )%
New markets
    3,566        826       2,740       331.9 %
 
                         
Total
  $ 27,225     $ 25,420     $ 1,805       7.1 %
 
                         
 
                               
Statistical data
                               
Number of markets
                               
Comparable existing markets
    17       17                
New markets
    15       5       10          
 
                         
Total
    32       22       10          
 
                         
 
                               
Number of transactions closed during the period (2)
                               
Comparable existing markets
    3,167       3,304       (137 )     (4.1 )%
New markets
     662        163        499       306.1 %
 
                         
Total
    3,829       3,467        362       10.4 %
 
                         
 
                               
Average net revenue per transaction (3)
                               
Comparable existing markets
  $ 7,471     $ 7,444     $ 27       0.4 %
New markets
    5,387       5,066        321       6.3 %
All markets
  $ 7,110     $ 7,332     $ (221 )     (3.0 )%
 
(1)   Comparable existing markets consist of Atlanta GA, Baltimore MD, Boston MA, Chicago IL, Dallas TX, Fresno/Central Valley CA, Los Angeles CA, Houston TX, Las Vegas NV, Miami FL, Orange County CA, Phoenix AZ, Sacramento CA, San Diego CA, San Francisco Bay Area CA, Seattle WA and Washington DC. New markets are transferred to existing markets on January 1st following the completion of their first full calendar year. The Las Vegas, Houston and Miami markets opened during 2005 and, therefore, completed their first full calendar year at of the end of 2006. Accordingly, these markets were moved to existing markets as of January 1, 2007 and are included in comparable existing markets for all periods presented. New markets and the month opened consist of:
     
Tampa, FL
  February 2006
Orlando, FL
  April 2006
Minneapolis, MN
  May 2006
Austin, TX
  July 2006
Palm Beach, FL
  September 2006
Greater Philadelphia Area, PA
  December 2006
Naples, FL
  March 2007
Tucson, AZ
  March 2007
Denver, CO
  April 2007
Jacksonville, FL
  May 2007
Salt Lake City, UT
  July 2007
Richmond, VA
  July 2007
Virginia Beach, VA
  August 2007
Charlotte, NC
  August 2007
Raleigh-Durham, NC
  September 2007
 
(2)   The term “transaction” refers to each representation of a buyer or seller in a real estate purchase or sale.
 
(3)   Average net revenue per transaction equals net transaction revenues divided by number of transactions with respect to each period.

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     The increase in our net transaction revenues of $1.8 million for the three months ended September 30, 2007 compared to the three months ended September 30, 2006 was primarily due to a decrease in net transaction revenues of $0.9 million in our existing markets offset by an increase in net transaction revenues of $2.7 million from our new markets.
     The decrease in our existing markets was driven primarily by the decrease of 4.1% in the number of transactions closed during the period. We had 1,752 ZipAgents in existing markets at September 30, 2007 compared to 1,590 at September 30, 2006.
     The increase from our new markets was driven primarily by a 6.3% increase in average net revenue per transaction combined with a 306.1% increase in the number of transactions closed during the period as we opened ten new markets since September 30, 2006 and added new ZipAgents. We had 511 ZipAgents in new markets at September 30, 2007 compared to 157 at September 30, 2006.
Referral and other revenues
     Referral and other revenues consist primarily of certain co-marketing agreements and transaction referrals.
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
Referral and other revenues
  $ 804     $ 765     $ 39       5.0 %
     The absolute dollar increase in referral and other revenues was not significant.
     We expect that our referral and other revenues for 2007 will be flat and remain relatively consistent as a percentage of net revenues.
Cost of revenues
     Our cost of revenues for existing and new markets consists principally of commissions, related payroll taxes, benefits and expense allowances and reimbursements paid to our ZipAgents, and the amortization of internal-use software and website development costs which relate primarily to our ZAP technology.
                                 
    Three Months Ended              
    September 30,     Increase     Percent  
    2007     2006     (Decrease)     Change  
    (in thousands)  
Cost of revenues
                               
Comparable existing markets
  $ 13,712     $ 13,818     $ (106 )     (0.8 )%
New markets
    1,925        420       1,505       357.8 %
 
                         
Total
  $ 15,637     $ 14,238     $ 1,399       9.8 %
 
                         
     The increase in cost of revenues for the three months ended September 30, 2007 compared to the three months ended September 30, 2006 was primarily related to the overall increase in transaction revenue on which we pay agent commissions.
     Cost of revenues decreased in our existing markets by approximately $0.1 million related to the decrease in transaction revenue in our existing markets during the period. The cost of revenues as a percentage of existing market net transaction revenues increased by 1.8% primarily due to the mix of agent commissions paid as well as increased agent expense reimbursements. Additionally we made certain adjustments to our agent compensation plan to better motivate and retain our agents under the current market conditions.
     Cost of revenues increased in our new markets by approximately $1.5 million related to the increase in the transaction revenue closed in our new markets during the period. The cost of revenues as a percentage of new market net transaction revenues increased by 3.1% primarily due to the mix of agent commissions paid. This increase in the cost of revenues percentage in new markets is expected as increasing numbers of ZipAgents achieve higher commission splits as the new markets mature.
     We expect that our cost of revenues for 2007 will increase in absolute dollars because of the overall increase in transaction revenue, primarily from our new markets, and that they will increase modestly as a percentage of net revenues.

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Product development
     Product development expenses, net of capitalized costs of internally developed software, include our information technology costs, primarily compensation and benefits, depreciation of equipment and software, communications expenses and other operating costs relating to the maintenance of our website, proprietary technology systems and general information technology services.
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
Product development
  $ 1,835     $ 1,376     $ 459       33.4 %
     The increase in product development expenses for the three months ended September 30, 2007 compared to the three months ended September 30, 2006 was primarily due to ongoing website development and to support new market expansion and consisted primarily of increases in salaries and benefits of $0.2 million and general technology expenses (including depreciation) of $0.2 million. As a percentage of net revenues, product development costs were 6.5% in the period compared to 5.3% in the three months ending September 30, 2006.
     We expect our product development expenses to increase in 2007 in absolute dollars and as a percentage of net revenues as we continue to grow our business and enhance our proprietary consumer website and agent platform.
Sales and marketing
     Sales and marketing expenses consist primarily of compensation and related costs for personnel engaged in sales and sales support functions and customer service as well as promotional, advertising and client acquisition costs. These expenses have been categorized below between those incurred in the comparable existing and new markets offices and those expenses which are incurred by the regional and corporate support functions across all markets.
                                 
    Three Months Ended              
    September 30,     Increase     Percent  
    2007     2006     (Decrease)     Change  
    (in thousands)  
Sales and marketing
                               
Comparable existing markets
  $ 5,536     $ 5,311     $ 225       4.2 %
New markets
    2,466        898       1,568       174.7 %
Regional sales support and marketing
    1,628       1,510        118       7.8 %
 
                         
Total
  $ 9,630     $ 7,719     $ 1,911       24.8 %
 
                         
     The increase in sales and marketing expenses for the three months ended September 30, 2007 compared to the three months ended September 30, 2006 was primarily related to the overall growth in our business as a result of the expansion into new markets.
     Sales and marketing expenses increased in our existing markets by approximately $0.2 million principally attributable to increased spending on customer acquisition leads. As a percentage of existing market net transactions revenues, existing market sales and marketing expenses were 23.4% in the current period compared to 21.6% in the prior year.
     Sales and marketing expenses increased in our new markets by approximately $1.6 million principally attributable to opening ten new market offices since September 30, 2006. The increased expenses consisted primarily of salaries and benefits of $0.4 million, customer acquisition costs of $0.5 million, occupancy and related expenses of $0.3 million and recruiting/training expenses of $0.2 million. As a percentage of new market net transactions revenues, new market sales and marketing expenses were 69.1% in the current period compared to 108.7% in the prior year.
     Regional sales support and marketing expenses increased by approximately $0.1 million principally attributable to the costs of our new market expansion personnel. As a percentage of total net transactions revenues, regional sales support and marketing expenses were 6.0% in the current period compared to 5.9% in the prior year.
     We expect that our overall sales and marketing expenses for 2007 will increase in absolute dollars and as a percentage of net revenues primarily because of our new market expansion
General and administrative
     General and administrative expenses consist primarily of compensation and related costs for personnel and facilities related to our executive, finance, human resources, facilities and legal organizations, and fees for professional services. Professional services are principally comprised of outside legal, audit and outsourcing services.
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
General and administrative
  $ 3,357     $ 3,227     $ 130       4.0 %

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     The increase in general and administrative expenses for the three months ended September 30, 2007 compared to the three months ended September 30, 2006 was principally due to increased professional fees of $0.2 million. As a percentage of net revenues, general and administrative expenses were 12.0% in the period compared to 12.3% in the three months ended September 30, 2006.
     We expect our general and administrative expenses for 2007 to increase in absolute dollars and to increase modestly as a percentage of net revenues.
Litigation
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
Litigation
    $ 3,550     $     $ 3,550     100.0 %
     Litigation relates to a class action lawsuit filed by four former ZipAgents. The plaintiffs allege, among other things, that our expense allowance policies violate applicable law. There is a proposed settlement involving a payment of approximately $3.6 million, and a full release from any further liability on the matters raised in the lawsuit. See the description under Legal Proceedings in Part I.
Interest income
     Interest income relates to interest we earn on our money market deposits and short-term investments.
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
Interest income
  $ 1,147     $ 1,086     $ 61       5.7 %
     Interest income will fluctuate as our cash equivalents and short-term investment balances change and applicable interest rates increase or decrease. The increase in interest income for the three months ended September 30, 2007 compared to the three months ended September 30, 2006 was due primarily to higher interest rates and modestly higher average balances for our cash equivalents and short-term investments.
Other income (expense), net
     Other income (expense), net consists of non-operating items, which have not been significant to date.
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
Other income (expense), net
  $ 2     $ (8 )   $ 10       120.4 %
Provision for (benefit from) income taxes
     The provision for income taxes relates to our net book profit based on our best estimate of the tax provision (benefit) that will be provided for the full year.
                                 
    Three Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
Provision for income taxes
    $     $ 81   $ (81 )     100.0 %
     We continue to record a full valuation allowance against our deferred tax assets at September 30, 2007, due to uncertainties related to our ability to utilize our deferred tax assets, primarily consisting of net operating loss carryforwards, before they expire.

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Based on the full valuation allowance and the taxable loss for the three months ended September 30, 2007, the Company has not recorded a tax provision or benefit.
Comparison of the nine months ended September 30, 2007 and 2006
Net revenues
     Net transaction revenues and statistical data are presented below for comparable existing and new markets (1):
                                 
    Nine Months Ended              
    September 30,     Increase     Percent  
    2007     2006     (Decrease)     Change  
    (in thousands, except statistical data)  
Net transaction revenues
                               
Comparable existing markets
  $ 72,269     $ 69,228     $ 3,041       4.4 %
New markets
    8,137       1,035       7,102       686.7 %
 
                         
Total
  $ 80,406     $ 70,263     $ 10,143       14.4 %
 
                         
 
                               
Statistical data
                               
Number of markets
                               
Comparable existing markets
    17       17                
New markets
    15       5       10          
 
                         
Total
    32       22       10          
 
                         
 
                               
Number of transactions closed during the period (2)
                               
Comparable existing markets
    9,441       9,456       (15 )     (0.2 )%
New markets
    1,486        201       1,285       639.3 %
 
                         
Total
    10,927       9,657       1,270       13.2 %
 
                         
 
                               
Average net revenue per transaction (3)
                               
Comparable existing markets
  $ 7,655     $ 7,321     $ 334       4.6 %
New markets
    5,476       5,146        330       6.4 %
All markets
  $ 7,359     $ 7,276     $ 83       1.1 %
 
(1)   Comparable existing markets consist of Atlanta GA, Baltimore MD, Boston MA, Chicago IL, Dallas TX, Fresno/Central Valley CA, Los Angeles CA, Houston TX, Las Vegas NV, Miami FL, Orange County CA, Phoenix AZ, Sacramento CA, San Diego CA, San Francisco Bay Area CA, Seattle WA and Washington DC. New markets are transferred to existing markets on January 1st following the completion of their first full calendar year. The Las Vegas, Houston and Miami markets opened during 2005 and, therefore, completed their first full calendar year at of the end of 2006. Accordingly, these markets were moved to existing markets as of January 1, 2007 and are included in comparable existing markets for all periods presented. New markets and the month opened consist of:
     
Tampa, FL
  February 2006
Orlando, FL
  April 2006
Minneapolis, MN
  May 2006

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Table of Contents

     
Austin, TX
  July 2006
Palm Beach, FL
  September 2006
Greater Philadelphia Area, PA
  December 2006
Naples, FL
  March 2007
Tucson, AZ
  March 2007
Denver, CO
  April 2007
Jacksonville, FL
  May 2007
Salt Lake City, UT
  July 2007
Richmond, VA
  July 2007
Virginia Beach, VA
  August 2007
Charlotte, NC
  August 2007
Raleigh-Durham, NC
  September 2007
 
(2)   The term “transaction” refers to each representation of a buyer or seller in a real estate purchase or sale.
 
(3)   Average net revenue per transaction equals net transaction revenues divided by number of transactions with respect to each period.
     The increase in our net transaction revenues of $10.1 million for the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 was primarily due to an increase in net transaction revenues of $3.0 million in our existing markets plus an increase in net transaction revenues of $7.1 million from our new markets.
     The increase in net transaction revenues in our existing markets of $3.0 million or 4.4% was driven primarily by an increase in average net revenue per transaction of 4.6% partially offset by a modest decrease in the number of transactions closed during the period of 0.2%. We had 1,752 ZipAgents in existing markets at September 30, 2007 compared to 1,590 at September 30, 2006.
     The increase in our new markets of $7.1 million or 686.7% was driven primarily by a 639.3% increase in the number of transactions closed during the period as we opened ten new markets since September 30, 2006 and added new ZipAgents. The increase was also attributable to an increase in the average net revenue per transaction of $330 or 6.4%. We had 511 ZipAgents in new markets at September 30, 2007 compared to 157 at September 30, 2006.
Referral and other revenues
     Referral and other revenues consist primarily of certain co-marketing agreements and transaction referrals.
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
Referral and other revenues
  $ 2,286     $ 2,048     $ 238       11.6 %
     The absolute dollar increase in referral and other revenues was not significant.
Cost of revenues
     Our cost of comparable revenues for existing and new markets consists principally of commissions, related payroll taxes, benefits and expense allowances and reimbursements paid to our ZipAgents, and the amortization of internal-use software and website development costs which relate primarily to our ZAP technology.
                                 
    Nine Months Ended              
    September 30,     Increase     Percent  
    2007     2006     (Decrease)     Change  
    (in thousands)  
Cost of revenues
                               
Comparable existing markets
  $ 41,641     $ 39,045     $ 2,596       6.7 %
New markets
    4,383       523       3,860       736.8 %
 
                         
Total
  $ 46,024     $ 39,568     $ 6,456       16.3 %
 
                         
     The increase in cost of revenues for the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 was primarily related to the overall increase in transaction revenue on which we pay agent commissions.
     Cost of revenues increased in our existing markets by approximately $2.6 million related to the increase in net transactions revenue in our existing markets during the period. The cost of revenues as a percentage of existing markets net transaction revenues increased by about 1.2% primarily due to the mix of agent commissions paid as well as increased agent expense reimbursements. Additionally we made certain adjustments to our agent compensation plan to better motivate and retain our agents under the current market conditions.
     Cost of revenues increased in our new markets by approximately $3.9 million related to the increase in net transaction revenue during the period. The cost of revenues as a percentage of new market net transaction revenues increased by 3.2% primarily due to the mix of agent commissions paid. This increase in the cost of revenues percentage in new markets is expected as increasing numbers of ZipAgents achieve higher commission splits as the new markets mature.

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Product development
     Product development expenses, net of capitalized costs of internally developed software, include our information technology costs, primarily compensation and benefits, depreciation of equipment and software, communications expenses and other operating costs relating to the maintenance of our website, proprietary technology systems and general information technology services.
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
Product development
    $ 5,329     $ 4,128     $ 1,201     29.1 %
     The increase in product development expenses for the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 was primarily due to ongoing website development and to support new market expansion and consisted primarily of increases in salaries and benefits of $0.4 million and general technology expenses (including depreciation) of $0.7 million. As a percentage of net revenues, product development costs were 6.4% in the period compared to 5.7% in the nine months ending September 30, 2006.
Sales and marketing
     Sales and marketing expenses consist primarily of compensation and related costs for personnel engaged in sales and sales support functions and customer service as well as promotional, advertising and client acquisition costs. These expenses have been categorized below between those incurred in the existing and new markets offices and those expenses which are incurred by the regional and corporate support functions across all markets.
                                 
    Nine Months Ended              
    September 30,     Increase     Percent  
    2007     2006     (Decrease)     Change  
    (in thousands)  
Sales and marketing
                               
Comparable existing markets
  $ 17,293     $ 16,391     $ 902       5.5 %
New markets
    5,885       1,693       4,192       247.6 %
Regional sales support and marketing
    5,128       4,314       814       18.9 %
 
                         
Total
  $ 28,306     $ 22,398     $ 5,908       26.4 %
 
                         
     The increase in sales and marketing expenses for the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 was primarily related to the overall growth in our business principally the expansion into new markets.
     Sales and marketing expenses increased in our existing markets by approximately $0.9 million principally attributable to salaries and benefits of $0.5 million, customer acquisition costs of $0.3, occupancy and related expenses of $0.1 million. As a percentage of existing market net transactions revenues, existing market sales and marketing expenses were 23.9% in the current period compared to 23.7% in the prior year.
     Sales and marketing expenses increased in our new markets by approximately $4.2 million principally attributable to opening ten new market offices since September 30, 2006. The increased expenses consisted primarily of salaries and benefits of $1.4 million, travel of $0.1 million, customer acquisition costs of $1.2 million, occupancy and related expenses of $0.7 million and recruiting/training expenses of $0.4 million. As a percentage of new market net transactions revenues, new market sales and marketing expenses were 72.3% in the current year compared to 163.7% in the prior year.
     Regional sales support and marketing expenses increased by approximately $0.8 million principally attributable to the costs of our new market expansion personnel. As a percentage of total net transactions revenues, regional sales support and marketing expenses were 6.4% in the current period compared to 6.1% in the prior year.
General and administrative
     General and administrative expenses consist primarily of compensation and related costs for personnel and facilities related to our executive, finance, human resources, facilities and legal organizations, and fees for professional services. Professional services are principally comprised of outside legal, audit and outsourcing services.
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
General and administrative
    $ 11,782     $ 9,556     $ 2,226     23.3 %
     The increase in general and administrative expenses for the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 was principally due to increased salaries and benefits of $0.7 million, an increase in consulting, professional fees and outside services of $0.7 million, and an increase in stock-based compensation expense of $0.8 million. Included in the increase in general and administrative expenses during the period were the expenses associated with the termination of the Company’s former CEO which totaled $0.7 million. As a percentage of net revenues, general and administrative expenses were 14.2% in the period compared to 13.2% in the nine months ended September 30, 2006.

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Litigation
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
Litigation
    $ 3,550     $     $ 3,550       100.0%
     Litigation relates to a class action lawsuit filed by four former ZipAgents. The plaintiffs allege, among other things, that our expense allowance policies violate applicable law. There is a proposed settlement involving a payment of approximately $3.6 million, and a full release from any further liability on the matters raised in the lawsuit. See the description under Legal Proceedings in Part I.
Interest income
     Interest income relates to interest we earn on our money market deposits and short-term investments.
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
Interest income
    $ 3,329     $ 2,782     $ 547       19.7%
     Interest income will fluctuate as our cash equivalents and short-term investment balances change and applicable interest rates increase or decrease. The increase in interest income for the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006 was due primarily to higher interest rates and modestly higher average balances for our cash equivalents and short-term investments.
Other income (expense), net
     Other income (expense), net consists of non-operating items, which have not been significant to date.
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
Other income (expense), net
    $ 2     $ (8)     $ 10       120.4%
Provision for (benefit from) income taxes
     The provision for income taxes relates to our net book profit based on our best estimate of the tax provision (benefit) that will be provided for the full year.
                                 
    Nine Months Ended        
    September 30,   Increase   Percent
    2007   2006   (Decrease)   Change
    (in thousands)
Provision benefit from income taxes
    $     $ (179)     $ (179)       (100.0)%
     We continue to record a full valuation allowance against our deferred tax assets at September 30, 2007, due to uncertainties related to our ability to utilize our deferred tax assets, primarily consisting of net operating loss carryforwards, before they expire. Based on the full valuation allowance and the taxable loss for the nine months ended September 30, 2007, the Company has not recorded a tax provision or benefit.

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LIQUIDITY AND CAPITAL RESOURCES
     Prior to our initial public offering in November 2004, we funded our operations primarily through the sale of preferred stock and convertible notes, which provided us with aggregate net proceeds of approximately $65.8 million. In November 2004, we completed our initial public offering, which raised net proceeds, after underwriting discounts, commissions and expenses, of approximately $61.4 million.
     As of September 30, 2007, we had cash, cash equivalents and short-term investments of $85.4 million and had no bank debt, line of credit or equipment facilities.
Operating activities
     Our operating activities used cash and generated cash in the amount of $1.3 million and $1.8 million in the nine months ended September 30, 2007 and 2006, respectively. Cash used in the nine months ended September 30, 2007 resulted from a net loss of $9.0 million, which was partially offset by $2.1 million of depreciation and amortization, $2.9 million of non-cash stock-based compensation expense and a $3.5 million reserve established for pending litigation. Cash generated in the nine months ended September 30, 2006 resulted from a net loss of $0.4 million which was offset primarily by $1.8 million of depreciation and amortization, and $1.9 million of non-cash stock-based compensation expense and from changes in other non cash operating assets and liabilities, primarily the remaining payment of $3.2 million litigation settlement.
     Our primary source of operating cash flow is the collection of our commission income from escrow companies or similar intermediaries in the real estate transaction closing process. Due to the structure of our commission arrangements, our accounts receivable are converted to cash on a short-term basis and our accounts receivable balances at period end have historically been significantly less than one month’s net revenues. Our operating cash flows will be impacted in the future by the timing of payments to our vendors for accounts payable, which are generally paid within the invoice terms and conditions. Our cash outflows are also impacted by the timing of the payment of our accrued liabilities relating to commissions and related compensation costs and client acquisition costs.
     A number of non-cash items have been charged to expense and decreased our net income or increased our net loss. These items include depreciation and amortization of property and equipment and non-cash employee stock-based compensation expense and other stock-based compensation charges. To the extent these non-cash items increase or decrease in amount and increase or decrease our future operating results, there will be no corresponding impact on our cash flows.
Investing activities
     Our investing activities used cash in the amount of $0.1 million and generated cash of $0.2 million in the nine months ended September 30, 2007 and 2006, respectively. Cash used for the nine months ended September 30, 2007 represent net proceeds from the sales and purchases of short-term investments of $3.1 million offset by the purchases of property and equipment, furniture, and leasehold improvements totaling $3.2 million in connection with the purchase of additional server capacity, capitalization of internal use software and the build out of new district office space. Cash generated for the nine months ended September 30, 2006 was primarily related to net sales of short-term investments partially offset by purchases of property and equipment.
     We primarily maintain a minimum amount of cash and cash equivalents for operational purposes and invest the remaining amount of our cash in investment grade, highly liquid interest-bearing securities which allows for flexibility in the event our cash needs change.
     Currently, we expect our remaining 2007 capital expenditures to be approximately $1.8 million. Capital expenditures for the remainder of 2007 are expected to include investing in a second data center, increased server capacity, the purchase of computer hardware and software to increase our service capacity, normal replacements of computer related office equipment and the capital cost related to opening offices in new markets. In the future, our ability to make significant capital investments may depend on our ability to generate cash flow from operations and to obtain adequate financing, if necessary and available.

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Financing activities
     Our financing activities provided cash in the amount of $0.5 million and $0.5 million in the nine months ended September 30, 2007 and 2006, respectively. Sources of cash from financing activities primarily represented proceeds from stock option and warrant exercises.
     As of September 30, 2007, we had warrants outstanding for the purchase of an aggregate of 1,385,298 shares of our common stock at a weighted average exercise price of $3.93 per share. All of these warrants are currently exercisable at the option of the holders. If all or a portion of these warrants were exercised for cash, we could receive significant proceeds at that time.
Future needs
     We believe that cash flows from operations and our current cash, cash equivalents and short-term investments will be sufficient to fund our operations for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of growth into new geographic markets, our level of investment in technology and advertising initiatives. We are currently exploring several options for offering services relating to the purchase, sale and ownership of a home, including services related to title insurance, escrow, mortgage, and home warranty insurance and have begun offering property and casualty insurance (including auto insurance) services through a subsidiary. We refer to these services as core services. We expect that some of our core services will be offered through affiliates (including wholly owned subsidiaries), while others will be offered through joint ventures or marketing arrangements with independent third parties, such as title companies, banks and insurance companies. We may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. We currently have no bank debt or line of credit facilities. In the event that additional financing is required, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operations and results will likely suffer.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
     We lease office space under non-cancelable operating leases with various expiration dates through May 2013. The following table provides summary information concerning our future contractual obligations and commitments at September 30, 2007.
                                         
    Payments due by period
    Less than                   More than    
    1 year   1 to 3 years   3 to 5 years   5 years   Total
    (in thousands)
Minimum lease payments
    $ 2,299     $ 3,464     $ 2,619     $ 69     $ 8,451
OFF-BALANCE SHEET ARRANGEMENTS
     We do not have any off balance-sheet arrangements, investments in special purpose entities or undisclosed borrowings or debt. Additionally, we are not a party to any derivative contracts or synthetic leases.
Item 3. Quantitative and Qualitative Disclosures About Market Risk:
Interest rate sensitivity
     Our investment policy requires us to invest funds in excess of current operating requirements. The principal objectives of our investment activities are to preserve principal, provide liquidity and maximize income consistent with minimizing risk of material loss. We believe this investment policy is prudent, and helps to reduce, but does not prevent, loss of principal, and results in minimal interest rate exposure on our investments.
     As of September 30, 2007 and 2006, our cash and cash equivalents consisted primarily of money market funds and our short-term investments consisted primarily of investment grade, highly liquid interest-bearing securities. The recorded carrying amounts of cash and cash equivalents approximate fair value due to their short maturities and short-term investments are carried at fair value. The amount of credit exposure to any one issue, issuer and type of instrument is limited. Our interest income is sensitive to changes in the general level of interest rates in the United States, particularly since the majority of our investments are fixed income investments. If market interest rates were to increase or decrease immediately and uniformly by 10% from levels at September 30, 2007 and 2006, the increase or decline in fair market value of the portfolio would be approximately $0.3 million and $0.4 million, respectively.

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Exchange rate sensitivity
     We consider our exposure to foreign currency exchange rate fluctuations to be minimal, as we do not have any sales denominated in foreign currencies. We have not engaged in any hedging or other derivative transactions to date.
Item 4. Controls and Procedures:
     (a) Disclosure controls and procedures. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such items are defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”)) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures as of the end of the period covered by this Quarterly Report are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
     (b) Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting during the quarter ended September 30, 2007 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II — OTHER INFORMATION
Item 1. Legal Proceedings:
     On May 4, 2007, the Company was named in a class action lawsuit filed in United States District Court for the Central District of California, Lubocki, et al v. ZipRealty, case number CV 07 2959, by four former employee agents of the Company on behalf of themselves and others similarly situated. The complaint alleged, among other things, that the Company’s policies for expense allowances and expense reimbursement in place prior to October 2005, and its policy for commission payments to agents for transactions that do not close during the period of employment, violate applicable law. The Company has reached a proposed settlement which calls for a payment of $3,550,000 and, as a result, has recorded a charge in that amount during the quarter ended September 30, 2007. The proposed settlement is expected to include a full release from any further liability on the matters raised in the complaint, and is subject to the execution of a definitive settlement agreement and court approval.

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     On May 18, 2007, the Company was named in a class action lawsuit filed in the Superior Court of California, County of Alameda, Crystal Alexander, et al. v. ZipRealty, case number RG 07326622, by one former employee agent of the Company. The complaint alleges, among other things, that the Company’s practices for compensating agents and reimbursing expenses violate applicable law regarding the payment for overtime. The Company is in the initial stages of investigation and discovery in this matter. However, at this time, the Company believes that its business practices at issue in this case are in compliance with applicable law, and therefore intends to vigorously defend this lawsuit.
     The Company has filed a claim for malpractice against the law firm which provided counseling in connection with certain employment matters in California Superior Court, County of San Francisco, ZipRealty Inc., v. Squire, Sanders & Dempsey, LLP, Michael W. Kelly Esq., et. al., Case No. CGC 06450765. While the Company believes it has a good case, it is too early to determine the likelihood of a recovery, or to estimate the amount of recovery, if any.
     We are not currently subject to any other material legal proceedings. From time to time we have been, and we currently are, a party to litigation and subject to claims incident to the ordinary course of our business. The amounts in dispute in these matters are not material to us, and we believe that the resolution of these proceedings will not have a material adverse effect on our business, results of operations, financial position, or cash flows.
Item 1A. Risk Factors:
     Because of the following factors, as well as other variables affecting our operating results and financial condition, past financial performance may not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends in future periods.
RISKS RELATED TO OUR BUSINESS AND INDUSTRY
We have experienced losses in recent quarters and may incur losses in the future, and our limited operating history makes our future financial performance difficult to assess.
     We were formed in January 1999 and therefore have a limited operating history upon which to evaluate our operations and future prospects. We have had a history of losses from inception through the first half of 2003 and at September 30, 2007 had an accumulated deficit of $61.2 million. While we were profitable in the second half of 2003, and for a total of seven quarters during 2004, 2005 and 2006, we experienced net losses in the four most recent quarters (including the third quarter of 2007). Our outlook is cautious given market and geopolitical uncertainties, and we expect to experience a loss for calendar year 2007 as we continue to invest in our business during this period of market softness.
     We may incur additional expenses with the expectation that our revenues will grow in the future, which may not occur. As a result, we could experience budgeting and cash flow management problems, unexpected fluctuations in our results of operations and other difficulties, any of which could harm our ability to achieve or maintain profitability, increase the volatility of the market price of our common stock or harm our ability to raise additional capital. Additionally, as a public company we must work towards continued compliance with the requirements of the Securities and Exchange Commission, Nasdaq and the Sarbanes-Oxley Act of 2002, and we may incur costs in connection with that effort that are significantly higher than anticipated, which could negatively impact our profitability.
     We expect that we will continue to increase our expenses, including marketing and customer acquisition expenses and expenses incurred as a result of increasing the number of agents we employ. As we seek to grow our business in existing markets and expand to new markets, we cannot guarantee our business strategies will be successful or that our revenues will ever increase sufficiently to achieve and maintain profitability on a quarterly or annual basis.
Our business model requires access to real estate listing services provided by third parties that we do not control, and the demand for our services may be reduced if our ability to display listings on our website is restricted.
     A key component of our business model is that through our website we offer clients access to, and the ability to search, real estate listings posted on the MLSs in the markets we serve. Most large metropolitan areas in the United States have at least one MLS, though there is no national MLS. The homes in each MLS are listed voluntarily by its members, who are licensed real estate brokers. The information distributed in an MLS allows brokers to cooperate in the identification of buyers for listed properties.

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     If our access to one or more MLS databases, or our ability to offer our clients the ability to access and search listings on one or more MLSs, were restricted or terminated, our service could be adversely affected and our business may be harmed. Because participation in an MLS is voluntary, a broker or group of brokers may decline to post their listings to the existing MLS and instead create a new proprietary real estate listing service. If a broker or group of brokers created a separate real estate listing database, we may be unable to obtain access to that private listing service on commercially reasonable terms, if at all. As a result, the percentage of available real estate listings that our clients would be able to search using our website would be reduced, perhaps significantly, thereby making our services less attractive to potential clients.
     Additionally, we operate a virtual office website, or VOW, which is a password protected website that allows us to show comprehensive MLS data directly to consumers without their having to visit an agent. In late 2002, the National Association of REALTORS®, or NAR, the dominant trade organization in the residential real estate industry, adopted a mandatory policy for NAR-affiliated MLSs regarding the use and display of MLS listings data on VOWs. Under the NAR policy, individual MLSs affiliated with NAR, which includes the vast majority of MLSs in the United States, were required to implement their own individual VOW policies consistent with the NAR, but NAR extended the deadline for the implementation of its rules at least three times during an investigation by the Antitrust Division of the U.S. Department of Justice, or DOJ, into NAR’s policy that dictates how brokers can display other brokers’ property listings on their websites. In September 2005, NAR replaced its VOW policy with an Internet Listings Display, or ILD, policy containing some of the same or similar features of its former VOW policy, and the DOJ responded by immediately filing a lawsuit in federal court against NAR challenging the ILD policy. NAR has postponed the deadline for the implementation of its ILD rules by its member MLSs pending resolution of that lawsuit. We presently do not know whether or when the NAR rules will be implemented in their current form or in a revised form, if at all. Once the individual MLSs implement the ILD policy, the NAR policy currently provides that member brokerages will have up to 90 days to comply with the policy.
     The NAR policy is designed to provide structure to the individual MLS policies concerning the display of listing information through the Internet, subject to a number of areas in which the individual MLSs may tailor the policy to meet their local needs. One NAR policy provision with which the individual MLSs must adhere, once required to be implemented, is known as an “opt-out.” This provision creates a mechanism for individual brokers to prevent their listings data from being displayed by competitors on their websites but not by brick-and-mortar competitors at their offices by other means, which the DOJ has alleged is a mechanism designed to chill competition by Internet-based REALTORS®.
     We believe NAR’s policy and the DOJ action reflects a high degree of uncertainty regarding the real estate industry’s incorporation of and willingness to work with VOWs. Our success may be significantly affected by the outcome of the DOJ’s action. It may also be affected by the willingness of individual MLS’ to work cooperatively with VOW businesses such as ours.
We may be unable to integrate our technology with each MLS on a cost-effective basis, which may harm our operating results and adversely affect our ability to service clients.
     Each MLS is operated independently and is run on its own technology platform. Each has adopted its own rules and regulations. As a result, we must constantly modify our technology to successfully interact with each independent MLS in order to maintain access to that MLS’s home listings information. In addition, when a new MLS is created, we must customize our technology to work with that new system. These activities require constant attention and significant resources. We may be unable to successfully interoperate with the MLSs without significantly increasing our engineering costs, which would increase our operating expenses without a related increase in net revenues and cause our operating results to suffer. We may also be unable to interoperate or work with the MLSs effectively, or at all, which would likely adversely affect the demand for our services.
Our business could be harmed by transitions in the real estate markets and economic events that are out of our control and may be difficult to predict.
     The success of our business depends in part on the health of the residential real estate market, which traditionally has been subject to cyclical economic swings as well as other changes in local regional or national economic conditions. The purchase of residential real estate is a significant transaction for most consumers, and one which can not only be delayed or terminated based on the availability of discretionary income, but also can be delayed or terminated based on macroeconomic factors. Economic slowdown or

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recession, changes in the availability of mortgages or extension of credit, rising interest rates, adverse tax policies or changes in other regulations, lower availability of credit, increased unemployment, lower consumer confidence, lower wage and salary levels, war or terrorist attacks, natural disaster, oil price spikes or the public perception that any of these events may occur, could adversely affect the demand for residential real estate and would harm our business. Also, if the availability of mortgages or other financing options decline, or if interest rates increase significantly, homeowners’ ability to purchase a new home or a higher priced home may be reduced as higher monthly payments would make housing less affordable. In addition, these conditions could lead to a decline in transaction volume and sales prices, either of which would harm our operating results.
     Since early September of 2005 we have experienced significant increases in the available inventories of homes for sale in many of our markets, as well as increases in the amount of time listings are taking to sell. For example, average monthly inventories in our existing markets increased approximately 80% in 2006 compared to 2005, and months of inventory increased approximately 84% in December 2006 compared to December 2005. Pricing increases have also slowed, and some markets have shown declines in median selling prices over this period. According to NAR, national sales of existing homes fell 8.4% to 6.48 million in 2006 from 7.08 million in 2005. According to NAR, nationally sales of existing homes fell 19.1% year-over-year in September 2007 to a seasonally adjusted rate of 5.04 million. In the State of California, the California Association of REALTORS® reported that sales of existing homes declined 23% in 2006 compared to 2005 and declined 38.9% year-over-year during the month of September 2007. In our opinion, these data points suggest the housing market is in a period of transition, with more power shifting to buyers from sellers, which may impair our ability to grow the Company and our agent productivity.
The recent tightening in the availability of credit, particularly with respect to lenders in the mortgage market, may negatively impact the housing market.
     Consumer access to mortgage financing has been affordable and widely available by historic standards in recent years. The affordability and availability of mortgage financing is influenced by a number of factors, including interest rates, lender underwriting criteria, loan product availability, and the performance of mortgage backed securities in the secondary market. Since the fall of 2005, the residential real estate market has been softening as interest rates have been increasing. In addition, lender underwriting criteria began to change in 2006 as a result of tighter lending standards. Underwriting criteria changed further in 2007 as a result of tightening credit conditions caused by weakness in the housing market and rising foreclosures. Currently, we perceive there is a disruption in the availability of funds for mortgages as investors, who buy loans and securities backed by mortgages, are tightening credit standards and/ or exiting the market for loans that aren’t guaranteed by Fannie Mae or Freddie Mac. We also believe an entire group of loan products, including subprime and some Alt A loans, have become less available and pressures are building on prime, non-conforming loans (principally loans of more than $417,000, the limit observed by Fannie Mae and Freddie Mac). If these borrowers face higher interest rates, many may postpone or cancel home buying plans. When interest rates rise and when underwriting criteria becomes more restrictive, housing may become less affordable, since at a given income level people cannot qualify to borrow as much principal, or given a fixed principal amount they will be faced with higher monthly payments. This result may mean that fewer people will be able to afford homes at prevailing prices, leading to fewer transactions or reduction in home prices, either of which may reduce revenues. Should we not be able to offset the potential negative market influences on price and volume by increasing our transaction volume through market share growth, our financial results will be negatively impacted.
Foreclosures and short sales may cause significant disruption in our business.
     There has been a significant increase in the number of homes which are now in foreclosure and have involved a short sales. A short sale includes a sale where the sale price is less than the loans or debt secured by the home listed for sale. This may cause further softening in the real estate industry, which tends to decrease home prices, and delays the sales process as short sales can be complicated to complete.
Our business model is new and unproven, and we cannot guarantee our future success.
     Our Internet-enabled residential real estate brokerage service is a relatively new and unproven business model, and it has evolved, and may continue to evolve, over time. Our business model differs significantly from that of a traditional real estate brokerage firm in several ways, including our heavy reliance on the Internet and technology and our employee agent model. The success of our business model depends on its scalability and on our ability to achieve higher transaction volumes at an overall lower cost per transaction in order to offset the costs associated with our technology, employee benefits, marketing and advertising expenses and discounts and rebates. If we are unable to efficiently acquire clients and maintain agent productivity in excess of industry averages, our ZipAgents

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may close fewer transactions and our net revenues could suffer as a result. Also, given that our agent employee model is uncommon in the real estate industry, our compensation structure could be subject to legal challenge, and has been challenged as discussed under “Legal Proceedings” in Part II, Item 1 of this report. In addition, our agents generally earn a lower per transaction commission than a traditional independent contractor agent. If we are unsuccessful in providing our agents with an attractive value proposition, whether through more opportunities to close transactions or otherwise, when compared to the traditional model, our ability to hire and retain qualified real estate agents would be harmed, which would in turn significantly harm our business.
If we fail to recruit, hire and retain qualified agents, we may be unable to service our clients and our growth could be impaired.
     Our business requires us to hire employees who are licensed real estate agents, and our strategy is based on consistently and rapidly growing our team of ZipAgents. Competition for qualified agents is intense, particularly in the markets in which we compete, and retention is an industry-wide issue. While there are many licensed real estate agents in our markets and throughout the country, historically we have had difficulties in recruiting and retaining properly qualified licensed agents due particularly to agent discomfort with using technology and being actively managed by an employer. In addition, our lower per transaction agent commission model may be unattractive to certain higher performing agents. If we are unable to recruit, train and retain a sufficient number of qualified licensed real estate agents, we may be unable to service our clients properly and grow our business.
     Historically, we have experienced a high degree of agent turnover, most of which occurs in the first few months after commencing employment. This turnover has required us to expend a substantial amount of time and money to replace agents who have left as we have been growing our business. If this situation worsens, our rate of expansion into new markets could be slowed and we will continue to employ a significantly higher number of new agents with less experience operating in our business model, which could cause us to be less effective at expanding our market share in our existing markets and entering new markets.
We may incur additional expenses or liabilities if our current or former compensation or expense allowance or reimbursement policies are found to violate federal or state wage and hour laws.
     Because our ZipAgents are employees and not independent contractors, we are subject to federal and state regulation of our employment practices, including compensation and expense reimbursement for our ZipAgents. We rely on federal and state exemptions from minimum wage and fair labor standards laws for our ZipAgents, who are compensated primarily through commissions and who are reimbursed for certain business expenses. Such exemptions may not continue to be available, or we may not qualify for such exemptions, which could subject us to penalties and damages for non-compliance. For example, Nevada recently approved legislation that preempts the federal “outside sales exemption” from paying minimum wage and overtime in that state. That legislation takes effect on November 1, 2007. Accordingly, on November 1, 2007 we will begin paying ZipAgents in Nevada minimum wage offset against future commissions, and overtime subject to prior manager approval. Also, some states, such as California, have laws requiring the reimbursement of employee expenses, which caused us to change our compensation practices in 2005. Our current and former compensation and expense allowance and reimbursement policies are challenged from time to time through litigation and administrative complaints, including the class action lawsuits described in this Form 10-Q under Part II, Item 1, “Legal Proceedings.” If exemptions from paying minimum wages are not available in states where we desire to expand our operations or if they cease to be available in the states where we currently operate, or if we are required by federal or state laws to pay additional compensation or to reimburse additional expenses, we may incur significant expenses, be subject to lawsuits and administrative complaints, and be required to modify our agent compensation structure in some or all states, which could cause our compensation practices to be less attractive to agents or more expensive to the Company.
Our failure to effectively manage the growth of our ZipAgents and related technology could adversely affect our ability to service our clients.
     As our operations have expanded, we have experienced rapid growth in our headcount from 1,963 total employees, including 1,747 ZipAgents, at September 30, 2006 to 2,539 total employees, including 2,263 ZipAgents, at September 30, 2007. We expect to continue to increase headcount in the future, particularly the number of ZipAgents. Our rapid growth has demanded, and will continue to demand, substantial resources and attention from our management. We will need to continue to hire additional qualified agents and improve and maintain our related technology to properly manage our growth. If we do not effectively manage our growth, our client service and responsiveness could suffer and our costs could increase, which could negatively affect our brand and operating results.

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Our failure to effectively manage the growth of our control systems could adversely affect our ability to maintain legal compliance.
     As we grow, our success will depend on our ability to continue to implement and improve our operational, financial and management information and control systems on a timely basis, together with maintaining effective cost controls. This ability is particularly critical as we implement new systems and controls to help us better comply with the stringent requirements of being a public company, including the requirements of the Sarbanes-Oxley Act of 2002, which require management to evaluate and assess the effectiveness of our internal control over financial reporting and our disclosure controls and procedures. Effective internal control over financial reporting is required by law and is necessary for us to provide reliable financial reports and effectively prevent fraud. Effective disclosure controls and procedures are required by law and are necessary for us to file complete, accurate and timely reports under the Securities Exchange Act of 1934. Our ability to manage the growth of our control systems and maintain legal compliance could be thwarted by many factors, including turnover in management and the lack of adequate staffing with the requisite expertise and training. Any inability to provide reliable financial reports or prevent fraud or to file complete, accurate and timely reports under the Securities Exchange Act of 1934 could harm our business, harm our reputation and result in a decline in our stock price. We are continuing to evaluate and, where appropriate, enhance our systems, procedures and internal controls. If our systems, procedures or controls are not adequate to support our operations and reliable, accurate and timely financial and other reporting, we may not be able to successfully satisfy regulatory and investor scrutiny, offer our services and implement our business plan.
If we fail to comply with real estate brokerage laws and regulations, we may incur significant financial penalties or lose our licenses to operate.
     Due to the geographic scope of our operations and the nature of the real estate services we perform, we are subject to numerous federal, state and local laws and regulations, and regulatory authorities have relatively broad discretion to grant, renew and revoke licenses and approvals and implement regulations. For example, we are required to maintain real estate brokerage licenses in each state in which we operate and to designate individual licensed brokers of record. In some states, these licenses are personal to the broker. If we fail to maintain our licenses, lose the services of our designated broker of record or conduct brokerage activities without a license, we may be required to pay fines or return commissions received, our licenses may be suspended or revoked or not renewed or we may be subject to other civil and/or criminal penalties. As we expand into new markets, we will need to obtain and maintain the required brokerage licenses, which may be difficult, and comply with the applicable laws and regulations of these markets, which may be different from those to which we are accustomed, any of which will increase our compliance costs. In addition, because the size and scope of real estate sales transactions have increased significantly during the past several years, both the difficulty and cost of compliance with the numerous state licensing regimes and possible losses resulting from non-compliance have increased. Our failure to comply with applicable laws and regulations, the possible loss of real estate brokerage licenses or litigation by government agencies or affected clients may have a material adverse effect on our business, financial condition and operating results, and may limit our ability to expand into new markets.
We may have liabilities in connection with real estate brokerage activities.
     As a licensed real estate brokerage, we and our licensed employees are subject to statutory due diligence, disclosure and standard-of-care obligations. In the ordinary course of business we and our employees are subject to litigation from parties involved in transactions for alleged violations of these obligations. We self-insure some of this risk and, as we expand our business to include larger deals, we may not be able or otherwise determine not to obtain third party insurance on these larger deals with attractive terms. In addition, we may be required to indemnify our employees who become subject to litigation or other claims arising out of our business activities, including for claims related to the negligence of those employees. An adverse outcome in any such litigation could negatively impact our reputation and harm our business.
We may have liabilities if any of our employees violates laws concerning settlement procedures.
     Our business must comply with the provisions of the federal Real Estate Settlement Procedures Act, or RESPA, as well as comparable state statutes where we do business. These statutes, among other things, restrict payments which real estate brokers, agents and other settlement service providers may receive for referral of business to other settlement service providers in connection with the closing of real estate transactions. RESPA and similar state laws also require timely disclosure of certain relationships or financial interest that a broker has with providers of real estate settlement services. If any of our employees fails to comply with any of these statutes, a resulting enforcement proceeding could subject us to substantial financial penalties, be expensive to defend and materially harm our ability to continue operations.

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If any of our core services fails to comply with applicable federal and state law and regulations, we may incur significant financial penalties or lose licenses required to provide these services.
     We are currently exploring and beginning to implement several options for offering services relating to the purchase, sale and ownership of a home, including services related to title insurance, escrow, mortgage, home warranty insurance and property and casualty insurance (including auto insurance), which we refer to as core services. We expect that some of our core services will be offered through affiliates (including wholly owned subsidiaries), while others will be offered through joint ventures or marketing arrangements with independent third parties, such as title companies, banks and insurance companies. For example, as discussed above, we have entered into a co-marketing arrangement with E-LOAN, Inc. to provide the mortgage center on our website in exchange for a flat monthly fee established on a periodic basis. Also, we have formed a joint venture with a title insurance company to explore the offering to our clients of title insurance service in one or more of our markets, and we have formed a subsidiary to offer insurance services in certain markets.
     These core services may be subject to regulation at both the federal and state level, including, in certain instances, regulation under the Fair Housing Act, the Real Estate Settlement Procedures Act, or RESPA, state and local licensing laws and regulations (whether applicable to us or third parties with whom we have arrangements) and federal and state advertising laws, fair lending and insurance-related laws and regulations. Some of these laws and regulations, such as RESPA, do not offer definitive requirements for compliance, making it difficult to determine conclusively whether these core services will comply. The laws of the states in which we conduct business often vary considerably regarding the legality of and licensing requirements for conducting certain business practices, including the payment of compensation, in connection with offering mortgage, title insurance and other insurance products, and these states often do not provide definitive guidance concerning when these practices are illegal or require licensure, which can make it difficult to determine whether our practices are in legal compliance. In addition, to the extent that these core services are offered through affiliates or arrangements with independent third parties, we may have little ability to ensure that these parties comply with applicable laws and regulations. Also, as these core services are expanded into new markets, they will need to obtain and maintain the required licenses, which may be difficult to obtain, and comply with the applicable laws and regulations of these markets, which may be different from the laws and regulations to which they were previously subject, all of which will increase compliance costs.
     If our practices in offering these core services fail to comply with applicable laws and regulations (including if we fail to maintain any necessary licenses, whether through the loss of individuals or entities licensed to perform these services or otherwise, or if our practices are performed or compensated without required licenses), we and the other parties providing the core services may be required to pay fines or return commissions received and may be subject to other civil or criminal penalties under actions by government agencies or clients, and the licenses needed to provide these core services may be suspended, revoked or denied. Any of these events could also cause disruption in the relationships between us and the other parties involved in offering these core services. Consequently, any failure to comply with application laws and regulations may have a material adverse effect on our business, financial condition and operating results, and may limit our ability to expand our core services into new markets.
We may have liabilities in connection with our performance of core services.
     For some of the core services we anticipate offering, such as insurance and mortgage, we expect the performance of these core services to be subject to statutory due diligence, disclosure and standard-of-care obligations. In the ordinary course of business, we and the other parties involved in providing these core services may be subject to litigation from clients and other parties involved in transactions for alleged violations of these obligations. We anticipate that the vehicles providing these core services will self-insure some of this risk. In addition, these vehicles may be required to indemnify their employees who become subject to litigation or other claims arising out of their business activities, including for claims related to the negligence of these employees. An adverse outcome in any such litigation could negatively impact our reputation and have a material adverse impact on our business, operating results and financial condition.

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If our arrangements for providing core services become impaired, we may lose sources of revenue that may be difficult to replace and we may be less likely to engage in related transactions with our clients.
     As mentioned above, we are currently exploring and beginning to implement several options for offering core services, and we expect that some of these services will be offered through affiliates (including wholly owned subsidiaries), while others will be offered through joint ventures or marketing arrangements with independent third parties, such as title companies, banks and insurance companies. If these relationships are terminated or otherwise become impaired, we could lose sources of revenues that we may not be able to readily replace, and our clients could have a more difficult time obtaining services they require in connection with their purchase or sale of a home, reducing our likelihood of engaging in residential real estate or other transactions with these clients. For example, we receive revenues from our marketing relationship with E-LOAN, Inc., which provides the ZipRealty Mortgage Center on our website and pays us a flat monthly fee that is established on a periodic basis (representing less than 3% of our revenues during fiscal year 2006). E-LOAN was acquired by Popular, Inc. in late 2005. If our marketing relationship with E-LOAN became impaired, not only would we lose the marketing revenues from that relationship, but also our clients could have a more difficult time obtaining the financing needed to purchase a home through us, which could negatively impact our transaction revenues. In addition, upon the termination of an arrangement with an independent third party to provide core services, we or our affiliates may be required to pay certain costs or fees or be precluded from performing such services for a period of time. Any of these events could negatively impact our business and financial condition.
If consumers do not continue to use the Internet as a tool in their residential real estate buying or selling process, we may be unable to attract new clients and our growth and financial results may suffer.
     We rely substantially on our website and web-based marketing for our client lead generation. As the residential real estate business has traditionally been characterized by personal, face-to-face relationships between buyers and sellers and their agents, our success will depend to a certain extent on the willingness of consumers to increase their use of online services in the real estate sales and purchasing process. In addition, our success will depend on consumers visiting our website early in their selling or buying process so that we can interface with potential clients before they have engaged a real estate agent to represent them in their transactions. If we are unable to convince visitors to our website to transact business with us, our ZipAgents will have fewer opportunities to represent clients in residential real estate transactions and our net revenues could suffer.
Our success depends in part on our ability to successfully expand into additional real estate markets.
      We currently operate in 32 markets, including 17 of the 25 most populous U.S. metropolitan statistical areas. A part of our business strategy is to grow our business by entering into additional real estate markets and, to this end, in 2005 we commenced operations in Las Vegas in April, Houston in June and Miami in October. During 2006, we commenced operations in Tampa in February, Orlando in April, Minneapolis/St. Paul in May, Austin in July, Palm Beach in September, and the Greater Philadelphia area in December. To date in 2007 we have commenced operations in Naples and Tucson in March, Denver in April, Jacksonville in May, Salt Lake City and Richmond in July, Virginia Beach and Charlotte in August and Raleigh-Durham in September 2007. We have announced plans to enter Long Island and Westchester County in the fourth quarter of 2007 and may open additional markets. Key elements of this expansion include our ability to identify strategically attractive real estate markets and to successfully establish our brand in those markets. We consider many factors when selecting a new market to enter, including:
    the economic conditions and demographics of a market;
 
    the general prices of real estate in a market;
 
    Internet use in a market;
 
    competition within a market from local and national brokerage firms;
 
    rules and regulations governing a market;
 
    the ability and capacity of our organization to manage expansion into additional geographic areas, additional headcount and increased organizational complexity;
 
    the existence of local MLSs; and
 
    state laws governing cash rebates and other regulatory restrictions.

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     Before opening Las Vegas in 2005 we had not entered a new geographic market since July 2000 and have limited experience expanding into and operating in multiple markets, managing multiple sales regions and addressing the factors described above. In addition, this expansion could involve significant initial start-up costs. We expect that significant revenues from any new market may be achieved, if ever, only after we have been operating in that market for some time and begun to build market awareness of our services. As a result, geographic expansion is likely to significantly increase our expenses and cause fluctuations in our operating results. In addition, if we are unable to successfully penetrate these new markets, we may continue to incur costs without achieving the expected revenues, which would harm our financial condition and results of operations.
Unless we develop, maintain and protect a strong brand identity, our business may not grow and our financial results may suffer.
     We believe a strong brand is a competitive advantage in the residential real estate industry because of the fragmentation of the market and the large number of agents and brokers available to the consumer. Because our brand is relatively new, we currently do not have strong brand identity. We believe that establishing and maintaining brand identity and brand loyalty is critical to attracting new clients. In order to attract and retain both clients and employees, and respond to competitive pressures, we expect to increase our marketing and customer acquisition expenditures to develop, maintain and enhance our brand in the future.
     We plan to continue conducting and refining our online advertising and possibly to test and conduct print, radio, direct mail and outdoor campaigns. We plan to increase our online advertising expenditures in the near future. While we intend to enhance our marketing and advertising activities in order to attract and retain both clients and employees, these activities may not have a material positive impact on our brand identity. In addition, developing our brand will depend on our ability to provide a high-quality consumer experience and high quality service, which we may not do successfully. If we are unable to develop, maintain and enhance our brand, our ability to attract new clients and employees and successfully expand our operations will be harmed.
We have numerous competitors, many of which have valuable industry relationships, innovative business models and access to greater resources than we do.
     The residential real estate market is highly fragmented, and we have numerous competitors, many of which have greater name recognition, longer operating histories, larger client bases, and significantly greater financial, technical and marketing resources than we do. Some of those competitors are large national brokerage firms or franchisors, such as Prudential Financial, Inc., RE/MAX International Inc. and Realogy Corporation, which owns the Century 21, Coldwell Banker and ERA franchise brands, a large corporate relocation business and NRT Incorporated, the largest brokerage in the United States. NRT owns and operates brokerages that are typically affiliated with one of the franchise brands owned by Realogy. We are also subject to competition from local or regional firms, as well as individual real estate agents. Our technology-focused business model is a relatively new approach to the residential real estate market and many consumers may be hesitant to choose us over more established brokerage firms employing traditional techniques.
     Some of our competitors are able to undertake more extensive marketing campaigns, make more attractive offers to potential agents and clients and respond more quickly to new or emerging technologies. Over the past several years there has been a slow but steady decline in average commissions charged in the real estate brokerage industry, with the average commission percentage decreasing from 5.44% in 2000 to 5.18% in 2006 according to REAL Trends. Some of our competitors with greater resources may be able to better withstand the short- or long-term financial effects of this trend. In addition, the barriers to entry to providing an Internet-enabled real estate service are low, making it possible for current or new competitors to adopt certain aspects of our business model, including offering comprehensive MLS data to clients via the Internet, thereby reducing our competitive advantage. We may not be able to compete successfully for clients and agents, and increased competition could result in price reductions, reduced margins or loss of market share, any of which would harm our business, operating results and financial condition.
     We also compete or may in the future compete with various online services, such as InterActiveCorp and its LendingTree unit, HouseValues, Inc., HomeGain, Inc., Move, Inc. and its REALTOR.com® affiliate, Zillow and Yahoo! Inc. that also look to attract and monetize home buyers and sellers using the Internet. Move is affiliated with NAR, the National Association of Home Builders, or

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NAHB, and a number of major MLSs, which may provide Move with preferred access to listing information and other competitive advantages. In addition, the competitive landscape in the residential real estate industry is in the midst of significant changes as new business models enter the marketplace. In order to continue growing, our business model must remain attractive to consumers so that we can compete successfully with these newer models as they expand into our marketplaces.
     In addition, the competitive landscape in the residential real estate industry is in the midst of significant changes as new business models enter the marketplace. In order to continue growing, our business model must remain attractive to consumers so that we can compete successfully with these newer models as they expand into our marketplaces. In addition, to remain economically viable, we will need to be able to compete effectively with these new entrants for the acquisition of agents and leads.
Changes in federal and state real estate laws and regulations, and rules of industry organizations such as the National Association of REALTORS®, could adversely affect our business.
     The real estate industry is heavily regulated in the United States, including regulation under the Fair Housing Act, the Real Estate Settlement Procedures Act, state and local licensing laws and regulations and federal and state advertising laws. In addition to existing laws and regulations, states and industry participants and regulatory organizations could enact legislation, regulatory or other policies in the future, which could restrict our activities or significantly increase our compliance costs. Moreover, the provision of real estate services over the Internet is a new and evolving business, and legislators, regulators and industry participants may advocate additional legislative or regulatory initiatives governing the conduct of our business. If existing laws or regulations are amended or new laws or regulations are adopted, we may need to comply with additional legal requirements and incur significant compliance costs, or we could be precluded from certain activities. Because we operate through our website, state and local governments other than where the subject property is located may attempt to regulate our activities, which could significantly increase our compliance costs and limit certain of our activities. In addition, industry organizations, such as NAR and other state and local organizations, can impose standards or other rules affecting the manner in which we conduct our business. As mentioned above, NAR has adopted rules that, if implemented, could result in a reduction in the number of home listings that could be viewed on our website. NAR has extended the deadline for the implementation of its rules pending the resolution of a lawsuit filed in federal court by the Antitrust Division of the U.S. Department of Justice challenging, among other things, NAR’s proposed ILD policy that dictates how brokers can display other brokers’ property listings on their websites. We presently do not know whether or when the NAR rules will be implemented in their current form or in a revised form, if at all. The implementation of the rules will not limit our access to listing information, but could limit the display of listing information to our clients through our website in the manner we currently utilize, as well as increase our costs of ensuring compliance with such rules. Any significant lobbying or related activities, either of governmental bodies or industry organizations, required to respond to current or new initiatives in connection with our business could substantially increase our operating costs and harm our business.
We derive a significant portion of our leads through third parties, and if any of our significant lead generation relationships are terminated, impaired or become more expensive, our ability to attract new clients and grow our business may be adversely affected.
     We generate leads for our ZipAgents through many sources, including leads from third parties with which we have only non-exclusive, short-term agreements that are generally terminable on little or no notice and with no penalties. Our largest third-party lead source, Homegain, Inc., which competes with us for online customer acquisition, generated approximately 27% and 29% of our leads during 2006 and 2005, respectively. Should our lead replacement strategy upon the loss of a large lead supplier not be successful, or any of our other lead generation relationships become materially more expensive such that we could not obtain substitute sources on acceptable terms, our ability to attract new clients and grow our business may be impaired. Our business may also be impaired to the extent that state laws or NAR or MLS regulations make it more difficult or expensive for lead generators to provide us with sufficient leads.
Our ability to expand our business may be limited by state laws governing cash rebates to home buyers.
     A significant component of our value proposition to our home buyer clients is a cash rebate provided to the buyer at closing. Currently, our clients who are home buyers represent a substantial majority of our business and revenues. Certain states, such as Alaska, Kansas, Louisiana, Mississippi, New Jersey, Oklahoma, Oregon and Tennessee, may presently prohibit sharing any commissions with, or providing rebates to, clients who are not licensed real estate agents. In addition, other states may limit or restrict our cash rebate program as currently structured, including Missouri and New York, although we have received guidance from the New

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York State Attorney General’s office indicating that the applicable law in New York would not be interpreted and/or enforced in such a way as to restrict rebates to consumers. In connection with entry into the Greater Philadelphia area, we entered the New Jersey market, where the payment of cash rebates is currently not permitted by law. Consequently, in New Jersey, in lieu of offering a cash rebate to our buyers, we make a donation to a local charity through United Way equal to 20% of our commission in cash upon closing. Should we decide to expand into any of these other states where the payment of cash rebates are restricted or prohibited, we may need to adjust our pricing structure or refrain from offering rebates to buyers in these states. Moreover, we cannot predict whether alternative approaches will be cost effective or easily marketable to prospective clients. The failure to enter into these markets, or others that adopt similar restrictions, or to successfully attract clients in these markets, could harm our business.
We may be subject to liability for the Internet content that we publish.
     As a publisher of online content, we face potential liability for negligence, copyright, patent or trademark infringement, or other claims based on the nature and content of the material that we publish or distribute. Such claims may include the posting of confidential data, erroneous listings or listing information and the erroneous removal of listings. These types of claims have been brought successfully against the providers of online services in the past and could be brought against us or others in our industry. In addition, we may face liability if a MLS member or participant utilizes an opt-out provision, as previously discussed, and we fail to comply with that requirement. These claims, whether or not successful, could harm our reputation, business and financial condition. Although we carry general liability insurance, our insurance may not cover claims of these types or may be inadequate to protect us from all liability that we may incur.
We monitor and evaluate the use of our website by our registered users, which could raise privacy concerns.
     Visitors to our website that register with us receive access to home listing and related information that we do not make available to unregistered users. As part of the registration process, our registered users consent to our use of information we gather from their use of our website, such as the geographic areas in which they search for homes, the price range of homes they view, their activities while on our website and other similar information. They also provide us with personal information such as telephone numbers and email addresses and our registered users consent to our internal use of personal information. Our website includes a copy of our privacy policy, which sets forth our practices with respect to sharing website use and personal information when necessary to administer products or services we or our subsidiaries may provide, when we have users’ permission, when required by law, or as otherwise described in our privacy policy. If we were to use this information outside the scope of our privacy policy or otherwise fail to observe any legal obligation keep this information confidential from third parties, including our former agents, we may be subject to legal claims or government action and our reputation and business could be harmed. Also, concern among consumers regarding our use of information gathered from visitors to our website could cause them not to register with us, which would reduce the number of leads we derive from our website. Because our website is our primary client acquisition tool, any resistance by consumers to register on our website would harm our business and results of operations, and could cause us to alter our business practices or incur significant expenses to educate consumers regarding the use we make of information.
We may need to change the manner in which we conduct our business if government regulation of the Internet increases.
     The adoption or modification of laws or regulations relating to the Internet could adversely affect the manner in which we currently conduct our business. In addition, the growth and development of the market for online commerce may lead to more stringent consumer protection laws that may impose additional burdens on us. Laws and regulations directly applicable to communications or commerce over the Internet are becoming more prevalent. For example, both the U.S. government and the State of California have enacted Internet laws regarding privacy and sharing of customer information with third parties. Laws applicable to the Internet remain largely unsettled, even in areas where there has been some legislative action. It may take years to determine whether and how existing laws such as those governing intellectual property, privacy, libel and taxation apply to the Internet.
     In addition, because each state in which we do business requires us to be a licensed real estate broker, and residents of states in which we do not do business could potentially access our website, changes in Internet regulation could lead to situations in which we are considered to “operate” or “do business” in such states. Any such change could result in potential claims or regulatory action.
     If we are required to comply with new regulations or new interpretations of existing regulations, we may not be able to differentiate our services from traditional competitors and may not attract a sufficient number of clients for our business to be successful.

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Our operating results are subject to seasonality and vary significantly among quarters during each calendar year, making meaningful comparisons of successive quarters difficult.
     The residential real estate market traditionally has experienced seasonality, with a peak in the spring and summer seasons and a decrease in activity during the fall and winter seasons. Revenues in each quarter are significantly affected by activity during the prior quarter, given the typical 30- to 45-day time lag between contract execution and closing. Historically, this seasonality has caused our revenues, operating income, net income and cash flow from operating activities to be lower in the first and fourth quarters and higher in the second and third quarters of each year. However, there can be no assurance that the seasonality pattern for fiscal year 2007 or any fiscal year will be consistent, and macroeconomic changes in the market could mask the impact of seasonality.
     Factors affecting the timing of real estate transactions that can cause our quarterly results to fluctuate include:
    timing of widely observed holidays and vacation periods and availability of home buyers and sellers, real estate agents and related service providers during these periods;
 
    a desire to relocate prior to the start of the school year;
 
    inclement weather, which can influence consumers’ desire or ability to visit properties;
 
    timing of employment compensation changes, such as raises and bonuses;
 
    the time between entry into a purchase contract for real estate and closing of the transaction; and
 
    the levels of housing inventory available for sale.
     We expect our revenues to continue to be subject to these seasonal fluctuations, which, combined with our recent growth and macroeconomic market changes, make it difficult to compare successive quarters.
Our reputation and client and agent service offerings may be harmed by system failures and computer viruses.
     The performance and reliability of our technology infrastructure is critical to our reputation and ability to attract and retain clients and agents. Our network infrastructure is currently co-located at a single facility in Sunnyvale, California and we do not currently operate a back-up facility. As a result, any system failure or service outage at this primary facility would result in a loss of service for the duration of the failure or outage. Any system error or failure, or a sudden and significant increase in traffic, may significantly delay response times or even cause our system to fail resulting in the unavailability of our Internet platform. For example, in the summer of 2006 we experienced unscheduled outages in our website and ZAP system due to our rollout of new software and in 2005 we experienced an unscheduled outage that lasted approximately 12 hours. During this period our clients and prospective clients were unable to access our website or receive notifications of new listings. While we have taken measures to prevent unscheduled outages, outages may occur in the future. In addition, our systems and operations are vulnerable to interruption or malfunction due to certain events beyond our control, including natural disasters, such as earthquakes, fire and flood, power loss, telecommunication failures, break-ins, sabotage, computer viruses, intentional acts of vandalism and similar events. Our network infrastructure is located in the San Francisco Bay area, which is susceptible to earthquakes and has, in the past, experienced power shortages and outages, any of which could result in system failures and service outages. We may not be able to expand our network infrastructure, either on our own or through use of third party hosting systems or service providers, on a timely basis sufficient to meet demand. Any interruption, delay or system failure could result in client and financial losses, litigation or other consumer claims and damage to our reputation.
Our business is geographically concentrated, which makes us more susceptible to business interruption and financial loss due to natural disasters, inclement weather, economic or market conditions or other regional events outside of our control.
     Presently, our business is conducted principally in a few states in the western United States, especially California, and along the eastern seaboard. For example, we derived approximately 35% of our net transaction revenues in the quarter ended September 30, 2007 in the State of California. In addition, our servers and other technology infrastructure are located principally in the State of California. Our geographic concentration makes us as a whole more vulnerable to the effects of regional disasters in these areas, such

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as earthquakes, harsh weather, economic or market conditions or other events outside of our control, such as shifts in populations away from markets that we serve. These events could cause us to sustain a business interruption or other financial loss that would be greater than if our business were more dispersed geographically.
Our intellectual property rights are valuable and our failure to protect those rights could adversely affect our business.
     Our intellectual property rights, including existing and future patents, trademarks, trade secrets and copyrights, are and will continue to be valuable and important assets of our business. We believe that our proprietary ZAP technology and ZipNotify, as well as our ability to interoperate with multiple MLSs and our other technologies and business practices, are competitive advantages and that any duplication by competitors would harm our business. We have taken measures to protect our intellectual property, but these measures may not be sufficient or effective. For example, we seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements. We also seek to maintain certain intellectual property as trade secrets. Intellectual property laws and contractual restrictions may not prevent misappropriation of our intellectual property or deter others from developing similar technologies. In addition, others may develop technologies that are similar or superior to our technology, including our patented technology. Any significant impairment of our intellectual property rights could harm our business.
We may in the future be subject to intellectual property rights disputes, which could divert management attention, be costly to defend and require us to limit our service offerings.
     Our business depends on the protection and utilization of our intellectual property. Other companies may develop or acquire intellectual property rights that could prevent, limit or interfere with our ability to provide our products and services. One or more of these companies, which could include our competitors, could make claims alleging infringement of their intellectual property rights. Any intellectual property claims, with or without merit, could be time-consuming and expensive to litigate or settle and could significantly divert management resources and attention.
     Our technologies may not be able to withstand any third-party claims or rights against their use. If we were unable to defend successfully against such claims, we may have to:
    pay damages;
 
    stop using the technology found to be in violation of a third party’s rights;
 
    seek a license for the infringing technology; or
 
    develop alternative non-infringing technology.
     If we need to obtain a license for the infringing technology, it may not be available on reasonable terms, if at all. Developing alternative non-infringing technology could require significant effort and expense. If we cannot license or develop alternative technology for the infringing aspects of our business on attractive terms, we may be forced to limit our product and service offerings. Any of these results could reduce our ability to compete effectively, and harm our business and results of operations.
We have undergone significant management transitions recently and need to successfully integrate new members of the management team as well as retain key personnel or our business could be harmed.
     The loss of the services of one or more of our key personnel could seriously harm our business. For example, Gary M. Beasley, our former President and Chief Financial Officer, departed on January 5, 2007 and Richard F. Sommer, our fomer Chief Executive Officer, departed on June 4, 2007. Mr. Sommer was succeeded by Mr. Joseph Patrick Lashinsky, who assumed the position of President on January 8, 2007 and the additional position of Chief Executive Officer on June 4, 2007, and Mr. David A. Rector assumed the position of Chief Financial Officer on May 3, 2007. Our success depends on the contributions of Mr. Lashinsky and other senior level sales, operations, marketing, technology and financial officers. Our business plan was developed in large part by our senior level officers and its implementation requires their skills and knowledge. With the exception of Mr. Lashinsky, none of our officers or key employees has an employment agreement, and their employment is at will. We do not have “key person” life insurance policies covering any of our executives.

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We intend to evaluate acquisitions or investments in complementary technologies and businesses and we may not realize the anticipated benefits from, and may have to pay substantial costs related to, any acquisitions or investments that we undertake.
     As part of our business strategy, we plan to evaluate acquisitions of, or investments in, complementary technologies and businesses. We may be unable to identify suitable acquisition candidates in the future or be able to make these acquisitions on a commercially reasonable basis, or at all. If we complete an acquisition or investment, we may not realize the benefits we expect to derive from the transaction. Any future acquisitions and investments would have several risks, including:
    our inability to successfully integrate acquired technologies or operations;
 
    diversion of management’s attention;
 
    problems maintaining uniform standards, procedures, controls and policies;
 
    potentially dilutive issuances of equity securities or the incurrence of debt or contingent liabilities;
 
    expenses related to amortization of intangible assets;
 
    risks associated with operating a business or in a market in which we have little or no prior experience;
 
    potential write offs of acquired assets;
 
    loss of key employees of acquired businesses; and
 
    our inability to recover the costs of acquisitions or investments.
The value of our services could be diminished if anti-spam software filters out an increasing portion of the emails we send.
     Our ZAP system includes a feature that sends out personalized email messages to our registered users on behalf of our agents. Given the volume of these messages, anti-spam software used by Internet service providers and personal computer users sometimes treats these messages incorrectly as unsolicited email, or “spam,” and filters them out. If this problem becomes more pervasive, the value of this aspect of our marketing and communication approach could be diminished, which could harm our business.
As we implement changes in our agent compensation policies, we may incent behaviors that cause a decrease in our profit margin with the goal of increasing our profits.
     From time to time, we implement changes to our agent compensation policies to achieve certain goals, for example, the improvement of agent productivity and retention. Recently, we implemented a program to pay higher commission splits to a select number of our agents as the cumulative number of deals they close increases. Our goal for this program is to incent all of our agents to achieve higher levels of productivity and to thereby increase our profits. However, we anticipate that the implementation of this program may cause a slight decrease in our gross margin. We may, in the future, opt to implement additional changes in our agent compensation policies that may decrease our profit margins with the goal of increasing our profits.
OTHER RISKS RELATED TO OUR STOCK PRICE
Our stock price may be volatile.
     The trading price of our common stock may fluctuate widely, depending upon many factors, some of which are beyond our control. These factors include, among others, the risks identified above and the following:
    variations in our quarterly results of operations;
 
    announcements by us or our competitors or lead source providers;

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    the relatively low level of public float and average daily trading volumes of our common stock;
 
    changes in estimates of our performance or recommendations, or termination of coverage by securities analysts;
 
    inability to meet quarterly or yearly estimates or targets of our performance;
 
    the hiring or departure of key personnel, including agents or groups of agents or key executives;
 
    changes in our reputation;
 
    acquisitions or strategic alliances involving us or our competitors;
 
    changes in the legal and regulatory environment affecting our business; and
 
    market conditions in our industry and the economy as a whole.
     In addition, the stock market in general, and the market for technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our actual operating performance. Also, in the past, following periods of volatility in the overall market and the market price of a company’s securities, securities class action litigation has often been instituted against these companies. Such litigation, if instituted against us, could result in substantial costs and a diversion of our management’s attention and resources and could harm the price of our common stock. Although we carry general liability and errors and omissions insurance, our insurance may not cover claims of these types or may be inadequate to protect us from all liability that we may incur.
Our share price could decline due to the large number of outstanding shares of our common stock eligible for future sale.
     The market price of our common stock could decline as a result of sales of substantial amounts of our common stock in the public market, or from the perception that these sales could occur. These sales could also make it more difficult for us to sell our equity or equity-related securities in the future at a time and price that we deem appropriate.
     As of September 30, 2007, we had 23,279,205 shares of common stock outstanding. All of these shares are eligible for sale, subject in some cases to the volume and other restrictions of Rule 144 and Rule 701 under the Securities Act of 1933.
     In addition, we have registered approximately 6.0 million shares of common stock that have been issued or reserved for future issuance under our stock incentive plans. Of those shares, options for 1,908,734 shares were exercisable as of September 30, 2007 and, if those options are exercised, those shares are eligible for sale. Also as of September 30, 2007, we had outstanding warrants for 1,385,298 shares that were fully vested and, if those warrants are exercised, those shares will be eligible for sale, subject to any Rule 144 waiting periods, volume, and other restrictions. As of November 1, 2007, warrants for 1,184,917 of those shares remained outstanding. Nearly all of those warrants (representing 1,181,633 shares) are exercisable at $3.93 per share and expire on the following dates: December 17, 2007 (965,875 shares), February 18, 2008 (31,491 shares), and June 27, 2008 (184,267 shares). Any sales of those shares prior to expiration of the warrants could have a dilutive effect on our stock price.
Our principal stockholders, executive officers and directors own a significant percentage of our stock, and as a result, the trading price for our shares may be depressed and these stockholders can take actions that may be adverse to your interests.
     Our executive officers and directors and entities affiliated with them, in the aggregate, beneficially own nearly half of our common stock. This significant concentration of share ownership may adversely affect the trading price for our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders. These stockholders, acting together, will have the ability to exert control over all matters requiring approval by our stockholders, including the election and removal of directors and any proposed merger, consolidation or sale of all or substantially all of our assets. In addition, these stockholders who are executive officers or directors, or who have representatives on our Board of Directors, could dictate the management of our business and affairs. This concentration of ownership could have the effect of delaying, deferring or preventing a change in control, or impeding a merger or consolidation, takeover or other business combination that could be favorable to our other stockholders.

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     Our charter documents and Delaware law could prevent a takeover that stockholders consider favorable and could also reduce the market price of our stock.
     Our amended and restated certificate of incorporation and our bylaws contain provisions that could delay or prevent a change in control of our company. These provisions could also make it more difficult for stockholders to elect directors and take other corporate actions. These provisions include:
    providing for a classified board of directors with staggered, three-year terms;
 
    not providing for cumulative voting in the election of directors;
 
    authorizing the board to issue, without stockholder approval, preferred stock with rights senior to those of common stock;
 
    prohibiting stockholder action by written consent;
 
    limiting the persons who may call special meetings of stockholders; and
 
    requiring advance notification of stockholder nominations and proposals.
     In addition, the provisions of Section 203 of Delaware General Corporate Law govern us. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging or combining with us for a certain period of time.
     These and other provisions in our amended and restated certificate of incorporation, our bylaws and under Delaware law could discourage potential takeover attempts, reduce the price that investors might be willing to pay for shares of our common stock in the future and result in the market price being lower than it would be without these provisions.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds:
     On November 9, 2004, the Securities and Exchange Commission declared effective our Registration Statement on Form S-1 (File No. 333-115657) for our initial public offering. We commenced our offering immediately thereafter. We completed our sale of 4,550,000 shares of common stock on November 15, 2004 at a price of $13.00 per share, and on November 18, 2004 we sold the remainder of our registered shares of common stock (682,500 shares) at the same price per share pursuant to the underwriters’ exercise of the over-allotment option. UBS Securities LLC, Deutsche Bank Securities Inc., Thomas Weisel Partners LLC and Pacific Growth Equities, LLC acted as the underwriters for the offering.
     The aggregate purchase price of the offering was $68,022,500. The net offering proceeds received by us after deducting total estimated expenses were $61,402,757. We incurred total estimated expenses in connection with the offering of $6,619,743, which consisted of $1,795,943 in legal, accounting and printing fees, $4,761,575 in underwriters’ discounts, fees and commissions, and $62,225 in miscellaneous expenses. No payments for such expenses were made directly or indirectly to (i) any of our directors, officers or their associates, (ii) any person owning 10% or more of any class of our equity securities or (iii) any of our affiliates.
     We have not used any of the net offering proceeds from the offering for operational purposes. We currently estimate that we will use the net proceeds as described in the prospectus for the offering: for general corporate purposes, including working capital. We have not assigned specific portions of the net proceeds for any particular uses, and we will retain broad discretion in the allocation of the net proceeds. Although we evaluate potential acquisitions of complementary businesses, technologies or other assets in the ordinary course of business, we have no specific understandings, commitments or agreements with respect to any acquisition at this time.

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     Pending such uses, we have invested all of the net proceeds from the offering in short-term, investment-grade securities. We cannot predict whether the net proceeds invested will yield a favorable return.
Item 5. Other Information:
     The Company hereby clarifies a statement made during the question and answer portion of its November 7, 2007 earnings call concerning its expense reimbursement policy: For California agents, the Company reimburses all necessary and reasonable business expenses that agents incur as a result of their job performance, as set forth in its expense reimbursement policy. For agents outside of California, the Company reimburses certain necessary and reasonable business expenses, subject to specific limitations set forth in its expense reimbursement policy, after agents have achieved certain pre-determined performance standards. Additionally, the Company bears the cost of providing materials and services related to marketing a home listed with the company.
Item 6. Exhibits:
     The exhibits listed in the Exhibit Index are filed as a part of this report.

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SIGNATURE
     Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
         
  ZIPREALTY, INC.
 
 
  By:   /s/ David A. Rector    
    David A. Rector   
    Senior Vice President and Chief Financial Officer   
 
     Date: November 9, 2007

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Exhibit Index
     
Exhibit number   Description
3.1(a)(1)
  Amended and Restated Certificate of Incorporation
 
   
3.2(a)(1)
  Bylaws
 
   
10.1(2)*
  Separation Agreement and Release with Richard W. Williams dated September 14, 2007
 
   
10.2(2)*
  Restricted Stock Award Agreement with J. Patrick Lashinsky dated September 13, 2007
 
   
10.3(2)*
  Stock Option Award Agreement with J. Patrick Lashinsky dated September 13, 2007
 
   
31.1
  Certification of Chief Executive Officer, as required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934
 
   
31.2
  Certification of Chief Financial Officer, as required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934
 
   
32.1
  Certification of Chief Executive Officer, as required by Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350)
 
   
32.2
  Certification of Chief Financial Officer, as required by Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350)
 
(1)   Incorporated by reference to the exhibit of the same number to the Registrant’s Registration Statement on Form S-1(File No. 333-115657) filed with the Securities and Exchange Commission on May 20, 2004, as amended.
 
(2)   Incorporated by reference to the exhibit of the same number to the Registrant’s Current Report on Form 8-K (File No. 000-51002) filed with the Securities and Exchange Commission on September 19, 2007.
 
*   Identifies a management contract or compensatory plan or agreement required to be filed as an exhibit of this report.

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