Isilon Systems, Inc. - FORM 10-Q

Attached files

file	filename
EX-31.2 - SECTION 302 CFO CERTIFICATION - Isilon Systems, Inc.	dex312.htm
EX-32.2 - SECTION 906 CFO CERTIFICATION - Isilon Systems, Inc.	dex322.htm
EX-31.1 - SECTION 302 CEO CERTIFICATION - Isilon Systems, Inc.	dex311.htm
EX-32.1 - SECTION 906 CEO CERTIFICATION - Isilon Systems, Inc.	dex321.htm
EX-10.1 - FORM OF CHANGE OF CONTROL SEVERANCE AGREEMENT (CEO) - Isilon Systems, Inc.	dex101.htm
EX-10.2 - FORM OF CHANGE OF CONTROL SERVERANCE AGREEMENT (SECTION 16) - Isilon Systems, Inc.	dex102.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

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

For the quarterly period ended September 30, 2010

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

For the transition period from to

Commission File Number 001-33196

Isilon Systems, Inc.

(Exact name of registrant as specified in its charter)


Delaware		91-2101027
(State or other jurisdiction of		(IRS Employer
incorporation or organization)		Identification No.)

3101 Western Ave
Seattle, WA		98121
(Address of principal executive offices)		(Zip code)

Registrant’s telephone number, including area code:

206-315-7500

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 x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.


Large accelerated filer ¨		Accelerated filer x		Non-accelerated filer ¨		Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x

As of October 18, 2010, 66,402,053 shares of the registrant’s Common Stock were outstanding.

TABLE OF CONTENTS


Part I – Financial Information
Item 1.	Financial Statements (Unaudited)	3
	Consolidated Statements of Operations for the three and nine months ended September 30, 2010 and September 30, 2009	3
	Consolidated Balance Sheets as of September 30, 2010 and December 31, 2009	4
	Consolidated Statements of Cash Flows for the three and nine months ended September 30, 2010 and September 30, 2009	5
	Notes to Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	23
Item 4.	Controls and Procedures	23

Part II – Other Information
Item 1.	Legal Proceedings	24
Item 1A.	Risk Factors	24
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	35
Item 3.	Defaults Upon Senior Securities	35
Item 5.	Other Information	35
Item 6.	Exhibits	35

Signatures		36
EXHIBIT 10.1
EXHIBIT 10.2
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I – FINANCIAL INFORMATION

ITEM 1. Financial Statements

Isilon Systems, Inc.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except per share data)


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2010			2009			2010			2009
Revenue:
Product	$	42,912		$	22,835		$	107,790		$	64,531
Services		10,934			7,669			30,397			21,849

Total revenue		53,846			30,504			138,187			86,380

Cost of revenue:
Product		15,228			9,631			40,038			29,691
Services (1)		4,435			3,510			11,708			11,972

Total cost of revenue		19,663			13,141			51,746			41,663


Gross profit		34,183			17,363			86,441			44,717

Operating expenses:
Research and development (1)		6,745			5,902			18,597			18,148
Sales and marketing (1)		17,348			10,843			45,557			32,443
General and administrative (1)		4,070			3,439			10,968			10,776
Restructuring charges		—			—			—			357
Legal settlement		—			2,000			—			2,000
Legal expenses associated with indemnification obligations and other related costs, net		2,300			124			3,551			405

Total operating expenses		30,463			22,308			78,673			64,129


Income (loss) from operations		3,720			(4,945	)		7,768			(19,412	)
Other income (expense), net		332			164			(239	)		702


Income (loss) before income tax expense		4,052			(4,781	)		7,529			(18,710	)


Income tax expense		(64	)		(86	)		(413	)		(304	)


Net income (loss)	$	3,988		$	(4,867	)		7,116		$	(19,014	)

Net income (loss) per common share

Basic	$	0.06		$	(0.08	)	$	0.11		$	(0.30	)

Diluted	$	0.05		$	(0.08	)	$	0.10		$	(0.30	)

Shares used in computing net income (loss) per common share

Basic		66,036			64,550			65,533			64,184
Diluted		73,547			64,550			71,697			64,184

(1)Includes stock-based compensation as follows:
Cost of revenue	$	118		$	60		$	299		$	202
Research and development		531			402			1,602			1,256
Sales and marketing		1,247			418			2,692			1,339
General and administrative		1,048			545			2,260			1,536

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

Isilon Systems, Inc.

CONSOLIDATED BALANCE SHEETS

(unaudited)

(in thousands, except per share data)


	As of
	September 30, 2010			December 31, 2009
	(in thousands)
ASSETS
Current assets:
Cash and cash equivalents	$	19,843		$	23,135
Marketable securities		93,963			56,019
Trade receivables, net		26,508			20,824
Inventories		7,526			5,636
Other current assets		7,053			5,819

Total current assets		154,893			111,433

Property and equipment, net		6,584			6,660

Total assets	$	161,477		$	118,093

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		10,589			7,313
Accrued liabilities		6,024			5,155
Accrued compensation and related benefits		9,654			6,828
Deferred revenue		32,313			24,421

Total current liabilities		58,580			43,717

Deferred revenue, net of current portion		23,096			13,380
Deferred rent, net of current portion		2,247			2,717

Total liabilities		83,923			59,814


Commitments and contingencies (Note 11)

Stockholders’ equity:
Common stock, par value $0.00001: 250,000 authorized; 66,362 and 64,965 shares issued and outstanding		1			1
Additional paid-in capital		217,353			205,192
Accumulated other comprehensive loss		(375	)		(373	)
Accumulated deficit		(139,425	)		(146,541	)

Total stockholders’ equity		77,554			58,279

Total liabilities and stockholders’ equity	$	161,477		$	118,093

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

Isilon Systems, Inc.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2010			2009			2010			2009
Cash flows from operating activities:
Net income (loss)	$	3,988		$	(4,867	)	$	7,116		$	(19,014	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization		1,014			1,445			3,242			4,629
Amortization of discount on marketable securities		372			187			926			327
Stock-based compensation expense		2,943			1,425			6,852			4,333
Changes in operating assets and liabilities:
Accounts receivable, net		(6,339	)		(2,361	)		(5,697	)		(3,519	)
Inventories, net		(574	)		62			(1,890	)		6,467
Other current assets		2,397			(37	)		(1,232	)		(6	)
Accounts payable		413			1,164			2,814			(840	)
Accrued liabilities, compensation and deferred rent		929			1,404			3,231			1,877
Deferred revenue		7,931			2,457			17,608			5,394

Net cash provided by (used in) operating activities		13,074			879			32,970			(352	)

Cash flows from investing activities:
Purchases of property and equipment		(1,513	)		(212	)		(2,757	)		(1,483	)
Purchases of marketable securities		(34,707	)		(9,110	)		(95,876	)		(35,092	)
Proceeds from sales and maturities of marketable securities		21,698			6,850			57,007			31,175

Net cash used in investing activities		(14,522	)		(2,472	)		(41,626	)		(5,400	)

Cash flows from financing activities:
Proceeds from exercise of stock options		1,626			1,139			3,695			1,566
Proceeds from employee stock purchase plan		1,103			—			1,676			—

Net cash provided by financing activities		2,729			1,139			5,371			1,566

Effect of exchange rate changes on cash and cash equivalents		63			9			(7	)		110

Net increase (decrease) in cash and cash equivalents		1,344			(445	)		(3,292	)		(4,076	)
Cash and cash equivalents at beginning of period		18,499			30,711			23,135			34,342

Cash and cash equivalents at end of period	$	19,843		$	30,266		$	19,843		$	30,266

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

Isilon Systems, Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Organization and Significant Accounting Policies

Organization

Isilon Systems, Inc. (the “Company” or “Isilon”) designs, develops and markets unified scale-out storage systems for storing and managing data. The Company sells systems that generally include a software license, hardware, post-contract customer support and, in some cases, additional services or applications.

Significant Accounting Policies

Accounting Principles

The consolidated financial statements and accompanying notes were prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).

Basis of Presentation

The accompanying unaudited consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2009 filed with the Securities and Exchange Commission (“SEC”) on February 5, 2010.

These financial statements include all adjustments which, in the opinion of management, are necessary for a fair statement of the financial position, results of operations and cash flows for the periods presented. Operating results for the three and nine months ended September 30, 2010, are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2010.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Significant estimates are inherent in the preparation of the consolidated financial statements and include accounting for revenue, the allowance for doubtful accounts, obsolete and excess inventory, the valuation allowance for deferred tax assets, and the calculation of stock-based compensation expense. Some of these estimates require difficult, subjective or complex judgments about matters that are uncertain. Actual results could differ from those estimates.

Concentration of Risks

The Company’s cash and cash equivalents are invested with financial institutions in deposits that may exceed federally insured limits. The Company has not experienced any losses on its deposits of cash and cash equivalents.

The Company does not require collateral to support credit sales. Allowances are maintained for potential credit losses. During the three and nine months ended September 30, 2010 and 2009, no single customer represented more than 10% of total revenue. As of September 30, 2010 and December 31, 2009, no single customer represented more than 10% of total net accounts receivable.

The Company is dependent on two contract manufacturers for its products, and certain key components in its products come from single or limited sources of supply.

Revenue Recognition

The Company derives its revenue from sales of its products and services. Product revenue consists of sales of hardware systems and software. The Company’s OneFS operating system software is integrated with industry standard hardware and is essential to the functionality of the integrated system product. The Company also sells optional software applications. Substantially all of the Company’s products are sold in combination with services, which primarily consist of hardware and software support. Hardware

Isilon Systems, Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

support includes Internet access to technical content through the Company’s knowledge database, onsite repair or replacement of hardware in the event of breakage or failure, and telephone and Internet access to technical support personnel during the term of the support period. Software support includes software subscriptions which provide customers with rights to unspecified software updates and enhancements and to maintenance releases and patches released during the term of the support period, on a when and if available basis. Installation services, when provided, are also included in services revenue.

The Company recognizes product revenue when it has entered into an arrangement with a customer, delivery has occurred, the fee is deemed fixed or determinable and free of significant contingencies and uncertainties, and collection is reasonably assured. On sales to channel partners, the Company evaluates whether fees are considered fixed or determinable by considering a number of factors, including the Company’s ability to estimate returns, the geography in which a sales transaction originates, payment terms and the Company’s relationship and past history with the particular channel partner. If fees are not considered fixed or determinable at the time of sale to a channel partner, revenue recognition is deferred until there is persuasive evidence indicating product has sold-through to an end-user. Persuasive evidence of sell-through may include reports from channel partners documenting sell-through activity, copies of end-user purchase orders, data indicating an order has shipped to an end-user, cash payments or letters of credit guaranteeing cash payments or other similar information.

Products are typically considered delivered upon shipment. At the time of shipment, the Company records revenue reserves for estimated sales returns and stock rotation arrangements. Sales returns and stock rotation reserves are estimated based on historical activity and expectations of future experience. The Company monitors and analyzes actual experience and adjusts these reserves on a quarterly basis.

In instances where final acceptance of the product, system, or solution is specified by the customer, revenue is deferred until all acceptance criteria have been deemed satisfied or the acceptance clause or contingency lapses. Hardware and software support services revenue is deferred and recognized ratably over the period during which the services are to be performed, which is typically from one to three years. Installation services revenue is recognized upon completion of the installation. Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue.

In October 2009, the Financial Accounting Standards Board (FASB) amended the accounting standards for revenue recognition to remove tangible products containing software components and non-software components that function together to deliver the product’s essential functionality from the scope of industry-specific software revenue recognition guidance. The FASB also amended the accounting standards for multiple deliverable revenue arrangements to:

provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and how the consideration should be allocated;

ii)

require an entity to allocate revenue in an arrangement using estimated selling prices (ESP) of deliverables if a vendor does not have vendor-specific objective evidence (VSOE) or third-party evidence (TPE) of selling price; and

iii)

eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method.

The Company elected to early adopt this accounting guidance at the beginning of its first quarter of fiscal year 2010 on a prospective basis for applicable transactions originating after January 1, 2010. As a result of the adoption of this standard, revenue increased by approximately $200,000 and decreased by approximately $450,000 during the three and nine months ended September 30, 2010, respectively. This guidance does not change the units of accounting for the Company’s revenue transactions.

Most products and services qualify as separate units of accounting. For multi-element arrangements that include tangible products containing software essential to the tangible product’s functionality and undelivered software elements relating to the tangible product’s essential software, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the newly adopted accounting principles establish a hierarchy to determine the selling price to be used for allocating revenue to deliverables as follows: (i) VSOE, (ii) TPE and (iii) ESP.

The Company establishes VSOE of selling price for both support services, which is based on the renewal prices paid by the Company’s customers when the services are sold separately on a standalone basis, and installation services, which is based on the price separately charged to the Company’s customers for the same or similar services. The Company is unable to obtain reliable TPE because of the unique nature of the Company’s products. The Company calculates ESP for hardware and software products using a method consistent with the way management prices and markets products. The ESP incorporates multiple factors that the

Isilon Systems, Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Company considers in developing the ESPs for its products including the Company’s historical pricing practices, the costs incurred to manufacture the product, the nature of the customer relationship, and market trends. The Company periodically reviews VSOE and ESP and maintains internal controls over the establishment and updates of these estimates.

The Company recognizes revenue in accordance with industry specific software accounting guidance for the following types of sales transactions: (i) standalone sales of optional software application products and (ii) sales of support services related to standalone software products. For such transactions, the Company has established VSOE for the fair value of support services as measured by the renewal prices paid by its customers when the services are sold separately on a standalone basis. The Company uses the residual method to determine the amount of software product revenue to be recognized. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the sales amount is recognized as product revenue.

Accounting for Stock-Based Compensation

The Company accounts for stock-based compensation expense based on the estimated fair value of the stock-based awards as of the grant or modification date. The fair value of restricted stock units is determined based on the number of shares granted and the quoted price of the Company’s common stock at the grant date. The fair value of stock option awards is determined using the Black-Scholes option valuation model, which requires the input of subjective assumptions including the expected stock price volatility, the calculation of expected term, and the fair value of the underlying common stock on the date of grant, among other inputs. Stock compensation expense is recognized on a straight-line basis over each optionee’s requisite service period, which is generally the vesting period.

The Company bases its estimate of expected volatility on reported market value data for a group of publicly traded companies, which were selected from market indices that are believed would be indicators of its future stock price volatility, after consideration of their size, stage of lifecycle, profitability, growth, risk and return on investment as well as the Company’s own historical volatility. The Company calculates the expected term of its options using a blend of historical and forecasted Company data.

Stock-based compensation expense is recorded net of estimated forfeitures. Forfeitures are estimated based on historical forfeiture rates at the time of grant and this estimate is revised, if necessary, in subsequent periods. If the actual number of forfeitures differs from that estimated, adjustments may be required to stock-based compensation expense in future periods.

During the three and nine months ended September 30, 2010 and 2009, the Company recorded non-cash stock-based compensation expense of $2.9 million and $6.9 million, and $1.4 million and $4.3 million, respectively. As of September 30, 2010, total unrecognized compensation cost related to stock-based awards was $21.1 million, which will be recognized over the weighted-average remaining requisite service period of approximately 2.8 years. The Company recorded no tax benefit related to these options during the three and nine months ended September 30, 2010 and 2009 since a full valuation allowance is currently maintained on net deferred tax assets. In future periods, stock-based compensation expense is expected to increase as the Company records expense related to previously issued stock-based compensation awards and issues additional equity-based awards to continue to attract and retain key employees.

2. Restructuring Charges

In April 2009, the Company initiated a restructuring plan to reduce operating expenses in response to the uncertainties associated with the recent deterioration in the global economy. The restructuring plan consisted entirely of a reduction in workforce. As a result, during the second quarter of 2009, the Company recorded a restructuring charge of $357,000. This charge consisted of employee severance, benefits, and related costs and was recorded as a separate component of operating expenses within the consolidated statement of operations for the nine month period ended September 30, 2009. Of the total restructuring charges recorded, substantially all amounts were paid out during the quarter ended June 30, 2009.

3. Legal Settlement

On October 24, 2009, the Company filed a stipulation of settlement providing for the settlement and dismissal of the class action complaint which asserted claims under the federal securities laws. The settlement provided for a payment to the plaintiff class of $15.0 million, of which Isilon contributed $2.0 million and the balance was contributed by the Company’s insurers in December 2009. The amounts were paid into an escrow fund pending final court approval. The class action settlement was approved by the court on March 5, 2010. The $2.0 million for which the Company was responsible was included as a separate component of operating expenses within the consolidated statement of operations for the three and nine month periods ended September 30, 2009. The $2.0 million was paid during the quarter ended December 31, 2009.

Isilon Systems, Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

4. Net Income (Loss) Per Common Share

Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common and dilutive common stock equivalent shares outstanding during the period, determined using the treasury-stock method.

The following table sets forth the computation of basic and diluted net income (loss) per share (in thousands, except per share data):


	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2010		2009			2010		2009
Numerator
Net income (loss)	$	3,988	$	(4,867	)	$	7,116	$	(19,014	)
Denominator
Weighted average shares outstanding - basic		66,036		64,550			65,533		64,184
Dilutive effect of stock based awards		7,511		—			6,164		—
Weighted average shares outstanding - diluted		73,547		64,550			71,697		64,184
Basic net income (loss) per share	$	0.06	$	(0.08	)	$	0.11	$	(0.30	)
Diluted net income (loss) per share	$	0.05	$	(0.08	)	$	0.10	$	(0.30	)

For the three and nine months ended September 30, 2010, approximately 630,000 and 850,000 of common shares potentially issuable from stock options were excluded from the calculation of diluted earnings per share because the exercise price was greater than the average market price of common stock for the respective period. For the three and nine months ended September 30, 2009, approximately 9.6 million and 9.6 million of common shares were excluded because the impact of all potentially dilutive securities outstanding was anti-dilutive as the Company was in a net loss position. As such, both basic and diluted net loss per common share were the same for the three and nine months ended September 30, 2009.

5. Comprehensive Income (Loss)

Comprehensive income (loss) is as follows:


	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2010		2009			2010			2009
	(in thousands)					(in thousands)
Net income (loss)	$	3,988	$	(4,867	)	$	7,116		$	(19,014	)
Unrealized gain (loss) on marketable securities		6		(77	)		—			(281	)
Foreign currency translation adjustment		7		210			(3	)		226

Total comprehensive income (loss)	$	4,001	$	(4,734	)	$	7,113		$	(19,069	)

6. Marketable Securities

The appropriate classification of marketable securities is determined at the time of acquisition and reevaluated as of each balance sheet date. At their date of acquisition, the Company’s marketable securities were classified as available-for-sale, and are reported at fair value with the related unrealized gains and losses included as a separate component in stockholders’ equity. Realized gains and losses and declines in value of securities judged to be other than temporary are included in other income (expense), net. The fair value of marketable securities is based on quoted market prices, broker-dealer quotations or alternative pricing sources with reasonable levels of price transparency. Realized and unrealized gains and losses are based on the specific identification method. The Company’s investments in marketable securities are diversified among high-credit quality securities in accordance with the Company’s investment policy.

Marketable securities totaled $94 million as of September 30, 2010 and consisted of investments in commercial paper, corporate bonds and notes, and government securities. There were no realized gains, losses or other than temporary declines in the fair value on the marketable securities for the three and nine months ended September 30, 2010 and 2009.

Isilon Systems, Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

The fair value of the Company’s marketable securities fluctuates based on changes in market conditions and interest rates. Fixed rate securities may have their market value adversely impacted due to rising interest rates. In a declining interest rate environment, as short term investments mature, reinvestment occurs at less favorable market rates. Given the short-term maturities of the Company’s investments, management believes that these instruments are not subject to significant market or interest rate risk.

Marketable securities consists of the following:


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)
As of September 30, 2010
Commercial paper	$	1,649	$		$			$	1,649
Corporate bonds and notes		1,517							1,517
Government securities		90,770		32		(5	)		90,797

	$	93,936	$	32	$	(5	)	$	93,963

As of December 31, 2009
Commercial paper	$	2,547	$	—	$	—		$	2,547
Corporate bonds and notes		517		—		—			517
Government securities		52,926		53		(24	)		52,955

	$	55,990	$	53	$	(24	)	$	56,019

Fair Value Measurements

Fair value is defined as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, the authoritative guidance establishes a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require companies to develop their own assumptions. This hierarchy requires companies to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. On a recurring basis, the Company measures certain financial assets and liabilities at fair value, including its marketable securities.

The Company’s cash equivalents and marketable securities instruments are classified within Level 1 and Level 2 of the fair value hierarchy because they are valued using quoted market prices, broker-dealer quotations, or alternative pricing sources with reasonable levels of price transparency. The types of instruments valued based on quoted market prices in active markets include money market securities. Such instruments are generally classified within Level 1 of the fair value hierarchy. The types of instruments valued based on other observable inputs include investment-grade corporate bonds, mortgage-backed and asset-backed products, commercial paper, and state, municipal and provincial obligations, and government agencies. Such instruments are generally classified within Level 2 of the fair value hierarchy. There were no transfers between levels in the fair value hierarchy for the three and nine months ended September 30, 2010.

Isilon Systems, Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

The following table summarizes, by major security type, and categorized using the fair value hierarchy, the Company’s assets that are measured at fair value on a recurring basis (in thousands) as of September 30, 2010 and December 31, 2009:


	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs
	(Level 1)		(Level 2)
As of September 30, 2010
*Cash Equivalents:*
Money market fund	$	4,415	$	—
Government securities		—		1,751

	$	4,415	$	1,751
*Marketable securities:*
Government securities	$	—	$	90,797
Corporate debt securities		—		1,517
Commercial paper		—		1,649

	$	—	$	93,963

As of December 31, 2009
*Cash Equivalents:*
Money market fund	$	14,709	$	—
Government securities		—		2,396

	$	14,709	$	2,396
*Marketable securities:*
Government securities	$	—	$	52,955
Corporate debt securities		—		517
Commercial paper		—		2,547

	$	—	$	56,019

7. Inventories

The Company outsources the manufacturing of its products to contract manufacturers that assemble each product to the Company’s specifications. As protection against component shortages and to provide replacement parts for its service teams, the Company also stocks limited supplies of certain key product components.

Inventories consist of the following:


	As of
	September 30, 2010		December 31, 2009
	(in thousands)
Service inventory	$	3,722	$	2,728
Finished goods		1,348		830
Evaluation units		2,456		2,078

	$	7,526	$	5,636

At September 30, 2010 and December 31, 2009, component inventory, included in service inventory and finished goods, totaled $1.8 million and $1.1 million, respectively. Service inventory is also comprised of finished goods to support the Company’s field services organization. The Company reduces inventory to its estimated net realizable value by reserving for excess and obsolete inventories determined primarily based on historical usage, forecasted demand and evaluation unit conversion rate and age.

Isilon Systems, Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

During the first quarter of 2009, the Company recorded an inventory write-down of $3.8 million as the result of softening economic conditions as well as lower forecasted demand for certain products due to the anticipated migration to a new suite of products announced in March 2009.

8. Stockholders’ Equity

Stock Options

Detail related to stock option activity is as follows:


	Number of Shares Outstanding			Weighted- Average Exercise Price
Balance as of December 31, 2009		9,330,861		$	4.07
Options granted		4,619,289		$	10.33
Options exercised		(1,146,352	)	$	3.22
Options cancelled/forfeited		(516,791	)	$	4.97

Balance as of September 30, 2010		12,287,007		$	6.47

The total intrinsic value for options exercised during the nine months ended September 30, 2010 and 2009, was $7.4 million and $2.1 million, respectively, representing the difference between the estimated market value of our common stock underlying these options at the dates of exercise and the exercise prices paid.

The fair value of each stock option on the date of grant was estimated using the Black-Scholes option pricing model and the following assumptions were used for the valuations of options granted during the three and nine months ended September 30, 2010 and 2009:


	Three Months Ended		Nine Months Ended
	September 30, 2010	September 30, 2009	September 30, 2010	September 30, 2009
Risk-free interest rate	0.9% -1.2%	1.2% -2.0%	0.9% -1.9%	1.0% -2.3%
Expected term	2.5-3.5 years	2.5-4 years	2.5-3.5 years	2.5-4 years
Dividend yield	None	None	None	None
Volatility	52%	52% -54%	52 - 54%	51% -56%

The estimated weighted-average grant date fair value of options granted during the three months ended September 30, 2010 and September 30, 2009 was $6.80 and $2.01, respectively.

During the first quarter 2010, the Company adopted the Amended and Restated Employee Stock Purchase Plan (the “ESPP”) whereby employees may purchase shares of common stock through payroll deductions at a price per share that is 85% of the fair market value of the Company’s common stock on either the applicable purchase date or the offering date, whichever is lower. The ESPP plan has a period of six months. A total of 2,248,087 shares of the Company’s common stock have been reserved for sale under the ESPP. The total liability for the ESPP, for the purchase period which commenced in August 2010, is $636,000 as of September 30, 2010 and is included in accrued compensation and related benefits.

Restricted Stock Units

During the first quarter of 2010, the Company granted 86,490 restricted stock units (“RSUs”) to a group of its employees. RSUs are stock awards that are granted to employees entitling the holder to shares of common stock as the award vests. The Company measures the value of RSUs at fair value based on the number of shares granted and the quoted price of the Company’s common stock at the date of grant. The fair value is amortized as stock-based compensation expense over the vesting term of one to four years on the straight-line method. Total stock compensation expense related to RSUs during the three and nine months ended September 30, 2010 was $122,000 and $311,000. As of September 30, 2010, unrecognized compensation expense related to RSUs was approximately $321,000, which will be recognized over the remaining vesting term of the grants.

Isilon Systems, Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

9. Income Taxes

As of September 30, 2010, the Company had total net operating loss carryforwards for federal and state income tax purposes of $137 million. The benefits of net operating losses and other deferred tax assets are dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, net deferred tax assets have been fully offset by a valuation allowance. If not utilized, these net operating loss carryforwards will expire for federal purposes between 2021 and 2029. Utilization of these net operating loss carryforwards is subject to an annual limitation due to provisions of the Internal Revenue Code of 1986, as amended. Events that cause limitations in the amount of net operating losses that the Company may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50% of the Company’s stock, as defined, over a three-year period.

For the three and nine months ended, September 30, 2010 and 2009, the Company recorded income tax expense of $64,000 and $413,000 and $86,000 and $304,000, respectively, comprised primarily of foreign taxes. The effective rate for each of these respective periods differs from the federal statutory rate of 34% primarily due to the valuation allowance applied to the deferred tax benefit of U.S. losses, slightly offset by current tax expense in foreign jurisdictions.

10. Segment Information

Operating segments are defined as components of an enterprise for which separate financial information is available and evaluated regularly by the chief operating decision-maker, or decision-making group, in deciding how to allocate resources and in assessing performance. The Company is organized as, and operates in, one reportable segment: the development and sale of storage systems. The Company’s chief operating decision-maker is its Chief Executive Officer. The Company’s Chief Executive Officer reviews financial information presented on a consolidated basis, accompanied by information about revenue by geographic region, for purposes of evaluating financial performance and allocating resources. The Company and its Chief Executive Officer evaluate performance based primarily on revenue in the geographic locations in which the Company operates. Revenue is attributed by geographic location based on the location of the end customer. The Company’s assets are primarily located in the United States of America and not allocated to any specific region; therefore, geographic information is presented only for total revenue. During 2009, the Company replaced the United States geographic region with a North America geographic region which includes Canada and Mexico.

The following presents total revenue by geographic region:


	Three Months Ended				Nine Months Ended
	September 30, 2010		September 30, 2009		September 30, 2010		September 30, 2009
	(in thousands)				(in thousands)
North America (1)	$	40,653	$	23,359	$	99,977	$	64,786
Asia		6,739		4,081		20,822		13,577
Europe, Middle East, and Africa		6,454		3,064		17,388		8,017

Total	$	53,846	$	30,504	$	138,187	$	86,380

(1)	The Company recognized $39.8 million and $95.8 million, and $22.3 million and $62.1 million in revenue from customers in the United States for the three and nine months ended September 30, 2010 and 2009, respectively.

11. Commitments and Contingencies

Contractual Obligations

As of September 30, 2010, the Company’s principal commitments consisted of obligations outstanding under operating leases. The Company leases its facilities under operating leases that expire at various dates through 2014. There have been no material changes in the principal lease commitments compared to those discussed in the Annual Report on Form 10-K for the year ended December 31, 2009.

The Company typically maintains with its contract manufacturers, a rolling 90-day firm order for products that they manufacture on the Company’s behalf. These orders may only be rescheduled, modified, or cancelled by the contract manufacturers under certain circumstances. The remaining amount on the open purchase order with the contract manufacturers and other partners and suppliers at September 30, 2010 was approximately $6.9 million.

Isilon Systems, Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Legal Proceedings

On March 18 and 24, 2008, shareholder derivative actions were filed in the Superior Court of the State of Washington (King County), allegedly on behalf of and for the benefit of Isilon, against certain of the Company’s current and former directors and officers. Isilon is named as a nominal defendant. On April 17, 2008, the court consolidated these actions and appointed lead counsel. In re Isilon Systems, Inc. Derivative Litigation, Case No. 08-2-09536-3-SEA (Wash. Super. King County). The derivative complaints generally allege that the individual defendants breached fiduciary duties owed to Isilon by publicly misrepresenting the Company’s business prospects and failing to properly account for certain revenues recognized in the fourth quarter of and the fiscal year ended December 31, 2006, and in the first and second quarters of fiscal 2007. The complaints seek unspecified damages and equitable relief, disgorgement of compensation, attorneys’ fees, costs, and expenses. Because the complaints are derivative in nature, they do not seek monetary damages from Isilon. However, the Company may be required to advance the legal fees and costs incurred by the individual defendants.

By letter dated June 8, 2010 to the court, the parties reported that an agreement in principle had been reached to settle the derivative litigation and provided a signed Memorandum of Understanding. On August 20, 2010, the court issued an order preliminarily approving a settlement of the derivative litigation, and setting the matter for a final approval hearing on October 12, 2010. The terms of the settlement include payment of plaintiff’s attorney fees in the amount of $500,000 (which is covered by the Company’s insurers), and certain corporate therapeutic measures to be taken by the Company. On October 12, 2010, the court issued a final order dismissing with prejudice the derivative litigation.

On September 14, 2009, the Securities and Exchange Commission filed a federal civil action against the former CFO of the Company alleging various violations of federal securities regulations related to the Company’s prior restatement of financial statements (Securities and Exchange Commission v. Fuhlendorf, No. C-09-1292 (W.D. Wa.). This matter is currently in an active discovery phase, and trial is set for April 2011.

Pursuant to the Company’s charter documents and indemnification agreements, the Company has certain indemnification obligations to its current and former officers and directors, including the obligation to pay reasonable legal fees and expenses for matters covered within the scope of the agreement. Although the Company maintains insurance coverage up to certain prescribed and contracted amounts related to these indemnification obligations, such coverage is subject to limitations under the respective policies.

In connection with the SEC’s civil action against the Company’s former CFO, the Company, pursuant to its indemnification obligations, has incurred and will likely continue to incur substantial expenses related to legal fees and expenses advanced to its former CFO. During the three and nine months ended September 30, 2010, the Company incurred $2.3 million and $3.6 million in legal expenses related to this civil action. The Company has also incurred and will likely continue to incur substantial legal fees and expenses on behalf of current and former employees, officers and directors who are potential witnesses in the civil action.

In connection with the SEC’s civil action against the Company’s former CFO, a dispute has arisen between the Company and one of the Company’s insurance providers regarding the insurance provider’s obligations under its agreement with the Company. On August 27, 2010, the Company filed suit against the insurer alleging breach of contract, breach of implied covenant of good faith and fair dealing and for declaratory relief (Isilon Systems, Inc. vs. Twin City Fire Insurance Co.; C-10-1390 (W.D. Wa.).

A dispute has also arisen between the Company and its former CFO regarding the reasonableness of legal fees and expenses submitted to the Company for payment. The Company’s former CFO filed suit against the Company in Delaware on August 30, 2010, alleging breach of the indemnification agreement (Fuhlendorf vs. Isilon Systems, Inc.; C.A. No. 57772-VCN). The Company filed its answer to the lawsuit on September 24, 2010.

The Company’s overall directors’ and officers’ insurance for the respective policy period is restricted to certain prescribed and contracted amounts, and is subject to certain limitations. While the Company has been substantially reimbursed for such advances by four of its insurance carriers, the fifth insurance carrier (Twin City/Hartford) has refused to pay, leading to the above-referenced insurance coverage litigation. Moreover, such prescribed and contracted amounts may be exhausted prior to the current trial setting in April 2011.

All advances by the Company pursuant to its indemnification obligations are expensed as incurred. To the extent reimbursements are received or become receivable from the insurance carriers, such amounts are treated as a reduction in expense in the period in which it becomes estimable and probable that such reimbursement will be received. Amounts payable for these matters are included in accounts payable and accrued liabilities as appropriate. To the extent that these amounts are covered under the Company’s insurance policies, they are recorded as a receivable in current assets.

The Company’s potential indemnity obligations could result in significant liability to the Company and have a material adverse effect on the Company’s consolidated financial position, results of operations, and cash flows, to the extent that the advancement of fees and costs or ultimate indemnity obligations are not covered by, or exceed, the available directors’ and officers’ insurance.

ITEM 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Act”) and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by those sections. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to them. In some cases you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “potential,” and similar expressions intended to identify forward-looking statements. Examples of these statements include, but are not limited to, statements regarding competitive environment and the health of the overall storage sector and impact of U.S. and global macro-economic conditions; the anticipated growth of data; the expected demand for and benefits of our storage products; our future business plans and growth strategy; pricing pressures and fluctuations; our ability to improve existing products and to develop new and future products; our ability to attract new customers; our anticipated revenue and expenses; our ability to add value-added resellers and distributors and to sell our products domestically and internationally; our ability to realize operating leverage and realize efficiencies in our sales model by leveraging partners and distributors to sell to new and existing customers; seasonality in our business; anticipated results of potential or actual litigation or regulatory proceedings; our ability to manage our supply chain and improve operational efficiency; anticipated development or acquisition of intellectual property and resulting benefits; expected impacts of changes in accounting rules, including the impact on deferred tax benefits; the impact of governmental regulation; employee hiring and retention; the future payment of dividends, use of cash, cash needs and ability to raise capital; and potential liability from contractual relationships. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in Part II, Item 1A of this Quarterly Report on Form 10-Q and our other filings with the SEC. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. You should read this Quarterly Report on Form 10-Q completely and with the understanding that our actual future results may be materially different from what we expect. Except as required by law, we assume no obligation to update these forward-looking statements, whether as a result of new information, future events, or otherwise.

The following discussion and analysis should be read in conjunction with the unaudited financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Overview

We are a global provider of unified scale-out storage systems for storing and managing data. Our storage systems consist of three or more storage nodes. Each node is comprised of our proprietary OneFS operating system software and industry standard hardware components integrated into a self-contained, rack-mountable chassis. Customers can scale our storage systems incrementally as their needs grow by purchasing additional nodes or clusters of nodes from us to enhance storage capacity, performance or both. We also sell optional software applications that provide enhanced functionality to our systems. Substantially all of our products are sold in combination with services, which primarily consist of hardware and software support.

We market and sell our products directly and through multiple indirect sales channels in North America; Asia; and Europe, the Middle East, and Africa (EMEA). Our customer base spans a spectrum of industries including media and entertainment, life sciences, internet, government, and manufacturing.

We are headquartered in Seattle, Washington. Our personnel and operations are also located in Australia, Canada, China, France, Germany, India, Japan, Korea, Singapore, the United Kingdom and throughout the United States. We expect to continue to add personnel in the United States and internationally to provide additional geographic sales and technical support coverage.

Key Business Metrics

We monitor a number of key metrics to help forecast growth, establish budgets, measure the effectiveness of our sales and marketing efforts, and measure operational effectiveness.

New Customers and Repeat Sales Orders. Our goal is to attract a significant number of new customers and to encourage existing customers to purchase additional products, specifically our higher margin software applications, InsightIQ^®, SyncIQ^® , SnapshotIQ™, SmartConnect™, SmartPools™ and SmartQuotas™. A majority of our customers buy our storage systems and later add additional nodes or software applications as the need arises under our ‘pay-as-you-grow’ model. We monitor our sales to both new and existing customers and consider overall revenue concentration by customer type and geographic location as indicators of current and future trends.

Channel and Indirect Distribution Leverage. We are actively growing our relationships with channel and distribution partners to further penetrate our targeted markets domestically and internationally. We track our sales orders by direct or indirect customers with the goal of increasing revenue from channel partners.

Gross Margin. Some of the key factors affecting our gross margin are the revenue attributable to software applications as a percentage of total revenue, the rate at which our customers adopt our higher margin products, the timing of component cost reductions through product redesign, the timing of supplier cost reductions, the ability to manage inventory levels, the ability to control costs associated with servicing our customers and overall market conditions. We consider our ability to monitor and manage these factors to be a key aspect of attaining and expanding our profitability.

Operating and Free Cash Flow. We closely monitor our operating cash flow and free cash flow, measured as operating cash flow less cash used for the purchases of property and equipment, as a measure of our business performance. Some of the key factors affecting operating cash flow are our ability to generate net income and manage working capital. Our goal is to maximize cash flow while continuing to invest in our business. Our close tracking of operating cash flow allows us to better manage the cash needs of our business.

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with United States generally accepted accounting principles, or GAAP. These accounting principles require us to make certain estimates and judgments that can affect the reported amounts of assets and liabilities as of the dates of the consolidated financial statements, the disclosure of contingencies as of the dates of the consolidated financial statements, and the reported amounts of revenue and expenses during the periods presented. We believe the following to be our critical accounting policies because they are important to the portrayal of our financial condition and results of operations and they require critical management estimates and judgments about matters that are uncertain: revenue recognition, allowance for doubtful accounts, stock-based compensation, inventory valuation, and accounting for income taxes. See “Risk Factors” for certain matters that may affect our future financial condition or results of operations. Although we believe that our estimates and judgments are reasonable under the circumstances, actual results may differ from those estimates. These critical accounting policies are consistent with those disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009.

Results of Operations

The following discussion and analysis should be read in conjunction with our consolidated financial statements, related notes and risk factors included elsewhere in this Quarterly Report on Form 10-Q.

Revenue. We derive our revenue from sales of our products and services. Our customers typically purchase a cluster of our storage devices comprised of three or more nodes and related support services. Each node includes our OneFS^® operating system software and industry standard hardware. We offer various systems to meet customer-specific storage capacity and performance requirements. In addition, customers may purchase separate additional software applications for enhanced functionality. Substantially all of our products are sold in combination with services, which primarily consist of hardware and software support.

Our business is affected by economic conditions as our customers and suppliers respond to changes in their economic conditions. While the global economy appears to be recovering, the pace and trajectory of the recovery is varied by geography.


	Three Months Ended						Nine Months Ended
	September 30, 2010			September 30, 2009			September 30, 2010			September 30, 2009
				(dollars in thousands)
Revenue by type:
Product	$	42,912		$	22,835		$	107,790		$	64,531
Services		10,934			7,669			30,397			21,849

Total revenue	$	53,846		$	30,504		$	138,187		$	86,380

% revenue by type:
Product		80	%		75	%		78	%		75	%
Services		20			25			22			25

Total		100	%		100	%		100	%		100	%

Revenue by geography:
North America	$	40,653		$	23,359		$	99,977		$	64,786
Other International		13,193			7,145			38,210			21,594

Total revenue	$	53,846		$	30,504		$	138,187		$	86,380

% revenue by geography:
North America		75	%		77	%		72	%		75	%
Other International		25			23			28			25

Total		100	%		100	%		100	%		100	%

Revenue by sales channel:
Direct	$	19,570		$	12,654		$	48,443		$	38,294
Indirect		34,276			17,850			89,744			48,086

Total revenue	$	53,846		$	30,504		$	138,187		$	86,380

% revenue by sales channel:
Direct		36	%		41	%		35	%		44	%
Indirect		64			59			65			56

Total		100	%		100	%		100	%		100	%

Total revenue increased by $23.3 million, or 77%, and $51.8 million, or 60%, for the three and nine months ended September 30, 2010, from the comparable periods in the prior year. This increase is primarily attributable to significant increases in our indirect channel business, an expansion of our customer base and improving global economic conditions.

North America sales revenue increased 74% and 54% for the three and nine months ended September 30, 2010, from the comparable periods in the prior year. Other international sales revenue increased 85% and 77% for the three and nine months ended September 30, 2010, from the comparable periods in the prior year. This significant growth in both North America and other international revenue year over year is the result of increased sales efforts and channel expansion as well as global economic improvements. We plan to continue to expand into additional international locations and introduce our products in new markets both directly and indirectly through channel partners.

During the three and nine months ended September 30, 2010, we derived 64% and 65% of our total revenue from indirect channels compared to 59% and 56% in the comparable periods in 2009. The increase in indirect channel revenue is due to our focus on enhancing our relationships with indirect channel and distribution partners. No indirect channel or distribution partner accounted for more than 10% of our revenue during the three and nine months ended September 30, 2010 and 2009. We plan to continue to expand our relationships with indirect channel and distribution partners and over time expect the percentage of revenue generated through indirect channels to grow.

Our customer base increased 33% from September 30, 2009 to September 30, 2010, and the number of new customers added during the three and nine months ended September 30, 2010 was 96 and 267, respectively, bringing our total customer base to approximately 1,460. This increase is due, in part, to our focus on enhancing our relationships with our indirect channel and distribution partners who provide us with greater sales capacity.

For the three and nine months ended September 30, 2010, reorders from existing customers represented approximately 75% and 73% of product revenue, compared to 69% and 73% for the comparable periods in the prior year. The average initial order size increased 18% from the nine months ended September 30, 2009 to September 30, 2010, while the average reorder size increased 12% in the same comparative period.

Product revenue increased $20.1 million, or 88%, for the three months ended September 30, 2010 compared to the same period in the prior year primarily due to significant growth in North America, the expansion of our indirect channel sales and increases in our customer base as previously noted. North American product revenue increased by $15.2 million from the three months ended September 30, 2009 to the three months ended September 30, 2010. Product revenue increased $43.3 million, or 67%, for the nine months ended September 30, 2010 compared to the same period in the prior year due to both North American and other international growth, the expansion of our indirect channel sales and increases in our customer base as previously noted. North American product revenue increased by approximately $29.5 million from the nine months ended September 30, 2009 to the nine months ended September 30, 2010.

Services revenue includes support services for both our software and our hardware products. Services revenue increased $3.3 million, or 43%, and $8.5 million, or 39%, for the three and nine months ended September 30, 2010 compared to the same periods in the prior year. These increases in services revenue are the result of an increase in our customer base currently on service and maintenance contracts. Since many of our customers renew their services contracts, as our installed customer base grows we expect services revenue to continue to grow. Services revenue as a percentage of total revenue decreased to 20% and 22% for the three and nine months ended September 30, 2010 compared to 25% and 25% for the three and nine months ended September 30, 2009 due to the significant growth of product revenue during 2010.

Cost of Revenue and Gross Margin. Cost of product revenue consists primarily of amounts paid to our contract manufacturers in connection with the procurement of hardware components and assembly of those components into our systems, costs of shipping and logistics, and valuation reserves taken for excess and obsolete inventory. The components that are used in the assembly of our products include disk drives, memory and CPUs. Our contract manufacturers do not enter into long-term contracts for any of these components; thus, prices for these components are subject to fluctuations in the spot market, which can cause our cost of product revenue to fluctuate. Cost of services revenue is primarily comprised of salaries and employee benefits, hardware service replacements, and third-party costs in providing technical and logistical support.

Our gross margin has been and will continue to be affected by a variety of factors, including charges related to excess and obsolete inventory, average sales prices of our systems, the revenue attributable to sales of software applications as a percentage of total revenue, the rate at which our customers adopt our higher margin products and software applications, the timing of component cost reductions, the timing of supplier cost reductions, and overall market conditions.


	Three Months Ended						Nine Months Ended
	September 30, 2010			September 30, 2009			September 30, 2010			September 30, 2009
				(dollars in thousands)
Cost of revenue:
Product	$	15,228		$	9,631		$	40,038		$	29,691
Services		4,435			3,510			11,708			11,972

Total cost of revenue	$	19,663		$	13,141		$	51,746		$	41,663

Gross margin:
Product		65	%		58	%		63	%		54	%
Services		59			54			61			45
Total gross margin		63	%		57	%		63	%		52	%

Gross margin increased 6 percentage points to 63% and 11 percentage points to 63% for the three and nine months ended September 30, 2010, from 57% and 52% for the comparable periods of the prior year. In the first quarter of 2009, we recorded an inventory write-down of $3.8 million, representing a 4 percentage point decrease in gross margin for the nine months ended September 30, 2009. This write down was the result of softening economic conditions as well as lower than forecasted demand for some of our existing products due to the anticipated migration to a new suite of products announced in March 2009. The write down of inventory impacted both our gross margin from product revenue as well as our gross margin for services revenue. The remaining gross margin increase of 6 percentage points for the three months and 7 percentage points for the nine months ended September 30, 2010, is the result of product cost reductions that have outpaced the market decline in the cost per unit of storage and economies of scale that we have gained as our customer base expands.

Gross margin for product revenue increased 7 and 9 percentage points for the three and nine months ended September 30, 2010 from the comparable periods in the prior year. Excluding the inventory write down previously discussed, gross margin for product revenue increased 7 and 5 percentage points during each of the three and nine months ended September 30, 2010 compared to the comparable periods in the prior year. The remaining increase was primarily due to two factors. First, we experienced an increase in sales of our higher margin software applications. During the second quarter of 2010, we released two new data management software applications: SmartPools and InsightIQ, both designed to optimize cost and simplicity for enterprise data centers. Second, our product costs are contained through effective cost management and supply chain efficiencies which have outpaced the market decline in the cost per unit of storage.

We have experienced, and expect to continue to experience, pricing pressures within our industry as the price per terabyte of storage decreases year over year. This downward pricing pressure is primarily due to the decreasing prices of disk drives and other industry standard hardware components. Depending on the product type, disk drives can represent approximately one-third of product cost. In the vast majority of historical periods, however, significant increases in market demand for storage capacity have outpaced price per terabyte declines, resulting in overall data storage market growth.

Gross margin for services revenue increased 5 and 16 percentage points for the three and nine months ended September 30, 2010, compared to the comparable periods in the prior year. Services revenue includes support services for both our software and our hardware products and professional services fees. Software support provides customers with software updates, maintenance releases and patches, which have minimal direct costs. Hardware support includes Internet access to our technical knowledge database and to technical support personnel, service spares costs, and third-party costs in providing support. Excluding the effect of the fiscal 2009 inventory write-down previously discussed, gross margin for services revenue increased 5 and 11 percentage points for the three and nine months ended September 30, 2010 compared to the comparable periods in the prior year. The increase in gross margin was primarily driven by our increasing customer base and the economies of scale in our service organization as the number of service contracts continues to grow. Customer service headcount increased from 54 at September 30, 2009 to 89 at September 30, 2010.

As our customer base continues to grow, it will be necessary for us to continue to make significant expenditures related to our customer service and support structure to support this growth. The rate at which we add new customers as well as the added complexity of managing spares inventory located in various geographic regions will affect the amount of these upfront investments. The timing of these additional expenditures could materially affect our cost of revenue, both in absolute dollars and as a percentage of total revenue, in any particular period.

Research and Development Expenses. Research and development expenses primarily include personnel costs, prototype expenses, information systems expenses, facilities expenses and depreciation of equipment used in research and development. Research and development expenses are recorded when incurred. We are devoting substantial resources to the development of additional functionality for existing products and the development of new systems and software products. We intend to continue to invest significantly in our research and development efforts because we believe they are essential to maintaining and improving our competitive position.


	Three Months Ended											Nine Months Ended
	September 30,											September 30,
	2010			2009			$ change		% change			2010			2009				$ change	% change
				(dollars in thousands)											(dollars in thousands)
Research and development expenses	$	6,745		$	5,902		$	843		14	%	$	18,597		$	18,148		$449			2	%
Percent of total revenue		13	%		19	%							13	%		21	%

Research and development expenses increased by $843,000 or 14% for the three months ended September 30, 2010 from the same period in the prior year primarily due to an increase in salaries and benefits expense of $550,000 and stock-based compensation expense of $130,000 due to our increased hiring. Research and development headcount increased from 122 at September 30, 2009 to 137 at September 30, 2010. In addition, professional services expenses increased by approximately $100,000 and various other items including travel led to the remaining increase. These increases are partially offset by decreases in depreciation and hardware development expenses.

Research and development expenses increased by $449,000 or 2% for the nine months ended September 30, 2010 from the same period in the prior year. The increase is primarily due to an increase in stock-based compensation of $350,000 and salaries and benefits of $125,000 due to increases in our hiring. In addition, professional services increased by approximately $275,000 and various other items including travel led to the remaining increase. These increases were partially offset by a decrease in depreciation expense of $550,000 resulting from a lower capital equipment base in 2010.

Sales and Marketing Expenses. Sales and marketing expenses primarily include personnel costs, sales commissions, professional services fees, trade shows, marketing programs, information systems expenses, facilities and depreciation expenses. We plan to

continue to invest heavily in sales and marketing by increasing the size of our field sales force and the number of our indirect channel partners to allow us to expand in existing and into new geographic and vertical markets. We also plan to continue to invest in expanding our North American and international sales and marketing activities and building brand awareness. We expect that sales and marketing expenses will increase in absolute dollars and remain our largest expense category. Generally, sales personnel are not immediately productive and thus sales and marketing expenses do not immediately result in revenue. Hiring additional sales personnel reduces short-term operating margins until the sales personnel become fully productive. Accordingly, the timing of sales personnel hiring and the rate at which they become productive will affect our future performance.


	Three Months Ended											Nine Months Ended
	September 30,											September 30,
	2010			2009			$ change		% change			2010			2009			$ change		% change
				(dollars in thousands)											(dollars in thousands)
Sales and marketing expenses	$	17,348		$	10,843		$	6,505		60	%	$	45,557		$	32,443		$	13,114		40	%
Percent of total revenue		32	%		36	%							33	%		38	%

Sales and marketing expenses increased $6.5 million or 60%, and $13.1 million or 40% during the three and nine month periods ended September 30, 2010 compared to the same periods in the prior year primarily due to variable compensation driven by increased sales. Variable compensation increased by $2.0 million and $6.0 million in the three and nine months ended September 30, 2010 from the comparable periods in the prior year. There were also increases in stock-based compensation of $825,000 and $1.4 million and increases in salaries expense of $1.6 million and $2.3 million for the three and nine months ended September 30, 2010 from the comparable periods in the prior year resulting from increased headcount. Sales and marketing headcount increased from 133 at September 30, 2009 to 186 at September 30, 2010. The remaining increases are the result of trade shows and similar advertising, travel expenses and professional services.

General and Administrative Expenses. General and administrative expenses primarily include personnel costs; facilities expenses related to our executive, finance, human resources, information technology and legal organizations; bad debt expense; and public company related expenses and fees for professional services such as legal, accounting, compliance and information systems.


	Three Months Ended											Nine Months Ended
	September 30,											September 30,
	2010			2009			$ change		% change			2010			2009			$ change		% change
				(dollars in thousands)											(dollars in thousands)
General and administrative expenses	$	4,070		$	3,439		$	631		18	%	$	10,968		$	10,776		$	192		2	%
Percent of total revenue		8	%		11	%							8	%		12	%

General and administrative expenses increased by $631,000 or 18% for the three months ended September 30, 2010, compared to the comparable period in the prior year. This increase is primarily due to an increase in salaries expense of $425,000, stock-based compensation of $500,000, and professional services of $600,000, partially offset by a decrease in depreciation expense of $600,000 resulting from a lower capital equipment base in 2010 and a decrease in information systems expense of $500,000 resulting from overhead allocations. General and administrative headcount increased from 43 at September 30, 2009 to 54 at September 30, 2010.

General and administrative expenses increased by $192,000 or 2% for the nine months ended September 30, 2010, compared to the comparable period in the prior year. This increase is primarily due to an increase in salaries expense of $675,000, stock-based compensation expense of $725,000 and supplies and licenses of $425,000. These increases were partially offset by a decrease of $1.1 million in depreciation expense resulting from a lower capital equipment base in 2010 and a decrease in information systems expense of $500,000 resulting from overhead allocations.

Restructuring Charges. In April 2009, we initiated a restructuring plan to reduce our operating expenses in response to the uncertainties associated with the then present deterioration in the global economy. Under this plan, we reduced our workforce by approximately 10%. For the three months ended June 30, 2009, we recorded restructuring charges of $357,000. These charges consisted of employee severance, benefits, and related costs. Of the total restructuring charges recorded, substantially all amounts were paid out during the quarter ended June 30, 2009.

Legal Settlement. On October 24, 2009, the Company filed a stipulation of settlement providing for the settlement and dismissal of the class action complaint which asserted claims under the federal securities laws. The settlement provided for a payment to the plaintiff class of $15.0 million, of which Isilon contributed $2.0 million and the balance was contributed by the Company’s insurers in December 2009. The amounts were paid into an escrow fund pending final court approval. The class action settlement was

approved by the court on March 5, 2010. The $2.0 million for which the Company was responsible was included as a separate component of operating expenses for the three and nine month periods ended September 30, 2009. The $2.0 million was paid during the quarter ended December 31, 2009.

Legal expenses associated with indemnification obligations and other related costs, net. These expenses consist of legal fees for the Company’s indemnification obligations and other related fees and costs involved in the SEC’s civil action against our former CFO. Legal fees for the three and nine months ended September 30, 2010 were $2.3 million and $3.6 million, compared to $0.1 million and $0.4 million during the comparable periods in the prior year. As more fully described in note 11 to our consolidated financial statements, discovery in the SEC’s civil action is active and the matter is currently set for trial in April 2011. In connection with this matter, we have incurred and will likely continue to incur substantial expenses related to legal fees and expenses advanced to our former CFO. We have also incurred and will likely continue to incur substantial legal fees and expenses on behalf of current and former employees, officers and directors who are potential witnesses in the matter.

Other income (expense), net. Other income (expense), net includes interest income on cash, cash equivalents and marketable securities as well as foreign exchange gains and losses.


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2010		2009		$ change		2010			2009		$ change
			(in thousands)							(in thousands)
Other income (expense), net	$	332	$	164	$	168	$	(239	)	$	702	$	(941	)

Other income (expense), net increased by $168,000 for the three months ended September 30, 2010, compared to the comparable period in the prior year due to fluctuations in foreign exchange rates related to our accounts receivable denominated in foreign currencies partially offset by decreases in our interest income resulting from declining interest rates. Other income (expense), net decreased by $941,000 for the nine months ended September 30, 2010, compared to the comparable period in the prior year due to fluctuations in foreign exchange rates related to our accounts receivable denominated in foreign currencies as well as decreases in our interest income resulting from declining interest rates.

Liquidity and Capital Resources

As of September 30, 2010, our principal sources of liquidity consisted of cash, cash equivalents and marketable securities of $114 million, which will be sufficient to fund our projected operating requirements for at least twelve months. Our principal uses of cash historically have consisted of payroll and other operating expenses, purchases of inventory and purchases of property and equipment primarily to support the development of new products.

Working capital and cash and cash equivalents as of the stated dates:


	As of
	September 30, 2010		December 31, 2009
	(in thousands)
Working capital	$	96,313	$	67,715
Cash, cash equivalents and marketable securities		113,806		79,154

Cash flows from operating activities, investing activities and financing activities for the stated periods:


	Three Months Ended						Nine Months Ended
	September 30, 2010			September 30, 2009			September 30, 2010			September 30, 2009
				(in thousands)
Net cash provided by (used in) operating activities	$	13,074		$	879		$	32,970		$	(352	)
Net cash used in investing activities		(14,522	)		(2,472	)		(41,626	)		(5,400	)
Net cash provided by financing activities		2,729			1,139			5,371			1,566

Cash Flows from Operating Activities

Net cash provided by operating activities was $13.1 million for the three months ended September 30, 2010 compared to net cash provided by operating activities of $879,000 for the three months ended September 30, 2009. The increase from operations for the three months ended September 30, 2010 resulted from increased net income combined with changes in operating assets and liabilities, as adjusted for various non-cash items including stock-based compensation, depreciation and amortization charges.

Net cash provided by operating activities was $33.0 million for the nine months ended September 30, 2010 compared to net cash used in operating activities of $352,000 for the nine months ended September 30, 2009. The increase from operations for the nine months ended September 30, 2010 resulted from increased net income combined with changes in operating assets and liabilities, as adjusted for various non-cash items including stock-based compensation, depreciation and amortization charges.

We expect that cash provided by operating activities may fluctuate in future periods as a result of a number of factors including fluctuations in our operating results, shipment linearity, accounts receivable collections performance, inventory and supply chain management, and the timing and amount of compensation and other payments.

Cash Flows from Investing Activities

Cash flows from investing activities relate to net sales and maturities and purchases of marketable securities and capital expenditures to support our growth. Net cash used in investing activities during the three months ended September 30, 2010 was $14.5 million, comprised primarily of $13.0 million of net purchases of marketable securities. Net cash used in investing activities for the three months ended September 30, 2009 was $2.5 million, comprised primarily of $2.3 million of net purchases of marketable securities.

Net cash used in investing activities during the nine months ended September 30, 2010 was $41.6 million and was comprised primarily of net purchases of marketable securities of $38.9 million as well as capital expenditures of $2.8 million. Net cash used in investing activities for the nine months ended September 30, 2009 was $5.4 million, comprised of $3.9 million in net purchases of marketable securities and $1.5 million of capital expenditures.

Cash Flows from Financing Activities

Net cash provided by financing activities for the three months ended September 30, 2010 was $2.7 million, and was due to proceeds from the issuance of common stock in connection with the exercise of stock options and the employee stock purchase plan. Net cash provided by financing activities during the three months ended September 30, 2009 was $1.1 million, and was due to the proceeds from the issuance of common stock in connection with the exercise of stock options and the employee stock purchase plan.

Net cash provided by financing activities for the nine months ended September 30, 2010 was $5.4 million, and was due to proceeds from the issuance of common stock in connection with the exercise of stock options and the employee stock purchase plan. Net cash provided by financing activities during the nine months ended September 30, 2009 was $1.6 million, and was entirely due to the proceeds from the issuance of common stock in connection with the exercise of stock options.

Net proceeds from the issuance of common stock related to employee participation in employee stock programs including stock options and employee stock purchase plans have increased during the first three quarters of 2010. The extent to which our employees participate in these programs generally increases or decreases based upon changes in the market price of our common stock. As a result, our cash flow resulting from the issuance of common stock in connection with employee participation in employee stock programs will vary.

Contractual Obligations

As of September 30, 2010, our principal commitments consisted of obligations outstanding under operating leases. We lease our facilities under operating leases that expire at various dates through 2014. There have been no material changes in our principal lease commitments compared to those discussed in our Annual Report on Form 10-K for the year ended December 31, 2009.

We typically maintain, with our contract manufacturers, a rolling 90-day firm order for products they manufacture for us, and these orders may only be rescheduled or cancelled by our contract manufacturers under certain limited conditions and, even then, with certain restrictions and penalties up to the full cost of the product. The remaining amount on the open purchase order with our contract manufacturers at September 30, 2010 was $6.9 million.

Off-Balance Sheet Arrangements

During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

ITEM 3. Quantitative and Qualitative Disclosures about Market Risk

A description of our quantitative and qualitative disclosures about market risks is set forth in Part II, Item 7A, of our Annual Report on Form 10-K for the year ended December 31, 2009 filed with the SEC on February 5, 2010.

ITEM 4. Controls and Procedures

a) Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of our management, including our chief executive officer and chief financial officer (together, our “certifying officers”), of the effectiveness of the design and operation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act. Disclosure controls and procedures are controls and other procedures designed to ensure that information required to be disclosed by us in our reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms, and that the information is accumulated and communicated to our management, including our certifying officers, to allow timely decisions regarding required disclosure. Based upon this evaluation, our certifying officers concluded that our disclosure controls and procedures were effective as of September 30, 2010.

b) Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the three months ended September 30, 2010, that our certifying officers concluded materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 1. Legal Proceedings

The information set forth under the “Legal Proceedings” section in Note 11 – Commitments and Contingencies in the Notes to the Consolidated Financial Statements in Item 1 Part 1 of this Quarterly Report on Form 10-Q, is incorporated herein by reference.

ITEM 1A. Risk Factors

We face intense competition and expect competition to increase in the future, which could reduce our revenue, margins and customer base.

The storage market is highly competitive and we expect competition to intensify in the future. This competition could make it more difficult for us to sell our products, and result in increased pricing pressure, reduced profit margins, increased sales and marketing expenses and failure to increase, or the loss of, market share, any of which would likely seriously harm our business, operating results and financial condition. For instance, the decrease in the price of disk drives and other industry standard hardware components has resulted in increased pricing pressure and a reduction in the price per megabyte of storage.

Currently, we face competition from a number of established companies, including EMC Corporation, Hewlett-Packard Company, Hitachi Data Systems Corporation, International Business Machines Corporation, NetApp, Inc. and Sun Microsystems, Inc, a division of Oracle Corporation. We also face competition from a large number of private companies and new market entrants. Many of our current competitors have, and some of our potential competitors could have, longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, sales, marketing and other resources than we have. Potential customers may prefer to purchase from their existing suppliers rather than a new supplier regardless of product performance or features.

We expect increased competition from other established and emerging companies, including companies such as networking infrastructure and storage management companies that provide complementary technology and functionality. In addition, third parties currently selling our products could market products and services that compete with ours. Some of our competitors, including EMC, Hewlett-Packard, NetApp, and Oracle have made acquisitions of businesses that allow them to offer more directly competitive and comprehensive solutions than they had previously offered. Our current and potential competitors may also establish cooperative relationships among themselves or with third parties. If so, new competitors or alliances that include our competitors may emerge that could acquire significant market share. We expect these trends to continue and potentially accelerate as companies attempt to strengthen or maintain their market positions in this evolving industry and in the midst of continuing global economic challenges. In addition, we compete against internally developed storage solutions as well as combined third-party software and hardware solutions. Any of these competitive threats, alone or in combination with others, could seriously harm our business, operating results and financial condition.

Economic conditions in the United States and globally could adversely affect our business.

Our business is affected by global economic conditions. Since at least mid-2007, global credit, financial and other markets in the U.S. and globally have suffered substantial stress, volatility, illiquidity and disruption. More recently, the global financial crisis has negatively impacted various European countries and markets. Such market conditions pose risks to the overall global economy as businesses and consumers may defer, delay or forgo purchases in response to negative financial or economic news and events which could affect demand for our products and services. There could be a number of negative follow-on effects from such global economic uncertainty on our business, including slower growth opportunities in key geographic markets, insolvency of key suppliers resulting in product delays, and inability of customers to obtain credit to finance purchases of our products and/or customer insolvencies.

Moreover, product demand could be different from our current expectations due to factors including negative changes in general business and economic conditions and/or further tightening or deterioration in global credit markets, either of which could affect consumer confidence, customer acceptance of our and our competitors’ products and changes in customer order patterns including order cancellations.

In early April 2009, we announced a company-wide reduction in force of approximately 10%. This and other cost-saving initiatives were intended to improve our cost structure and path to sustainable profitability. If economic conditions in the U.S. or globally worsened, we would need to evaluate whether further cost and workforce reductions are warranted, which could negatively impact our research and development efforts, our sale capacity and our relationships with customers and vendors. Accordingly, adverse economic conditions in the U.S. and globally could negatively impact our operations, growth and competitive position in the marketplace.

Our operating results may fluctuate significantly, which makes our future results difficult to predict and could cause our operating results to fall below expectations.

Our operating results may fluctuate due to a variety of factors, many of which are outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful. You should not rely on our past results as an indication of our future performance. In addition, a significant portion of our quarterly sales typically occurs near the end of the quarter. As a result, small delays can make our operating results difficult to predict. If our revenue or operating results fall below the expectations of investors or any securities analysts that follow our company, the price of our common stock would likely decline.

Factors that may affect our operating results include:

•

changes and uncertainty in the U.S. and global economies and macroeconomic conditions, and specific economic conditions in the computer and storage industries;

•

general or sustained decrease in global corporate spending on information technology and storage related products leading to a decline in demand for our products;

•

reductions in customers’ budgets for information technology and storage related purchases, delays in their purchasing cycles or deferments of their product purchases based on market and economic uncertainty or in anticipation of new products or updates from us or our competitors;

•

the ability of our customers, channel partners, and suppliers to obtain financing or to fund capital expenditures and their ability to continue as a going concern;

•

the timing and magnitude of shipments and timing of installations of our products in each quarter;

•

our ability to develop, introduce and ship in a timely manner new products and product enhancements that meet customer requirements;

•

our ability to build, expand and improve our direct sales operations, reseller and other distribution channels;

•

our ability to build, expand and improve sales backlogs and improve sales linearity;

•

our ability to improve our marketing and demand generation and attract new customers;

•

our ability to continually improve and provide high quality customer service and experience;

•

our ability to effectively manage our relationships with our third party maintenance providers that provide onsite support, hardware replacement, manage and disburse our spares product inventory and provide other field services in the U.S. and international regions in which we sell our products;

•

the rates at which customers purchase additional storage systems from us and renew their service contracts with us;

•

the timing of recognizing revenue as a result of revenue recognition rules;

•

fluctuations in demand, sales cycles and prices for our products and services;

•

the timing of product releases, upgrades or announcements by us or our competitors;

•

any change in competitive dynamics, including new entrants or discounting of product prices;

•

our ability to control costs, including our operating expenses and the costs of the components we use in our products;

•

the possibility of seasonality of demand for our products;

•

volatility in our stock price, which may lead to higher stock compensation expenses as volatility is a key input in our fair value stock-based compensation measurement;

•

actual outcomes might differ from judgments, assumptions and estimates used in determining the carrying value of certain assets in our financial statements;

•

future accounting pronouncements and changes in accounting policies; and

•

geopolitical events such as war or incidents of terrorism.

If we fail to manage future growth effectively, we may not be able to market and sell our products and services successfully.

Our company has been in existence since January 2001, and we first began shipping products in January 2003. Much of our growth has occurred since October 2005 and we anticipate that further significant expansion will be required. Our future operating results depend to a large extent on our management’s ability to manage expansion and growth successfully, including, but not limited to, hiring, training and developing our sales personnel to become productive and generate revenue, forecasting revenue, controlling expenses, implementing and enhancing infrastructure, systems and processes, addressing new markets and expanding international operations. A failure to manage our growth effectively could materially and adversely affect our ability to market and sell our products and services.

We have a history of losses and we may not be profitable in the future.

Although we have been profitable during the first nine months of fiscal 2010, we have not been profitable in any fiscal year since we were formed. We experienced a net loss of $18.9 million in 2009, $25.1 million in 2008, and $26.9 million in 2007. As of September 30, 2010, our accumulated deficit was $139 million. We expect to make significant expenditures related to the development of our products and expansion of our business, including expenditures for additional sales and marketing and research and development personnel. We may encounter unforeseen difficulties, complications and delays and other unknown factors that require additional expenditures. As a result of these increased expenditures, we will have to generate and sustain substantially increased revenue to achieve profitability. Our revenue growth trends in prior periods are not likely to be sustainable. Accordingly, we may not be able to maintain profitability and we may continue to incur significant losses in the future.

If we fail to maintain effective internal controls, our ability to produce accurate, complete and timely financial statements could be impaired.

Section 404 of the Sarbanes-Oxley Act requires that management report annually on the effectiveness of our internal control over financial reporting and identify any material weaknesses in our internal control and financial reporting environment. We have expended significant resources in developing and maintaining the necessary documentation and testing procedures required by Section 404 of the Sarbanes-Oxley Act and expect to continue to expend significant resources in maintaining this compliance. We cannot be certain that the actions we have taken to continue to improve our internal control over financial reporting will be sufficient or that we will be able to maintain and continue to implement and improve our processes and procedures in the future, which could cause us to be unable to produce accurate financial statements on a timely basis. Any of the foregoing could cause investors to lose confidence in the reliability of our consolidated financial statements, which could cause the market price of our common stock to decline and make it more difficult for us to finance our operations and growth.

Pending or future litigation could have a material adverse impact on our results of operation, financial condition and liquidity.

We are exposed to claims and litigation arising in the normal course of business. Litigation in general can be expensive, lengthy and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. We can neither quantify this exposure, generally, nor predict the impact on us as a result of any such claim or litigation, specifically. As reflected in note 9 to our consolidated financial statements regarding current legal proceedings, pursuant to the Company’s charter documents and indemnification agreements, the Company has certain indemnification obligations to its current and former officers and directors. Although the Company maintains insurance coverage up to certain prescribed and contracted amounts related to these indemnification obligations, such coverage is subject to limitations under the respective policies. In connection with the SEC’s civil action against our former CFO, the Company, pursuant to its indemnification obligations, has incurred and will likely continue to incur substantial expenses related to legal fees and expenses advanced to our former CFO. The Company has also incurred and will likely continue to incur substantial legal fees and expenses on behalf of current and former employees, officers and directors who are potential witnesses in the civil action. The Company’s potential indemnity obligations could result in significant liability to the Company and have a material adverse effect on the Company’s consolidated financial position, results of operations, and cash flows, to the extent that the advancement of fees and costs or ultimate indemnity obligations are not covered by, or exceed, the available directors’ and officers’ insurance.

Our future financial performance depends on growth in the storage of data. If growth in the storage of data does not continue at the rate that we forecast, our operating results would be materially and adversely impacted.

Our products are designed to address the growth in storage of data. Accordingly, our future financial performance will depend in large part on growth in this sector and on our ability to adapt to emerging demands. Changes in technologies could adversely affect the demand for storage systems. For example, advances in file compression technology could result in smaller file sizes and reduce the

demand for storage systems. A reduction in demand for storage of data caused by lack of customer acceptance, weakening economic conditions, competing technologies and products, decreases in corporate spending or otherwise, would result in decreased revenue or a lower revenue growth rate. We cannot assure you that growth in the storage of data will continue or that we will be able to respond adequately to changes in the future. If we are unable to maintain or replace our relationships with customers or to increase the diversification of our customer base, it would be more difficult to maintain or grow our revenue and our growth might be limited.

While the Company’s revenue base, in terms of customers and industries served, has diversified, in the past, a significant portion of our total revenue has come from a limited number of customers in a small number of industries, particularly media and entertainment companies. Accordingly, the potential for concentrated purchases by certain new and existing customers remains and our largest customers may continue to vary from quarter to quarter. As a consequence of historical patterns and the potential concentrated nature of our customers’ purchasing patterns, the proportion of our total revenue derived from a small number of customers may be higher in any future quarter. If this were to occur, we cannot provide any assurance that we will be able to sustain such revenue.

In addition, our customers, including our larger customers, generally buy systems on a purchase order basis and as such generally do not enter into long-term contracts or minimum purchase commitments. If we are unable to sustain our revenue from these customers or to replace it with revenue from new or existing customers, our growth may be limited. If economic conditions worsen for the industries in which our largest customers do business, or if we are unable to attract significant numbers of customers in other targeted industries, including life sciences, government, manufacturing and oil and gas, our ability to maintain or grow our revenue would be adversely affected.

If we are unable to develop and introduce new products and respond to technological changes, if our new products do not achieve market acceptance or if we fail to manage product transitions, we may fail to increase, or may lose, market share.

Our future growth depends on the successful development and introduction of new systems and software products. Due to the complexity of storage systems, these products are subject to significant technical risks that may impact our ability to introduce these products successfully. Our new products also may not achieve market acceptance. In addition, our new products must respond to technological changes and evolving industry standards. If we are unable, for technological or other reasons, to develop and introduce new products in a timely manner in response to changing market conditions, customer requirements and component supply, or if these products do not achieve market acceptance, our operating results could be materially and adversely affected.

Product introductions by us in future periods may also reduce demand for our existing products. As new or enhanced products are introduced, we must successfully manage the transition from older products in order to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories and ensure that sufficient supplies of new products can be delivered to meet customer demand.

We rely on value-added resellers and other distribution partners to sell our products, and disruptions to, or our failure to develop and manage, our distribution channels and the processes and procedures that support them could result in these resellers and partners discontinuing the marketing and distribution of our products and services.

Our future success is highly dependent upon establishing and maintaining successful relationships with a variety of value-added resellers and other distribution partners, including OEM partners that may bundle or include our products in a broader product set. A substantial portion of our total revenue is currently sold through our resellers and distribution partners. Therefore, our ability to maintain or grow our revenue will likely depend, in part, on our ability to maintain our arrangements with our existing resellers and other distribution partners, and to establish and expand arrangements with new partners in these areas, and any failure to do so could have a material adverse effect on our future revenue. Additionally, by relying on such partners, we may have less contact with the ultimate users of our products, thereby making it more difficult for us to establish brand awareness, ensure proper delivery and installation of our products, service ongoing customer requirements and respond to evolving customer needs.

Recruiting and retaining qualified resellers and distribution partners and training them in our technology and product offerings require significant time and resources. In order to develop and expand our distribution channel, we must continue to scale and improve our processes and procedures that support our partners, including investments in systems and training. Those processes and procedures may become increasingly complex and difficult to manage.

We typically enter into non-exclusive, written distribution agreements with our resellers and distribution partners that generally have a one-year term, have no minimum sales commitment and do not prohibit them from offering products and services that compete with ours. Accordingly, our distribution partners may choose to discontinue offering our products and services or may not devote sufficient attention and resources toward selling our products and services. Our competitors may provide incentives to our existing and potential distribution partners to use or purchase their products and services or to prevent or reduce sales of our products and services. Some of our distribution partners possess significant resources and advanced technical abilities and may, either independently or jointly with our competitors, develop and market products and related services that compete with our offerings. If this were to occur,

these distribution partners might discontinue marketing and distributing our products and services. In addition, these distribution partners would have an advantage over us when marketing their competing products and related services because of their existing customer relationships. The occurrence of any of these events would likely materially adversely affect our business, operating results and financial condition.

Claims by others that we infringe their proprietary technology could cause us to incur substantial costs, distract our management and, if these claims are successful, require us to pay substantial damages or prevent us from offering our products.

Third parties could claim that our products or technologies infringe their proprietary rights. The data storage industry is characterized by the existence of a large number of patents, trademarks and copyrights and by frequent litigation based on allegations of infringement or other violations of intellectual property rights. We expect that infringement claims may further increase as the number of products and competitors in our sector increases. We have not to date been involved in any litigation related to intellectual property. Prior to the Company’s IPO, in July 2006, we received a letter from a third-party suggesting that our products might be infringing certain of its patents. After an exchange of correspondence, there appeared to be no reasonable basis for a claim that Isilon infringed any of the third-party’s patents. We received no further correspondence in the matter. If this or similar matters arise, and we are unable to reach an amicable resolution, it is possible that litigation could result. The outcome of any litigation is inherently unpredictable, and accordingly, we cannot assure you that, in the future, a court would not find that our products infringed these patents. We cannot assure you that we do not currently infringe, or that we will not in the future infringe, upon any third-party patents or other proprietary rights.

Any claim of infringement by a third party, even one without merit, could cause us to incur substantial costs defending against the claim, and could distract our management from our business. Further, a party making such a claim, if successful, could secure a judgment that requires us to pay substantial damages. A judgment could also include an injunction or other court order that could prevent us from offering our products. In addition, we might be required to seek a license for the use of the infringed intellectual property, which might not be available on commercially reasonable terms or at all. Alternatively, we might be required to develop non-infringing technology, which could require significant effort and expense and might ultimately be unsuccessful. Any of these events could seriously harm our business, operating results and financial condition. Third parties may also assert infringement claims against our customers and channel partners. Any of these claims would require us to initiate or defend potentially protracted and costly litigation on their behalf, regardless of the merits of these claims, because we generally indemnify our customers and channel partners from claims of infringement of proprietary rights of third parties. If any of these claims succeeds, we might be forced to pay damages on behalf of our customers or channel partners, which could have a material adverse effect on our business, operating results and financial condition.

Our sales cycles can be long and unpredictable, and our sales development efforts require considerable time and expense. As a result, our sales are difficult to predict and may vary substantially from quarter to quarter, which may cause our operating results to fluctuate significantly.

The timing of our revenue is difficult to predict. Our sales efforts involve building and expanding our direct sales operations and reseller distribution channels and educating our customers about the use and benefits of our products, including their technical capabilities and potential cost savings to an organization. Customers may undertake a significant evaluation process that in the past has resulted in a lengthy sales cycle, in some cases more than 12 months. We spend substantial time and resources on our sales efforts without any assurance that our efforts will produce any sales. In addition, product purchases are frequently subject to budget constraints, multiple approvals and unplanned administrative processing and other delays, which may be further impacted by current macroeconomic concerns and conditions. If we do not realize expected sales from a specific customer for a particular quarter in that quarter or at all, our business, operating results and financial condition could be harmed.

We derive substantially all of our total revenue from sales of our Isilon IQ product family and customer and technical support services associated with this product family. As a result, we are vulnerable to fluctuations in demand for this product family, whether as a result of competition, product obsolescence, technological change, customer budgetary constraints or other factors. If demand for our Isilon IQ product family were to decline, our financial condition would be harmed.

If we are unable to continue to create valuable innovations in software, we may not be able to generate additional high-margin revenue to maintain or increase our gross margins.

Our industry has a history of declining storage hardware prices as measured on a cost per gigabyte or terabyte of storage capacity basis. In order to maintain or increase our gross margins, we will need to continue to create valuable software that is included with our scale-out storage systems and/or sold as separate standalone software applications. Any new feature or application that we develop or acquire may not be introduced in a timely or cost-effective manner and may not achieve the broad market acceptance necessary to help increase our overall gross margin. If we are unable to successfully develop or acquire, and then market and sell, additional software functionality, such as our SmartConnect, SnapshotIQ, SmartQuotas, SyncIQ, SmartPools, and InsightIQ software applications, our ability to maintain or increase our high-margin revenue and gross margin will be adversely affected.

We currently rely on two contract manufacturers to assemble our products, and our failure to forecast demand for our products accurately or manage our relationships with our contract manufacturers successfully could negatively impact our ability to sell our products.

We currently rely on two contract manufacturers. In August 2007, we established a contract manufacturing relationship with Flextronics International Ltd. Since that time, we have utilized Flextronics to manufacture and assemble certain of our products, procure components for our systems and help manage our supply chain, perform testing and manage delivery of our products. In September 2009, we entered into a master service agreement with Jabil Circuit, Inc. which provides for the manufacture and assembling of certain products, procuring components, helping manage our supply chain, performing testing and managing delivery of our products.

Our reliance on contract manufacturers reduces our control over the assembly process, exposing us to risks, including reduced control over quality assurance, production costs, component supply and excess inventory. If we fail to effectively manage or maintain our relationships with our contract manufacturers, or if our contract manufacturers experience delays, disruptions, capacity constraints or quality control problems in their operations, our ability to ship products to our customers could be impaired and our competitive position and reputation could be harmed. If we and our contract manufacturers are unable to negotiate with suppliers for reduced component costs, our operating results would be harmed. If we are required to change contract manufacturers or assume internal manufacturing operations, we may lose revenue, incur increased costs and damage our customer relationships. Qualifying new contract manufacturers and commencing volume production are expensive and time-consuming. We provide forecasts to our contract manufacturers regarding product demand and production levels. If we inaccurately forecast demand for our products, we may have excess or inadequate inventory or incur cancellation charges, carrying costs or penalties, which could adversely impact our operating results.

We intend to introduce new products and product enhancements, which could require us to achieve volume production rapidly by coordinating with our contract manufacturers and component suppliers. We may need to increase our component purchases, contract manufacturing capacity, and internal test and quality functions if we experience increased demand. The inability of our contract manufacturers to provide us with adequate supplies of high-quality products, or an inability to obtain adequate quantities of components, could cause a delay in our order fulfillment, and our business, operating results and financial condition would be adversely affected.

We rely on a limited number of suppliers, and in some cases single-source suppliers, and any disruption or termination of these supply arrangements could delay shipments of our products and could materially and adversely affect our relationships with current and prospective customers.

We rely on a limited number of suppliers for several key components utilized in the assembly of our products. Historically, we have purchased several of our required components, such as disk drives and chassis, from a single supplier. This reliance on a limited number of suppliers involves several risks, including:

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supplier capacity constraints;

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price increases;

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timely delivery; and

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component quality.

Component quality is particularly significant with respect to our suppliers of disk drives. In order to meet product capacity requirements, we must obtain disk drives of extremely high quality and capacity. We cannot assure you that we will be able to obtain enough of these components in the future or that prices of these components will not increase. In addition, problems with respect to supply, yield and quality of these components and timeliness of deliveries could occur. Disruption or termination of the supply of these components could delay shipments of our products and could materially and adversely affect our relationships with current and prospective customers. These delays could also materially and adversely affect our operating results.

Our products incorporate components that are subject to pricing and supply volatility, and, as a result, our cost structure and our ability to respond in a timely manner to customer demand are sensitive to such volatility in the market prices and supply for these components.

A significant portion of our expenses are directly related to the pricing of commoditized components utilized in the manufacture of our products, such as disk drives, memory, and CPUs. As part of our procurement model, we do not enter into long-term supply contracts for these components, but instead generally have our contract manufacturers purchase these components on our

behalf. In some cases, our contract manufacturers do so in a competitive-bid purchase order environment with suppliers or on the open market at spot prices. As a result, our cost structure is affected by price volatility in the marketplace for these components, especially for disk drives. This volatility makes it difficult to predict expense levels and operating results and may cause them to fluctuate significantly. Furthermore, such components can be subject to limits on supply or other supply volatility which may negatively impact our ability to obtain quantities necessary to grow our business and respond to customer demand for our products.

We maintain relatively low inventory and acquire components only as needed; as a result, if there are shortages of these components, we may not be able to secure enough components to build new products to meet customer demand.

We attempt to maintain relatively low inventory and acquire components as needed and in accordance with component lead times, utilizing vendor-managed inventory programs when available, and as a result do not enter into long-term supply contracts for these components. As a result, our ability to respond to customer orders efficiently may be constrained by the then-current availability or terms and pricing of these components. Our industry has experienced component shortages and delivery delays in the past, and we may experience shortages or delays of critical components in the future as a result of strong demand in the industry or other factors. In the past, we have encountered situations where we paid higher prices than we had anticipated for disk drives or had to use a larger or smaller capacity drives as a replacement. For example, the industry periodically experiences shortages of selected electronic components, which could negatively impact our costs and reduced availability of key components.

If we lose key personnel or if we are unable to attract and retain highly-qualified personnel on a cost-effective basis, it would be more difficult for us to manage our existing business operations and to identify and pursue new growth opportunities.

Our future performance depends on the continued service of our key technical, sales, services, and management personnel. The loss of key employees could result in significant disruptions to our business and, due to the difficulty in recruiting and training new key personnel, the integration of replacement personnel could be time-consuming, cause additional disruptions to our business or be unsuccessful. Moreover, we rely on our executive officers and senior management to manage our existing business operations and to identify and pursue new growth opportunities. The loss of the services of these key executives for any reason could adversely affect our business, operating results and financial condition.

Our future success also depends on our continued ability to attract and retain highly-qualified technical, sales, services, and management personnel. In particular, our ability to enhance and maintain our technology requires talented software development engineers with specialized skills in areas such as distributed computing, file systems and operating systems. If we are not able to recruit and retain these engineers, the quality and speed with which our products are developed would likely be seriously compromised, and our reputation and business would suffer as a result. Competition for these and the other personnel we require, particularly in the Seattle metropolitan area, is intense, and we may fail to retain our key technical, sales, services and management employees or to attract or retain other highly-qualified technical, sales, services, and management personnel in the future.

Our ability to sell our products is highly dependent on the quality of our customer support offerings, and our failure to offer high-quality customer support services would have a material adverse effect on our ability to market and sell our products and services.

After our products are deployed within our customers’ networks, our customers depend on our services organization to resolve issues relating to our products. High-quality customer support services are critical for the successful marketing and sale of our products. If we or our third-party maintenance providers or channel partners do not effectively assist our customers in deploying our products, succeed in helping our customers to resolve post-deployment issues quickly, and provide ongoing support, it would adversely affect our ability to sell our products to existing customers and could harm our prospects with potential customers. In addition, as we expand further into larger enterprise accounts, and expand our operations internationally, our customer services organization will face additional challenges, including those associated with providing more mission-critical services in enterprise accounts, as well as delivering services, training and documentation in languages other than English. As a result, our failure to maintain high-quality customer support services could have a material adverse effect on our business, operating results and financial condition.

Our products are highly technical and may contain undetected software or hardware defects, which could cause data unavailability, loss or corruption that might, in turn, result in liability to our customers and harm to our reputation and business.

Our storage products are highly technical and complex and are often used to store information critical to our customers’ business operations. Our products have contained and may contain undetected errors, defects or security vulnerabilities that could result in data unavailability, loss or corruption or other harm to our customers. Some errors in our products may only be discovered after they have been installed and used by customers. Any errors, defects or security vulnerabilities discovered in our products after commercial release, as well as any computer virus or human error on the part of our customer support or other personnel resulting in a customer’s data unavailability, loss or corruption could result in a loss of revenue or delay in revenue recognition, a loss of customers or increased service and warranty costs, any of which could adversely affect our business, operating results and financial condition. In addition, we could face claims for product liability, tort or breach of warranty, including claims relating to changes to our products

made by our channel partners. Our contracts with customers contain provisions relating to warranty disclaimers and liability limitations, which may be difficult to enforce. Defending a lawsuit, regardless of its merit, would be costly and might divert management’s attention and adversely affect the market’s perception of us and our products. In addition, if our business liability insurance coverage proves inadequate with respect to a claim or future coverage is unavailable on acceptable terms or at all, our business, operating results and financial condition could be adversely impacted.

Our international sales and operations subject us to additional risks that may adversely affect our international operations and reduce our international sales.

We derived approximately 28%, 26%, 32%, and 26% of our total revenue from customers outside of North America in the first nine months of 2010, and the fiscal years ending 2009, 2008, and 2007, respectively. We have sales and technical support personnel in several countries worldwide. We expect to continue to add personnel in additional countries. Our various international operations subject us to a variety of risks, including:

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the difficulty of managing and staffing international offices and the increased travel, infrastructure and legal compliance costs associated with multiple international locations;

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difficulties in enforcing contracts and collecting accounts receivable, and longer payment cycles, especially in emerging markets;

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the challenge of managing development teams in geographically disparate locations;

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tariffs and trade barriers and other regulatory or contractual limitations on our ability to sell or develop our products in various foreign markets;

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increased exposure to foreign currency exchange rate risk;

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reduced protection for intellectual property rights in some countries ; and

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political and economic instability, including a global recession.

As we continue to expand our business globally, our success will depend, in large part, on our ability to anticipate and effectively manage these risks. Our failure to manage any of these risks successfully could harm our international operations and reduce our international sales, adversely affecting our business, operating results and financial condition.

If we are unable to protect our intellectual property rights, our competitive position could be harmed or we could be required to incur significant expenses to enforce our rights.

Our success is dependent in part on obtaining, maintaining and enforcing our patent and other proprietary rights. We rely on trade secret, patent, copyright and trademark laws, and confidentiality agreements with employees and third parties, all of which offer only limited protection. The steps we have taken to protect our proprietary rights may not be adequate to prevent misappropriation of our proprietary information or infringement of our intellectual property rights, and our ability to prevent this misappropriation or infringement is uncertain, particularly in countries outside of the United States. Further, with respect to patent rights, we do not know whether any of our pending patent applications will result in the issuance of a patent or whether the examination process will require us to narrow our claims. To date, we have obtained eight issued United States patents and these patents, as well as any additional patents that may be issued to us may be contested, circumvented, found unenforceable or invalidated, and we may not be able to prevent third parties from infringing them. Moreover, the rights granted under any issued patents may not provide us with proprietary protection or competitive advantages, and, as a result, our competitors may be able to develop technologies similar or superior to ours.

Protecting against the unauthorized use of our products, trademarks and other proprietary rights is expensive and difficult. Litigation may be necessary in the future to enforce or defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Any such litigation could result in substantial costs and diversion of management resources, either of which could harm our business, operating results and financial condition. Further, many of our current and potential competitors have the ability to dedicate substantially greater resources to enforcing their intellectual property rights than we have. Accordingly, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property.

Our use of open source and third-party software could impose unanticipated conditions or restrictions on our ability to commercialize our products.

We incorporate open source software into our products. Although we monitor our use of open source software to avoid subjecting our products to conditions we do not intend, the terms of many open source licenses have not been interpreted by United States courts, and there is a risk that these licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to commercialize our products. In this event, we could be required to seek licenses from third parties in order to continue offering our products, to make generally available, in source code form, proprietary code that links to certain open source modules, to re-engineer our products, or to discontinue the sale of our products if re-engineering could not be accomplished on a timely basis, any of which could adversely affect our business, operating results and financial condition.

We may also find that we need to incorporate certain proprietary third-party technologies, including software programs, into our products in the future. However, licenses to relevant third-party technology may not be available to us on commercially reasonable terms, or at all. Therefore, we could face delays in product releases until equivalent technology can be identified, licensed or developed, and integrated into our current products. These delays, if they occur, could materially adversely affect our business, operating results and financial condition.

Our products must interoperate with many software applications that are developed by others and if we are unable to devote the necessary resources to ensure that our products interoperate with those applications, we may fail to increase, or we may lose, market share and we may experience a weakening demand for our products.

Our products must interoperate with many software applications that are developed by others. When new or updated versions of these software applications are introduced, we must sometimes develop updated versions of our software so that they interoperate properly with these applications. We may not accomplish these development efforts quickly, cost-effectively or at all. These development efforts require substantial capital investment and the devotion of substantial employee resources. For example, our products currently interoperate with a number of data protection applications marketed by vendors such as Symantec Corporation and EMC. If we fail to maintain compatibility with these applications, our customers may not be able to protect adequately the data resident on our products and we may, among other consequences, fail to increase, or we may lose, market share and experience a weakening in demand for our products, which would adversely affect our business, operating results and financial condition.

Our products must interoperate with various data-access protocols and, if we are unable to ensure that our products interoperate with these protocols, our products might become less competitive.

Our products interoperate with servers and software applications predominantly through the use of protocols, many of which are created and maintained by independent standards organizations. However, some of these protocols that exist today or that may be created in the future are or could be proprietary technology and therefore require licensing the proprietary protocol’s specifications from a third party or implementing the protocol without specifications, which might entail significant effort on our part. If we fail to obtain a license to these specifications from third-party vendors on reasonable terms or at all, and we are not able to implement the protocol in the absence of these specifications, our products might become less competitive, which would harm our business. For example, Microsoft Corporation maintains and enhances the Common Internet File System, or CIFS, a proprietary protocol that our products use to communicate with the Windows operating system, the most popular computer operating system in the world. Although our products are currently compatible with CIFS, at present we do not license the specifications to this proprietary protocol. If we are not able to continue to maintain adequate compatibility with CIFS or if we are not able to license adequate specifications to this protocol on reasonable terms, our products would likely be less competitive in the marketplace, which would adversely affect our business, operating results and financial condition.

If our products do not interoperate with our customers’ networks, servers or software applications, installations would be delayed or cancelled.

Our products must interoperate with our customers’ existing infrastructure, specifically their networks, servers and software applications. This infrastructure often utilizes multiple protocol standards, products from multiple vendors and a wide range of storage features. If we find, as we have in the past, defects in the existing software or hardware used in our customers’ infrastructure or an incompatibility or deficiency in our software, we may have to modify our software so that our products will interoperate with our customers’ infrastructure. This could cause longer sales and implementation cycles for our products and could cause order cancellations, either of which would adversely affect our business, operating results and financial condition.

We may engage in future acquisitions that could disrupt our business, cause dilution to our stockholders, reduce our financial resources and result in increased expenses.

In the future, we may acquire other businesses, products or technologies. We have not made any acquisitions to date. Accordingly, our ability as an organization to make acquisitions is unproven. We may not be able to find suitable acquisition candidates, and we may not be able to complete acquisitions on favorable terms, if at all. If we do complete acquisitions, we may not strengthen our competitive position or achieve our goals, or these acquisitions may be viewed negatively by customers, financial markets or investors. In addition, any acquisitions that we make could lead to difficulties in integrating personnel, technologies and operations from the acquired businesses and in retaining and motivating key personnel from these businesses. Acquisitions may

disrupt our ongoing operations, divert management from day-to-day responsibilities, increase our expenses and adversely impact our business, operating results and financial condition. Future acquisitions may reduce our cash available for operations and other uses, and could result in an increase in amortization expense related to identifiable assets acquired, potentially dilutive issuances of equity securities or the incurrence of debt.

Changes in financial accounting standards or practices may cause adverse, unexpected financial reporting fluctuations and affect our reported results of operations.

A change in accounting standards or practices can have a significant effect on our operating results and may affect our reporting of transactions completed before the change is effective. New accounting pronouncements and varying interpretations of existing accounting pronouncements have occurred and may occur in the future. Changes to existing rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business. For example, although not yet currently required, we could be required, as soon as fiscal year 2015, to adopt International Financial Reporting Standards, or IFRS, which are different than accounting principles generally accepted in the United States of America for our accounting and reporting standards.

Our business is subject to increasingly complex environmental legislation that has increased both our costs and the risk of noncompliance.

We face increasing complexity in our product design and procurement operations as we adjust to new and upcoming requirements relating to the materials composition of many of our products. The European Union, or EU, has adopted certain directives to facilitate the recycling of electrical and electronic equipment sold in the EU, including the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment, or RoHS, directive and the Waste Electrical and Electric Equipment Directive, or WEEE directive. The RoHS directive restricts the use of lead, mercury and certain other substances in electrical and electronic products placed on the market in the EU after July 1, 2006. The WEEE directive imposes certain responsibilities for the disposal of waste electrical and electronic equipment on manufacturers of such equipment.

In connection with our compliance with these environmental laws and regulations, we could incur substantial costs, including reserves taken for excess component inventory, and could be subject to disruptions to our operations and logistics. In addition, we will need to ensure that we can manufacture compliant products and that we can be assured a supply of compliant components from suppliers. Similar laws and regulations have been proposed or may be enacted in other regions, including in the United States, China and Japan. Other environmental regulations may require us to reengineer our products to utilize components that are compatible with these regulations, and this reengineering and component substitution may result in additional costs to us. We cannot assure you that existing laws or future laws will not have a material adverse effect on our business.

We are subject to governmental export and import controls that could impair our ability to compete in international markets.

Because we incorporate encryption technology into our products, our products are subject to United States export controls and may be exported outside the United States only with the required level of export license or through an export license exception. In addition, various countries regulate the importation of certain encryption technology and have enacted laws that could limit our ability to distribute our products or could limit our customers’ ability to implement our products in those countries. Changes in our products or changes in export and import regulations may create delays in the introduction of our products in international markets, prevent our customers with international operations from deploying our products throughout their global systems or, in some cases, prevent the export or import of our products to certain countries altogether. Any change in export or import regulations or related legislation, shift in approach to the enforcement or scope of existing regulations or change in the countries, persons or technologies targeted by these regulations could result in decreased use of our products by, or in our decreased ability to export or sell our products to, existing or potential customers with international operations.

If we need additional capital in the future, it may not be available to us on favorable terms, or at all.

We have historically relied on outside financing and customer payments to fund our operations, capital expenditures and expansion. We may require additional capital from equity or debt financing in the future to fund our operations or respond to competitive pressures or strategic opportunities. Due to the recent tightening of the credit and private equity markets, such financing may not be available, or we may not be able to secure timely additional financing on favorable terms. The terms of any additional financing may place limits on our financial and operating flexibility. If we raise additional funds through further issuances of equity, convertible debt securities or other securities convertible into equity, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. If we are unable to obtain adequate financing or financing on terms satisfactory to us, if and when we require it, our ability to grow or support our business and to respond to business challenges could be significantly limited.

Our business is subject to the risks of earthquakes and other natural catastrophic events, and to interruption by man-made problems such as computer viruses or terrorism.

Our corporate headquarters are located in Seattle, Washington, an area that is at heightened risk of earthquake and volcanic events. We may not have adequate business interruption insurance to compensate us for losses that may occur from any such significant events. A significant natural disaster, such as an earthquake or volcanic eruption, could have a material adverse impact on our business, operating results and financial condition. Also, our servers are vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering with our computer systems. In addition, acts of terrorism could cause disruptions in our or our customers’ business or the economy as a whole. To the extent that these disruptions result in delays or cancellations of customer orders or the deployment of our products, our business, operating results and financial condition would be adversely affected.

The trading price of our common stock is likely to be volatile.

The trading prices of the securities of technology companies have been highly volatile. Further, our common stock has a limited trading history. Since our initial public offering in December 2006 through October 21, 2010, our stock price has fluctuated from a high of $29.47 to a low of $1.86. Factors affecting the trading price of our common stock, some of which are outside our control, include:

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variations in our operating results or those of our competitors;

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market conditions in our industry, the industries of our customers and the economy as a whole;

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announcements of technological innovations, new products or product enhancements, strategic alliances or significant agreements by us or by our competitors;

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the gain or loss of significant customers;

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the level of sales in a particular quarter;

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lawsuits threatened or filed against us;

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inquiries or investigations by the SEC, NASDAQ, law enforcement or other regulatory bodies;

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the recruitment or departure of key personnel;

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changes in the estimates of our operating results or changes in recommendations by any securities analysts who elect to follow our common stock; and

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the adoption or modification of regulations, policies, procedures or programs applicable to our business.

In addition, if the market for technology stocks or the stock market in general experiences loss of investor confidence, the trading price of our common stock could decline for reasons unrelated to our business, operating results or financial condition. The trading price of our common stock might also decline in reaction to events that affect other companies in our industry even if these events do not directly affect us. For example, current macroeconomic conditions have caused substantial and continuing volatility in the U.S. stock markets. Although such conditions have not been specific to our company, our stock has experienced similar volatility. Some companies that have had volatile market prices for their securities have had securities class actions filed against them. If a suit were filed against us, regardless of its merits or outcome, it would likely result in substantial costs and divert management’s attention and resources. This could have a material adverse effect on our business, operating results and financial condition.

Insiders continue to have substantial control over us and will be able to influence corporate matters.

As of September 30, 2010, our directors and executive officers and their affiliates beneficially own, in the aggregate, approximately 51.6% of our outstanding common stock. As a result, these stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, such as a merger or other sale of our company or its assets. This concentration of ownership could limit other stockholders’ ability to influence corporate matters and may have the effect of delaying or preventing a third party from acquiring control over us.

Provisions in our certificate of incorporation and bylaws and Delaware law might discourage, delay or prevent a change of control of our company or changes in our management and, therefore, depress the trading price of our common stock.

Our certificate of incorporation and bylaws contain provisions that could depress the trading price of our common stock by acting to discourage, delay or prevent a change in control of our company or changes in our management that the stockholders of our company may deem advantageous. These provisions:

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establish a classified board of directors so that not all members of our board are elected at one time;

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provide that directors may only be removed “for cause;”

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authorize the issuance of “blank check” preferred stock that our board of directors could issue to increase the number of outstanding shares to discourage a takeover attempt;

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eliminate the ability of our stockholders to call special meetings of stockholders;

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prohibit stockholder action by written consent, which has the effect of requiring all stockholder actions to be taken at a meeting of stockholders;

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provide that the board of directors is expressly authorized to make, alter or repeal our bylaws; and

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establish advance notice requirements for nominations for election to our board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.

In addition, Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a change in control of our company by prohibiting stockholders owning in excess of 15% of our outstanding voting stock from merging or combining with us unless certain approvals are obtained.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

ITEM 3. Defaults Upon Senior Securities

None.

ITEM 5. Other Information

Our insider trading policy allows directors, officers and other employees covered under the policy to establish, under limited circumstances contemplated by Rule 10b5-1 under the Securities Exchange Act of 1934, as amended, written programs that permit automatic trading of our stock or trading of our stock by an independent person (such as a broker or an investment bank) who is not aware of material, nonpublic information at the time of the trade. On August 9, 2010, one of our executives entered into a Rule 10b5-1 trading plan pursuant to which shares of our common stock will be sold for his account from time to time in accordance with the provisions of the plan without any further action or involvement by the executive.

On October 22, 2010, the Compensation Committee adopted forms of Change in Control Severance Agreements (“Agreements”) for our CEO and Section 16 officers, and authorized the Company to enter into such agreements with certain executives, including our named executive officers.

A brief description of the materials terms and conditions of the Agreements is as follows:

In regard to the CEO, if within eighteen (18) months following a Change in Control (as defined in the Agreement), there is a qualifying termination (other than for Cause, Death or Disability, or a resignation for Good Reason) (each as defined in the Agreement), the CEO will receive a lump sum severance payment equal to 100% of the CEO’s then current annual base salary and reimbursement for COBRA premiums for twelve months, and 100% of the unvested portion of any then-outstanding equity awards will immediately vest. As a condition of such Agreement, the CEO will agree that the specific percentage acceleration provisions set forth in the Vesting Schedule of the Notice of Grant of Stock Option of all prior option agreements shall be null and void.

In regard to the Section 16 officers, if within eighteen (18) months following a Change in Control (as defined in the Agreement), there is a qualifying termination (other than for Cause, Death or Disability, or a resignation for Good Reason) (each as defined in the Agreement), the Executive will receive a lump sum severance payment equal to six months of the Executive’s then current annual base salary and reimbursement for COBRA premiums for six months, and 100% of the unvested portion of any then-outstanding equity awards will immediately vest. As a condition of such Agreement, the Executive will agree that the specific percentage acceleration provisions set forth in the Vesting Schedule of the Notice of Grant of Stock Option of all prior option agreements shall be null and void.

The foregoing description of the Agreements is not a complete description and is qualified by reference to the full text of such Agreements which the Company has filed herewith as Exhibits 10.1 and 10.2 to the Form 10-Q.

ITEM 6. Exhibits

The following exhibits are incorporated by reference or filed herewith.


Exhibit Number		Description

10.1*		Form of Change of Control Severance Agreement (CEO)

10.2*		Form of Change of Control Severance Agreement (Section 16)

31.1*		Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer.

31.2 *		Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer.

32.1 ‡		Section 1350 Certification of Chief Executive Officer.

32.2 ‡		Section 1350 Certification of Chief Financial Officer.

*		Filed herewith.

‡		Furnished herewith.

SIGNATURES

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


	ISILON SYSTEMS, INC.

Date: October 22, 2010	By:	/s/ Sujal Patel
		Sujal Patel
		President, Chief Executive Officer and Director (Principal Executive Officer)

	By:	/s/ William Richter
		William Richter
		Vice President of Finance and Chief Financial Officer (Principal Accounting and Financial Officer)

INDEX TO EXHIBITS


Exhibit Number		Description

10.1*		Form of Change of Control Severance Agreement (CEO)

10.2*		form of Change of Control Severance Agreement (Section 16)

31.1*		Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer.

31.2 *		Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer.

32.1 ‡		Section 1350 Certification of Chief Executive Officer.

32.2 ‡		Section 1350 Certification of Chief Financial Officer.

*		Filed herewith.

‡		Furnished herewith.

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Isilon Systems, Inc. Reports

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