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EX-3.1 - AMENDED AND RESTATED CERTIFICATE OF INCORPORATION - Arista Networks, Inc.ex31amendedandrestatedcert.htm
EXCEL - IDEA: XBRL DOCUMENT - Arista Networks, Inc.Financial_Report.xls
EX-3.2 - AMENDED AND RESTATED BYLAWS - Arista Networks, Inc.ex32amendedandrestatedbyla.htm
EX-31.1 - CERTIFICATION OF CEO PURSUANT TO EXCHANGE ACT RULES 13A-14(A) AND 15D-14(A) - Arista Networks, Inc.ex311ceocertification.htm
EX-32.1 - CERTIFICATIONS OF CEO AND CFO PURSUANT TO 18 U.S.C. SECTION 1350 - Arista Networks, Inc.ex321ceoandcfo906certifica.htm
EX-10.1 - SECOND AMENDMENT - IRVINE LEASE - Arista Networks, Inc.ex101secondamendmenttolease.htm
EX-31.2 - CERTIFICATION OF CFO PURSUANT TO EXCHANGE ACT RULES 13A-14(A) AND 15D-14(A) - Arista Networks, Inc.ex312cfocertification.htm
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________________________ 
FORM 10-Q
____________________________ 
(Mark One)

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2014
OR
 
o
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: 001-36468
____________________________
ARISTA NETWORKS, INC.
(Exact name of registrant as specified in its charter)
____________________________ 
Delaware
20-1751121
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification Number)
5453 Great America Parkway
Santa Clara, California 95054
(Address of principal executive offices)
(408) 547-5500
(Registrant’s telephone number, including area code)
 ________________ ___________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act 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     No  x 
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  x    No  o
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 definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
o
Accelerated filer
o
Non-accelerated filer
ý  (Do not check if a smaller reporting company)
Smaller reporting company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  x
The number of shares outstanding of the registrant’s Common Stock, $0.0001 par value, as of August 1, 2014 was 64,403,957.
 






ARISTA NETWORKS, INC.
TABLE OF CONTENTS
 
 
Page
Item 1.
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
 



PART I - FINANCIAL INFORMATION
Item 1. Financial Statements


ARISTA NETWORKS, INC.
Condensed Consolidated Balance Sheets
(Unaudited)
(in thousands, except par value)
 
June 30,
2014
 
December 31,
2013
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
397,198

 
$
113,664

Accounts receivable, net of allowances of $2,521 and $2,339 as of June 30, 2014 and December 31, 2013
67,946

 
77,999

Inventories
71,068

 
73,360

Deferred tax assets
8,696

 
12,356

Prepaid expenses and other current assets
9,768

 
4,144

Notes receivable
8,000

 
4,000

Total current assets
562,676

 
285,523

Property and equipment, net
68,799

 
67,204

Restricted cash

 
4,040

Deposits and other assets
3,806

 
3,212

Deferred tax assets
7,497

 
4,541

TOTAL ASSETS
$
642,778

 
$
364,520

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
CURRENT LIABILITIES:
 
 
 
Accounts payable
$
20,000

 
$
14,741

Accrued liabilities
28,016

 
26,909

Deferred revenue
37,888

 
41,306

Convertible notes payable, related party

 
24,743

Accrued interest payable, related party

 
4,484

Convertible notes payable

 
74,050

Accrued interest payable

 
12,967

Other current liabilities
11,790

 
10,144

Total current liabilities
97,694

 
209,344

Income taxes payable
15,072

 
14,716

Lease financing obligations, non-current
43,108

 
43,152

Other long-term liabilities
25,718

 
19,576

TOTAL LIABILITIES
181,592

 
286,788

Commitments and contingencies (Note 6)


 


STOCKHOLDERS’ EQUITY:
 
 
 
Preferred stock, $0.0001 par value—100,000 shares authorized, no shares issued and outstanding as of June 30, 2014; no shares authorized, issued and outstanding as of December 31, 2013

 

Convertible preferred stock, $0.0001 par value— no shares and 24,000 shares authorized, issued and outstanding at June 30, 2014 and December 31, 2013; aggregate liquidation preference of $6,000 as of December 31, 2013 (none as of June 30, 2014)

 
5,992

Common stock, $0.0001 par value—1,000,000 and 176,000 shares authorized as of June 30, 2014 and December 31, 2013; 64,386 and 31,927 shares issued and outstanding as of June 30, 2014 and December 31, 2013
7

 
3

Additional paid-in capital
384,253

 
28,737

Retained earnings
76,911

 
42,964

Accumulated other comprehensive income
15

 
36

TOTAL STOCKHOLDERS’ EQUITY
461,186

 
77,732

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
642,778

 
$
364,520

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

3


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Income
(Unaudited)
(in thousands, except per share amounts)

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
 
Revenue
$
137,947

 
$
83,485

 
$
255,154

 
$
144,833

Cost of revenue
44,567

 
29,584

 
80,460

 
48,804

Gross profit
93,380

 
53,901

 
174,694

 
96,029

Operating expenses:
 
 
 
 
 
 
 
Research and development
34,888

 
21,086

 
68,334

 
40,600

Sales and marketing
20,711

 
13,045

 
39,366

 
23,180

General and administrative
7,126

 
3,506

 
14,357

 
7,242

Total operating expenses
62,725

 
37,637

 
122,057

 
71,022

Income from operations
30,655

 
16,264

 
52,637

 
25,007

Other income (expense), net:
 
 
 
 
 
 
 
Interest expense—related party
(350
)
 
(433
)
 
(782
)
 
(861
)
Interest expense
(1,085
)
 
(1,339
)
 
(2,424
)
 
(2,662
)
Interest and other income (expense), net
2,472

 
(1
)
 
1,708

 
(100
)
Total other income (expense), net
1,037

 
(1,773
)
 
(1,498
)
 
(3,623
)
Income before provision for income taxes
31,692

 
14,491

 
51,139

 
21,384

Provision for income taxes
10,074

 
4,240

 
17,192

 
4,522

Net income
$
21,618

 
$
10,251

 
$
33,947

 
$
16,862

Net income attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
14,212

 
$
4,948

 
$
19,985

 
$
8,063

Diluted
$
14,851

 
$
5,159

 
$
21,121

 
$
8,372

 
 
 
 
 
 
 
 
Net income per share attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
0.37

 
$
0.18

 
$
0.59

 
$
0.30

Diluted
$
0.34

 
$
0.18

 
$
0.54

 
$
0.29

Weighted-average shares used in computing net income per share attributable to common stockholders:
 
 
 
 
 
 
 
Basic
38,491

 
26,926

 
33,834

 
26,607

Diluted
44,057

 
29,252

 
38,962

 
28,650


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



4


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Comprehensive Income
(Unaudited)
(in thousands)
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Net income
$
21,618

 
$
10,251

 
$
33,947

 
$
16,862

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Foreign currency translation adjustments
12

 
(34)

 
(21)

 
(67)

Other comprehensive income (loss)
12

 
(34)

 
(21)

 
(67)

Comprehensive income
$
21,630

 
$
10,217

 
$
33,926

 
$
16,795


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



5


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Stockholders’ Equity
(Unaudited)
(in thousands)
 
 
Convertible Preferred Stock
 
Common Stock  
 
Additional
Paid-In Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Total
Stockholders’
Equity
 
 
Shares
 
Amount
 
Shares
 
Amount
 
Balance—December 31, 2013
 
24,000

 
$
5,992

 
31,927

 
$
3

 
$
28,737

 
$
42,964

 
$
36

 
$
77,732

Net income
 

 

 

 

 

 
33,947

 

 
33,947

Other comprehensive loss, net of tax
 

 

 

 

 

 

 
(21
)
 
(21
)
Issuance of common stock from initial public offering, net of offering costs
 

 

 
6,037

 
1

 
238,723

 

 

 
238,724

Conversion of convertible preferred stock into common stock upon initial public offering
 
(24,000
)
 
(5,992
)
 
24,000

 
3

 
5,989

 

 

 

Conversion of notes payable and accrued interest into common stock upon initial public offering
 

 

 
1,543

 

 
66,338

 

 

 
66,338

Conversion of notes payable and accrued interest, related party, into common stock upon initial public offering
 

 

 
701

 

 
30,153

 

 

 
30,153

Tax benefit for equity incentive plans
 

 

 

 

 
454

 

 

 
454

Stock-based compensation
 

 

 

 

 
11,487

 

 

 
11,487

Vesting of stock options and restricted stock
 

 

 

 

 
1,940

 

 

 
1,940

Exercise of stock options, net of repurchases
 

 

 
178

 

 
432

 

 

 
432

Balance—June 30, 2014
 

 
$

 
64,386

 
$
7

 
$
384,253

 
$
76,911

 
$
15

 
$
461,186


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


6


ARISTA NETWORKS, INC.
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(in thousands)

 
 
Six Months Ended June 30,
 
 
2014
 
2013
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
Net income
 
$
33,947

 
$
16,862

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
4,713

 
1,484

Stock-based compensation
 
11,487

 
3,815

Deferred income taxes
 
703

 
(2,090
)
Provision for bad debts
 
374

 
313

Unrealized gain on notes receivable
 
(4,000
)
 

Amortization of debt discount
 
527

 
553

Write-off of debt discount on notes payable
 
680

 

Excess tax benefit on stock based-compensation
 
(459
)
 
(213
)
Changes in operating assets and liabilities:
 
 
 
 
Accounts receivable
 
9,678

 
(27,545
)
Inventories
 
2,291

 
(12,651
)
Prepaid expenses and other current assets
 
(5,621
)
 
(1,914
)
Deposits and other assets
 
(596
)
 
118

Accounts payable
 
4,789

 
2,227

Accrued liabilities
 
626

 
7,951

Deferred revenue
 
2,779

 
14,816

Interest payable
 
(1,630
)
 
2,232

Interest payable—related party
 
670

 
744

Income taxes payable
 
372

 
945

Other liabilities
 
2,616

 
1,101

Net cash provided by operating activities
 
63,946

 
8,748

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
 
Purchases of property and equipment
 
(8,579
)
 
(12,212
)
Change in restricted cash
 
4,040

 

Net cash used in investing activities
 
(4,539
)
 
(12,212
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
 
Proceeds from initial public offering, net of issuance cost
 
241,862

 

Repayment on notes payable
 
(20,000
)
 

Principal payments of lease financing obligations
 
(335
)
 

Proceeds from issuance of common stock upon exercising options, net of repurchases
 
2,078

 
5,282

Excess tax benefit on stock-based compensation
 
459

 
213

Net cash provided by financing activities
 
224,064

 
5,495

Effect of exchange rate changes
 
63

 
(54
)
NET INCREASE IN CASH AND CASH EQUIVALENTS
 
283,534

 
1,977

CASH AND CASH EQUIVALENTS—Beginning of period
 
113,664

 
88,655

CASH AND CASH EQUIVALENTS—End of period
 
$
397,198

 
$
90,632

 
 
 
 
 

7


 
 
Six Months Ended June 30,
 
 
2014
 
2013
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
 
Cash paid for income taxes
 
$
18,433

 
$
5,896

Cash paid for interest— lease financing obligation
 
$
1,283

 
$

Cash paid for interest— notes payable
 
$
3,639

 
$

SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING INFORMATION:
 
 
 
 
Increase (decrease) in accounts payable and accrued liabilities related to property and equipment
 
$
(2,261
)
 
$
317

Conversion of convertible preferred stock to common stock upon initial public offering
 
$
5,992

 
$

Conversion of notes payable and accrued interest to common stock upon initial public offering
 
$
66,338

 
$

Conversion of notes payable and accrued interest, related party, to common stock upon initial public offering
 
$
30,153

 
$

Unpaid deferred offering costs
 
$
3,138

 
$

Acquisition of building with financing obligation
 
$
456

 
$
17,713


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


8




ARISTA NETWORKS, INC.
Notes to Condensed Consolidated Financial Statements
(Unaudited)


1.    Overview and Basis of Presentation

Organization
Arista Networks, Inc. (together with our subsidiaries, “we,” “our” or “us”) is a supplier of cloud networking solutions that use software innovations to address the needs of large-scale Internet companies, cloud service providers and next-generation enterprise. Our cloud networking solutions consist of our Extensible Operating System, a set of network applications and our 10/40/100 Gigabit Ethernet switches. We were incorporated in October 2004 in the State of California under the name Arastra, Inc. In March 2008, we reincorporated in the State of Nevada and in October 2008 changed our name to Arista Networks, Inc. We reincorporated in the state of Delaware in March 2014. Our corporate headquarters are located in Santa Clara, California, and we have wholly-owned subsidiaries throughout the world, including North America, Europe, Asia and Australia.

Initial Public Offering
On June 6, 2014, we completed our initial public offering (the “IPO”) in which we sold 6,037,500 shares of our common stock at a public offering price of $43.00 per share, which included 787,500 shares of common stock issued pursuant to the exercise in full of the over-allotment option granted to the underwriters. The IPO resulted in proceeds of $238.7 million, net of underwriting discounts and commissions of $15.6 million and other estimated issuance costs of $5.3 million. In connection with the closing of the IPO, all of our outstanding convertible preferred stock automatically converted into 24,000,000 shares of common stock on a one-to-one basis.

Upon the closing of our IPO, all noteholders with the exception of one noteholder converted the principal and accrued interest amount outstanding under their subordinated convertible promissory notes into shares of our common stock at the IPO price of $43.00 per share. The noteholder, who did not elect to so convert, was paid a total of $23.6 million which included principal and accrued interest less applicable withholding taxes of $1.1 million. The remainder of the noteholders converted the remaining debt balance of approximately $96.5 million including principal and accrued interest into 2.2 million shares of our common stock.

Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (" U.S. GAAP") and following the requirements of the U.S. Securities and Exchange Commission (the “SEC”) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by U.S. GAAP can be condensed or omitted. In management’s opinion, the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments, which include only normal recurring adjustments, necessary for the fair presentation of our financial information. The results for the three and six months ended June 30, 2014, are not necessarily indicative of the results expected for the full fiscal year.

The condensed consolidated balance sheet as of December 31, 2013 has been derived from the audited consolidated financial statements at that date but does not include all of the information and notes required by generally accepted accounting principles for complete financial statements.
The accompanying unaudited condensed consolidated financial statements include the accounts of Arista Networks, Inc. and our wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
The accompanying unaudited condensed consolidated financial statements and related financial information should be read in conjunction with the audited consolidated financial statements and related footnotes included in our prospectus filed pursuant to Rule 424(b) under the Securities Act of 1933, as amended (the “Securities Act”), with the SEC on June 6, 2014 (the “Prospectus”).

9


There have been no material changes in our significant accounting policies from those that were disclosed in our audited consolidated financial statements for the year ended December 31, 2013 included in the Prospectus.

Use of Estimates

The preparation of the accompanying unaudited condensed consolidated financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the amounts reported and disclosed in the unaudited condensed consolidated financial statements and accompanying notes. Those estimates and assumptions include, but are not limited to, revenue recognition and deferred revenue; determination of fair value for stock-based awards; accounting for income taxes, including the valuation allowance on deferred tax assets and reserves for uncertain tax positions; valuation of inventory; valuation of warranty accruals; and the recognition and measurement of contingent liabilities. We evaluate our estimates and assumptions on an ongoing basis using historical experience and other factors and adjust those estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ from these estimates, and those differences could be material to the unaudited condensed consolidated financial statements.  

Business Concentrations
We work closely with third parties to manufacture and deliver our products. As of June 30, 2014 and December 31, 2013, two suppliers provided all of our electronic manufacturing services. Our products rely on key components, including certain integrated circuit components and power supplies some of which our contract manufacturers purchase on our behalf from a limited number of suppliers, including certain sole source providers. We do not have guaranteed supply contracts with any of our component suppliers, and our suppliers could delay shipments or cease manufacturing such products or selling them to us at any time. If we are unable to obtain a sufficient quantity of these components on commercially reasonable terms or in a timely manner, sales of our products could be delayed or halted entirely or we may be required to redesign our products. Quality or performance failures of our products or changes in our contractors’ or vendors’ financial or business condition could disrupt our ability to supply quality products to our customers. Any of these events could result in lost sales and damage to our end-customer relationships, which would adversely impact our business, financial condition and results of operations.

Concentrations of Credit Risk
Financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash, cash equivalents, restricted cash, accounts receivable and notes receivable. Our cash, cash equivalents and restricted cash are invested in high quality financial instruments with banks and financial institutions. Such deposits may be in excess of insured limits provided on such deposits.
Our accounts receivable are unsecured and represent amounts due to us based on contractual obligations of our customers. We mitigate credit risk in respect to accounts receivable by performing ongoing credit evaluations of our customers to assess the probability of accounts receivable collection based on a number of factors, including past transaction experience with the customer, evaluation of their credit history, the credit limits extended and review of the invoicing terms of the contract. We generally do not require our customers to provide collateral to support accounts receivable. We have recorded an allowance for doubtful accounts for those receivables that we have determined not to be collectible.
 
Our notes receivable are secured and represent amounts due to us from a private company. We mitigate credit risk in respect to the notes receivable by performing ongoing credit evaluations of the borrower to assess the probability of collecting all amounts due to us under the existing contractual terms.
We market and sell our products through both our direct sales force and our channel partners, including distributors, value-added resellers, system integrators and original equipment manufacturer (“OEM”) partners.

Recent Accounting Pronouncements

In May 2014, the FASB issued ASU No. 2014-09, Revenue From Contracts With Customers ("ASU 2014-09"), which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. ASU 2014-09 is effective for fiscal years (and interim reporting periods within those years) beginning after December 15, 2016. Early application is not permitted. ASU 2014-09 permits the use of either the retrospective or cumulative effect transition method. We are currently reviewing the provisions of ASU 2014-09 and have not yet selected a transition method nor have we determined the effect of the standard on our consolidated financial statements.


10


2.    Fair Value Measurements

Our assets and liabilities which require fair value measurement consist of cash and cash equivalents, restricted cash, accounts receivable, notes receivable, accounts payable and accrued liabilities. Cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities are stated at carrying amounts as reported in the consolidated financial statements, which approximates fair value due to their short term nature. Notes receivable are stated at fair value, as we have elected to fair value our notes receivable using the fair value option permitted to us.

Assets and liabilities recorded at fair value on a recurring basis in the accompanying unaudited condensed consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Fair value is defined as the exchange price that would be received for an asset or an exit price that would be paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The authoritative guidance on fair value measurements establishes a three-tier fair value hierarchy for disclosure of the inputs used to measure fair value instruments as follows:

Level I - Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date;

Level II - Inputs are observable, unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the related assets or liabilities; and
 
Level III - Unobservable inputs that are supported by little or no market data for the related assets or liabilities and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability.

Our financial instruments consist of Level I and Level III assets. Level I assets include highly liquid money market funds that are included in cash and cash equivalents. Level III assets that are measured on a recurring basis consist solely of our notes receivable. We classified the notes receivable as Level III, as we used unobservable inputs to the valuation methodology that were significant to the fair value measurement, and the valuation required management judgment due to the absence of quoted market prices. We measure the fair value of the notes receivable based upon the probability-weighted present value of expected future investment returns, considering each of the possible future outcomes available to us. The significant unobservable inputs used in the fair value measurement of the convertible notes are the scenario probabilities and the discount rate estimated at the valuation date. Generally, increases (decreases) in the discount rate would result in a directionally opposite impact to the fair value measurement of the notes. Also, changes in the probability scenarios would have had varying impacts depending on the weighting of each specific scenario. More weighting towards a change in control or an equity financing by the investee would result in an increase in fair value of the notes receivable.
We measure and report our cash equivalents, restricted cash and notes receivable at fair value. The following table sets forth the fair value of our financial assets by level within the fair value hierarchy as noted above (in thousands):
 
June 30, 2014
 
Level I
 
Level II
 
Level III
 
Total
Financial Assets
 
Money market funds
$
244,170

 
$

 
$

 
$
244,170

Notes receivable(2)   

 

 
8,000

 
8,000

Total financial assets
$
244,170


$

 
$
8,000

 
$
252,170


 
December 31, 2013
 
Level I 
 
Level II
 
Level III
 
Total
Financial Assets
 
 
 
 
 
 
 
Money market funds
$
47,036

 
$

 
$

 
$
47,036

Money market funds – restricted cash(1)  
4,040

 

 

 
4,040

Notes receivable(2)   

 

 
4,000

 
4,000

Total financial assets
$
51,076

 
$

 
$
4,000

 
$
55,076


11


 
 
(1)Included in “Restricted cash” in the accompanying Condensed Consolidated Balance Sheets.

(2)Included in “Notes receivable” in the accompanying Condensed Consolidated Balance Sheets. We invested $5.0 million during 2012 in a private company (See “Note 4 – Notes Receivable”), and there were no changes in the fair value of the Level III assets during the year ended December 31, 2013. During the three and six months ended June 30, 2014, we increased the fair value of our Notes receivable by $4.0 million (See “Note 4 – Notes Receivable”). During the six months ended June 30, 2014 and the year ended December 31, 2013, we had no transfers between levels of the fair value hierarchy of its assets measured at fair value. On December 31, 2013, we received a principal payment of $1.0 million and related accrued interest.

3.    Balance Sheet Components

Accounts Receivable, net
Accounts receivable, net consists of the following (in thousands):  
 
June 30,
2014
 
December 31,
2013
Accounts receivable
$
70,467

 
$
80,338

Allowance for doubtful accounts
(886
)
 
(810
)
Product sales return reserve
(1,635
)
 
(1,529
)
Accounts receivable, net
$
67,946

 
$
77,999


Inventories
Inventories consist of the following (in thousands):
 
June 30,
2014
 
December 31,
2013
Raw materials
$
13,078

 
$
18,286

Finished goods
57,990

 
55,074

Total inventories
$
71,068

 
$
73,360


As of June 30, 2014 and December 31, 2013, finished goods inventory included spare parts inventory of $8.3 million and $5.5 million, respectively.

Property and Equipment, net
    Property and equipment, net consists of the following (in thousands):
 
June 30,
2014
 
December 31,
2013
Equipment and machinery
$
15,973

 
$
13,733

Computer hardware and software
6,572

 
3,688

Furniture and fixtures
1,375

 
1,352

Leasehold improvements
19,212

 
19,407

Building
35,154

 
35,154

Construction-in-process
2,192

 
1,056

Property and equipment, gross
80,478

 
74,390

Less: accumulated depreciation
(11,679
)
 
(7,186
)
Property and equipment, net
$
68,799

 
$
67,204

 
Building consists of capitalized construction costs of our leased building in Santa Clara, California. Based on the terms of the lease agreement and due to our involvement in certain aspects of the construction, such as our financial involvement in structural elements of asset construction, making decisions related to tenant improvement costs and purchasing insurance not

12


reimbursable by the buyer-lessor (the Landlord), we are deemed the owner of the building (for accounting purposes only) during the construction period. We maintain continued involvement in the property after construction was completed and lack transferability of the risks and rewards of ownership, primarily due to our required maintenance of a $4.0 million letter of credit. Due to our continuing involvement in the property post construction and lack of transferability of related risks and rewards of ownership to the Landlord after construction is complete, we account for the building as a financing obligation. See “Note 6-Commitments and Contingencies”. Accordingly, as of June 30, 2014 and December 31, 2013, we have recorded assets of $53.4 million and $53.3 million, respectively, representing the total costs of the building and improvements incurred, including the costs paid by the Landlord. The building was completed in 2013.
Depreciation expense was $2.4 million, $4.7 million, $0.8 million and $1.5 million for the three and six months ended June 30, 2014 and 2013, respectively.
Accrued Liabilities
Accrued liabilities consist of the following (in thousands):
 
June 30,
2014
 
December 31,
2013
Accrued payroll related costs
$
13,276

 
$
9,090

Accrued warranty costs
3,564

 
5,075

Accrued accounts payable
4,876

 
5,370

Accrued manufacturing costs
1,577

 
3,633

Other
4,723

 
3,741

Total accrued liabilities
$
28,016

 
$
26,909

 
Warranty Accrual

We offer a one-year warranty on all of our hardware products and a 90-day warranty against defects in the software embedded in the products. We accrue for potential warranty claims at the time of shipment as a component of cost of revenues based on historical experience and other relevant information. We accrue specifically identified reserves if and when we determine we have a systemic product failure. The accrued warranty liability is recorded in accrued liabilities in the accompanying unaudited condensed consolidated balance sheets.
The following table summarizes the activity related to our accrued liability for estimated future warranty costs (in thousands):
 
Six Months Ended June 30,
 
2014
 
2013
Warranty accrual, beginning of period
$
5,075

 
$
5,314

Liabilities accrued for warranties issued during the period
967

 
2,935

Warranty costs incurred during the period
(1,288
)
 
(1,658
)
Adjustments related to change in estimate
(1,190
)
 

Warranty accrual, end of period
$
3,564

 
$
6,591

During the six months ended June 30, 2013, we identified specific products that were failing in the field prematurely at higher than expected rates due to various component issues. We determined that replacement of certain affected products was required and recorded specific warranty reserves of $0.3 million during the six months ended June 30, 2013. There were no specific warranty reserves recorded during the six months ended June 30, 2014.

13


Deferred Revenue
Deferred revenue consists of the following (in thousands):
 
June 30,
2014
 
December 31,
2013
Current portion of deferred revenue
$
37,888

 
$
41,306

Long-term portion of deferred revenue
23,795

 
17,598

Total deferred revenue
$
61,683

 
$
58,904

The long-term portion of deferred revenue is included in other long-term liabilities in the accompanying condensed consolidated balance sheets.

4.    Notes Receivable

In May and July 2012, we made loans in the aggregate of $1.0 million, under two convertible notes receivable to a private company. The interest rate on the notes receivable was 6.0% per annum. The notes are convertible into the private company’s preferred stock or any securities exchangeable for the private company’s preferred stock. All unpaid principal and accrued interest on the notes receivable was due and payable on the earlier of December 31, 2013, or upon default. The notes receivable may not be prepaid before the maturity date. The notes receivable were collateralized by the assets of the borrower. On December 31, 2013, we received a principal payment of $1.0 million and related accrued interest.
On December 31, 2012, we made an additional loan of $4.0 million to the same borrower. The terms of the notes receivable are the same as the amended May and July notes receivable, except that the maturity date is August 31, 2014.
In the event the borrower closes a Corporate Transaction after December 31, 2012, we will receive two times our outstanding principal balance as well as any unpaid accrued interest. A Corporate Transaction is defined as being a sale or lease of all assets, a consolidation or merger or other transaction in which 50% of the voting power is transferred. In the event the borrower completes a Qualified Financing, the outstanding principal and accrued interest on the notes receivable will automatically convert into shares of the borrower’s preferred stock. A Qualified Financing is defined as being a preferred stock financing in which the borrower receives $6.0 million or more in aggregate proceeds. The minimum number of preferred shares we would receive would be equal to the loan value divided by 80% of the lowest price per share the borrower received in the Qualified Financing. In addition, we were able to exchange the notes receivable at any time on or prior to June 30, 2014, if the borrower issued new debt securities on terms more favorable to other investors for debt securities similar to such new debt securities.
On July 30, 2014, the borrower signed a definitive agreement to close a Corporate Transaction through a merger based on the terms defined above. The transaction is expected to close in the fourth quarter of 2014, and we intend to extend the maturity date on August 31, 2014 of the notes receivable through the close date. As a result, we have increased the value of our convertible notes receivable by $4.0 million which represents two times our outstanding principal balance in accordance with terms noted above.
In conjunction with the notes receivable, we also entered into an Exclusivity and Supply Agreement (“Supply Agreement”) with the borrower. Under the terms of the Supply Agreement, the borrower has agreed to develop and produce certain products for us at mutually agreed on supply terms and with best in class pricing rights to us. In addition, any exclusive features developed between us and the borrower cannot be sold by the borrower to other customers for 24 months following the commercial availability of such production versions. The Supply Agreement does not have a maturity date. We determined that the fair value of the Supply Agreement on its inception was insignificant as the borrower is still in the development stage and there is no certainty that a commercial product will be developed.
We determined that we had a variable interest in the borrower through our notes receivable. However, we determined that we are not the primary beneficiary as we do not have the power to direct the borrower’s activities that most significantly affect the borrower’s economic performance. We also determined that our investment in the borrower is not an equity-method investment as the notes receivable have different risk and reward characteristics than those of the borrower’s common stock. We have elected the fair value option method of accounting for our notes receivable. We believe the fair value of the notes receivable is $8.0 million and $4.0 million as of June 30, 2014 and December 31, 2013, respectively, which corresponds to the maximum exposure to loss as a result of our variable interest involvement with the borrower.


14


5.    Debt Obligations

Our debt obligations consist of the following (in thousands):
 
June 30,
2014
 
December 31,
2013
Convertible notes payable—related party
$

 
$
25,000

Convertible notes payable

 
75,000

Total

 
100,000

Less: Unamortized discount on notes payable

 
1,207

Less: Current portion

 
98,793

Total long-term portion of debt
$

 
$

In January 2011, we sold $55.0 million aggregate principal amount of subordinated convertible promissory notes (“Convertible Notes”) to outside investors and $25.0 million aggregate principal amount of Convertible Notes to two trusts that are related to two of our co-founders. The Convertible Notes were convertible into shares of our common stock upon a change of control, a qualified IPO, or immediately prior to when the notes are to be voluntarily prepaid. The proceeds received in the financing were used to repay the outstanding principal on the related party notes payable of $55.6 million and accrued interest of $25.9 million. The repayment of the related party notes payable and the issuance of the aggregate 25.0 million in Convertible Notes to the two trusts were determined to be a debt modification for accounting purposes; therefore, no gain or loss was recognized in our consolidated statements of income for the year ended December 31, 2011.
In conjunction with the Convertible Notes, we also issued 2.0 million shares of our common stock, which had an aggregate fair value of $3.0 million upon issuance. The aggregate net carrying value of the Convertible Notes on their issuance was $77.0 million ($80.0 million in Convertible Notes and $3.0 million in unamortized debt discount). The debt discount was amortized to interest expense over the term of the Convertible Notes under the effective interest method.
In June 2011, we sold an additional $20.0 million in Convertible Notes and also issued 500,000 shares of our common stock, which had an aggregate fair value of $1.2 million, to outside investors. The aggregate net carrying value of the Convertible Notes on issuance was $18.8 million ($20.0 million in Convertible Notes and $1.2 million in unamortized debt discount). The debt discount was amortized to interest expense over the term of the Convertible Notes under the effective interest method.
 
The interest rate on the Convertible Notes was 6.0% per annum, computed on the basis of the actual number of days elapsed and a year of 365 days. All unpaid principal and accrued interest on the Convertible Notes were due and payable on the earlier of December 31, 2014 or upon the occurrence of an event of default, defined as: (i) failure to pay principal or interest when due; (ii) breaches of covenants; (iii) breaches of representations and warranties; (iv) failure to make other payment obligations resulting in the acceleration of maturity of indebtedness in excess of $10.0 million; (v) voluntary bankruptcy; (vi) involuntary bankruptcy; or (vii) certain adverse judgments. We could have voluntarily prepaid the Convertible Notes, in whole or in part, before the maturity date by giving each investor 10 days’ prior written notice. We were also required to prepay the Convertible Notes upon a change of control unless the investor elected to convert its Convertible Note immediately prior to the closing of such change of control.

Upon the closing of our IPO all noteholders with the exception of one noteholder converted the principal and accrued interest amount outstanding under their subordinated convertible promissory notes into shares of our common stock at the IPO price of $43.00 per share. The noteholder, who did not elect to so convert, was paid a total of $23.6 million which included principal and accrued interest less applicable withholding taxes of $1.1 million. The remainder of the noteholders converted the remaining debt balance of approximately $96.5 million including principal and accrued interest into 2.2 million shares of our common stock.


15


6.    Commitments and Contingencies

Operating Leases

We lease various operating spaces in North America, Europe, Asia and Australia under non-cancelable operating lease arrangements that expire on various dates through 2018. These arrangements require us to pay certain operating expenses, such as taxes, repairs, and insurance and contain renewal and escalation clauses. We recognize rent expense under these arrangements on a straight-line basis over the term of the lease.

As of December 31, 2013, the aggregate future minimum payments under non-cancelable operating leases consist of the following (in thousands):
Years Ending December 31,
 
2014
$
825

2015
540

2016
507

2017
411

2018
161

Total minimum future lease payments
$
2,444

    
Rent expense for all operating leases amounted to $0.7 million, $1.7 million, $0.9 million and $1.7 million for the three and six months ended June 30, 2014 and 2013, respectively.

Financing Obligation—Build-to-Suit Lease

In August 2012, we executed a lease for a building under construction in Santa Clara, California which will serve as our new headquarters. The lease term is 120 months and commenced in August 2013.
Based on the terms of the lease agreement and due to our involvement in certain aspects of the construction such as our financial involvement in structural elements of asset construction, making decisions related to tenant improvement costs and purchasing insurance not reimbursable by the buyer-lessor (the Landlord), we are deemed the owner of the building (for accounting purposes only) during the construction period. We maintained continued involvement in the property after construction was completed and lack transferability of the risks and rewards of ownership, primarily due to our required maintenance of a $4.0 million letter of credit. Due to our continuing involvement in the property post construction and lack of transferability of related risks and rewards of ownership to the Landlord after construction is complete, we account for the building and related improvements as a lease financing obligation.
Accordingly, as of June 30, 2014 and December 31, 2013, we have recorded assets of $53.4 million and $53.3 million, representing the total costs of the building and improvements incurred, including the costs paid by the lessor (the legal owner of the building) and additional improvement costs paid by us, and a corresponding financing obligation of $44.1 million and $44.0 million, respectively. As of June 30, 2014, $1.0 million and $43.1 million were recorded as short-term and long-term financing obligations, respectively. During the construction period, we continued to increase the asset and financing obligation as additional building and improvement costs were incurred until construction was completed.



16


As of December 31, 2013, the future minimum payments due under the lease financing obligation were as follows (in thousands):
Years Ending December 31,
 
 
2014
 
$
4,991

2015
 
5,601

2016
 
5,769

2017
 
5,948

2018
 
6,128

Thereafter
 
31,059

Total payments
 
59,496

Less: interest and land lease expense
 
(38,962
)
Total payments under facility financing obligations
 
20,534

Property reverting to landlord
 
23,436

Present value of obligation
 
43,970

Less current portion
 
(818
)
Long-term portion of obligation
 
$
43,152

    
Upon completion of construction in the third quarter of 2013, we evaluated the de-recognition of the asset and liability under the sale-leaseback accounting guidance. We concluded that we have forms of continued economic involvement in the facility, and therefore did not meet with the provisions for sale-leaseback accounting. Therefore, the lease is accounted for as a financing obligation and lease payments will be attributed to (1) a reduction of the principal financing obligation; (2) imputed interest expense; and (3) land lease expense (which is considered an operating lease and a component of cost of goods sold and operating expenses) representing an imputed cost to lease the underlying land of the building. In addition, the underlying building asset is depreciated over the building’s estimated useful life of 30 years. At the conclusion of the initial lease term, we will de-recognize both the net book values of the asset and the remaining financing obligation.

Purchase Commitments

Our products are manufactured, assembled and tested by third-party contract manufacturers in Asia who procure components and assemble products on our behalf based on our forecasts. These forecasts are based on estimates of future demand for our products, historical trend analysis provided by our sales and product marketing organizations and adjusted for overall market conditions. In order to reduce manufacturing lead times and plan for adequate component supply, we may issue purchase orders to these third-party contract manufacturers and vendors that may not be cancelable. As of June 30, 2014 and December 31, 2013, our contract manufacturer liability was $1.6 million and $1.8 million for non-cancelable purchase commitments issued to our vendors.
We have provided restricted deposits to our third-party contract manufacturers and vendors to secure our obligations to purchase inventory. We had $2.3 million in restricted deposits as of June 30, 2014 and December 31, 2013. Restricted deposits are classified in deposits and other non-current assets in our accompanying unaudited condensed consolidated balance sheets.

Guarantees

We have entered into agreements with some of our direct customers and channel partners that contain indemnification provisions relating to potential situations where claims could be alleged that our products infringe the intellectual property rights of a third party. We have at our option and expense the ability to repair any infringement, replace product with a non-infringing equivalent-in-function product or refund our customers the unamortized value of the product based on its estimated useful life. Other guarantees or indemnification agreements include guarantees of product and service performance and standby letters of credit for lease facilities and corporate credit cards. We have not recorded a liability related to these indemnification and guarantee provisions and our guarantee and indemnification arrangements have not had any significant impact on our consolidated financial statements to date.

17



Legal Proceedings

OptumSoft, Inc. Matters

On April 4, 2014, OptumSoft filed a lawsuit against us in the Superior Court of California, Santa Clara County titled OptumSoft, Inc. v. Arista Networks, Inc., in which it asserts (i) ownership of certain components of our EOS network operating system pursuant to the terms of a 2004 agreement between the companies and (ii) breaches of certain confidentiality and use restrictions in that agreement. Under the terms of the 2004 agreement, OptumSoft provided us with a non-exclusive, irrevocable, royalty-free license to software delivered by OptumSoft comprising a software tool used to develop certain components of EOS and a runtime library that is incorporated into EOS. The 2004 agreement places certain restrictions on our use and disclosure of the OptumSoft software and gives OptumSoft ownership of improvements, modifications and corrections to, and derivative works of, the OptumSoft software that we develop.

In its lawsuit, OptumSoft has asked the Court to order us to (i) give OptumSoft copies of certain components of our software for evaluation by OptumSoft, (ii) cease all conduct constituting the alleged confidentiality and use restriction breaches, (iii) secure the return or deletion of OptumSoft’s alleged intellectual property provided to third parties, including our customers, (iv) assign ownership to OptumSoft of OptumSoft’s alleged intellectual property currently owned by us, and (v) pay OptumSoft’s alleged damages, attorney’s fees, and costs of the lawsuit. David Cheriton, one of our founders and a former member of our board of directors who resigned from our board of directors on March 1, 2014 and has no continuing role with us, is a founder and, we believe, the largest stockholder and director of OptumSoft. The 2010 David R. Cheriton Irrevocable Trust dtd July 27, 2010, a trust for the benefit of the minor children of Mr. Cheriton, is our largest stockholder.

OptumSoft has identified in confidential documents certain software components it claims to own, which are generally applicable tools and utility subroutines and not networking specific code. We cannot assure which software components OptumSoft may ultimately claim to own in the litigation or whether such claimed components are material.

On April 14, 2014, we filed a cross-complaint against OptumSoft, in which we assert our ownership of the software components at issue and our interpretation of the 2004 agreement. Among other things, we assert that the language of the 2004 agreement and the parties’ long course of conduct support our ownership of the disputed software components. We ask the Court to declare our ownership of those software components, all similarly-situated software components developed in the future and all related intellectual property. We also assert that, even if we are found not to own any particular components at issue, such components are licensed to us under the terms of the 2004 agreement. However, there can be no assurance that our assertions will ultimately prevail in litigation.

On the same day, we also filed an answer to OptumSoft’s claims, as well as affirmative defenses based in part on OptumSoft’s failure to maintain the confidentiality of its claimed trade secrets, its authorization of the disclosures it asserts and its delay in claiming ownership of the software components at issue. We have also taken additional steps to respond to OptumSoft’s allegations that we improperly used and/or disclosed OptumSoft confidential information. While we believe we have strong defenses to these allegations, we believe we have (i) revised our software to remove the elements we understand to be the subject of the claims relating to improper use and disclosure of OptumSoft confidential information and made the revised software available to our customers and (ii) removed information from our website that OptumSoft asserted disclosed OptumSoft confidential information.

On August 1, 2014, the Santa Clara Superior Court held a case management conference (CMC). At the CMC, the Court set a trial date for April 2016.

We do not believe a loss is probable; however, it is a reasonable possibility. Due to the early stage of this matter, no estimate of the amount or range of possible amounts can be determined at this time.

We intend to vigorously defend against any action brought against us by OptumSoft. However, we cannot be certain that, if litigated, any claims by OptumSoft would be resolved in our favor. For example, if it were determined that OptumSoft owned components of our EOS network operating system, we would be required to transfer ownership of those components and any related intellectual property to OptumSoft. If OptumSoft were the owner of those components, it could make them available to our competitors, such as through a sale or license. In addition, if OptumSoft were to bring actual litigation, it could assert additional or different claims against us, including claims that our license from OptumSoft is invalid. An adverse litigation ruling could result in a significant damages award against us and injunctive relief. In addition, if our license was ruled to have been terminated, and we were not able to negotiate a new license from OptumSoft on reasonable terms, we could be

18


prohibited from selling products that incorporate OptumSoft intellectual property. Any such adverse ruling could materially adversely affect our business, prospects, results of operations and financial condition. Whether or not we prevail in a lawsuit, we expect that any litigation would be expensive, time-consuming and a distraction to management in operating our business.

Net Navigation LLC Matters

On April 23, 2014, Net Navigation LLC sued us for alleged infringement of U.S. Patent Nos. 5,901,147; 6,434,145; and 6,625,122 in U.S. District Court for the Eastern District of Texas. On June 30, 2014, we and Net Navigation LLC settled this dispute.

In the ordinary course of business, we are a party to other claims and legal proceedings including matters relating to commercial, employee relations, business practices and intellectual property. We record a provision for contingent losses when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Based on currently available information, management does not believe that the ultimate outcome of these other unresolved matters is probable or estimable and not likely, individually and in the aggregate, to have a material adverse effect on our financial position, results of operations or cash flows. However, litigation is subject to inherent uncertainties and our view of these matters may change in the future. Were an unfavorable outcome to occur, there exists the possibility of a material adverse impact on our financial position, results of operations or cash flows for the period in which the unfavorable outcome occurs, and potentially in future periods.

7.    Common Stock Reserved for Issuance

We have reserved shares of common stock, on an as-converted basis, for future issuance as follows (in thousands):
 
June 30,
2014
 
December 31,
2013
Conversion of convertible preferred stock outstanding (1)   

 
24,000

Outstanding stock options and RSAs
14,092

 
11,245

Outstanding stock purchase rights
2

 
2

Conversion of convertible debt and related interest expense (2)   

 
3,949

Shares reserved for future option and RSA grants
12,426

 
8,941

Shares reserved under Employee Stock Purchase Plan
651

 

Total
27,171

 
48,137

 
(1) Upon the closing of our IPO, all shares of our convertible preferred stock were converted to 24 million shares of common stock on a one-for-one basis.

(2) Upon the closing of our IPO, all noteholders with the exception of one noteholder converted the principal and accrued interest amount outstanding under their subordinated convertible promissory notes into shares of our common stock at the IPO price of $43.00 per share. The noteholder, who did not elect to so convert, was paid a total of $23.6 million which included principal and accrued interest less applicable withholding taxes of $1.1 million. The remainder of the noteholders converted the remaining debt balance of approximately $96.5 million including principal and accrued interest into 2.2 million shares of our common stock.
 

8.    Convertible Preferred Stock

Upon the closing of our IPO, all outstanding convertible preferred stock was converted into 24 million shares of common stock on a one-to-one basis.


19


9.    Stock-Based Compensation

Total stock-based compensation expense related to options, restricted stock awards, employee stock purchases and stock purchase rights granted were allocated as follows (in thousands):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Cost of revenue
$
301

 
$
83

 
$
512

 
$
150

Research and development
3,527

 
1,134

 
5,994

 
2,130

Sales and marketing
1,931

 
612

 
3,359

 
1,094

General and administrative
946

 
244

 
1,622

 
441

           Total stock-based compensation
$
6,705

 
$
2,073

 
$
11,487

 
$
3,815

Allocations to cost of revenue, research and development, general and administrative and selling and marketing expense are based upon the department to which the associated employee reported.

2004 Plan
During the year ended December 31, 2004, we adopted the 2004 Equity Incentive Plan ("the 2004 Plan) for the purpose of granting stock-based awards to employees, directors and consultants. Awards under the 2004 Plan may be in the form of Incentive Stock Options (“ISOs”), Nonstatutory Stock Options (“NSOs”) or Restricted Stock Awards (“RSAs”). ISOs could only be granted to employees with an exercise price not less than the fair value of the common stock on the grant date as determined by the board of directors, and NSOs may be granted to employees, directors or consultants at exercise prices not less than 85% of the fair value of the common stock on the grant date as determined by the board of directors. If, on the date of an option grant, the grantee directly or by attribution owns stock possessing more than 10% of the voting power of all classes of our stock, the exercise price must be at least 110% of the fair value of the common stock on the grant date as determined by the board of directors. Options may be granted with vesting terms as determined by the board of directors, and generally vest over an estimated period of 4 years. Options granted are exercisable over a maximum term of 10 years from the date of grant or five years from the date of grant for 10% stockholders. With the establishment of the 2011 Plan (as defined below), the 2004 Plan terminated with respect to the grant of future awards but the 2004 Plan continues to govern awards issued thereunder.

2011 Plan
During the year ended December 31, 2011, we adopted the 2011 Equity Incentive Plan (the "2011 Plan") for the purpose of granting stock-based awards to employees, directors, and consultants. Awards granted under the 2011 Plan could have been ISOs, NSOs, RSAs, Stock Appreciation Rights (“SARs”) or Restricted Stock Units (“RSUs”). ISOs may be granted to employees and NSOs may be granted to employees, directors or consultants, in all cases,with an exercise price not less than the fair value of the common stock on the grant date as determined by the board of directors. If, on the date if an ISO grant, the optionee directly or by attribution owns stock possessing more than 10% of the voting power of all classes of our stock, the exercise price must be at least 110% of the fair value of the common stock on the grant date as determined by the board of directors. Options may be granted with vesting terms as determined by the board of directors, and generally vest over an estimated period of 4 years. Options granted are exercisable over a maximum term of 10 years from the date of grant or five years from the date of grant for 10% stockholders. With the establishment of the 2014 Plan (as defined below), the 2011 Plan terminated with respect to the grant of future awards but the 2011 Plan continues to govern awards previously issued thereunder.

2014 Plan

In April 2014, the board of directors and stockholders approved the 2014 Equity Incentive Plan (the “2014 Plan”), effective on the first day that our common stock was publicly traded. A total of 6,510,000 shares of our common stock were initially reserved for issuance under the 2014 Plan. In addition, the shares reserved for issuance under our 2014 Plan will also include (a) those shares reserved but unissued under the 2011 Plan and 2004 Plan as of the effective date and (b) shares returned to our 2011 Plan and 2004 Plan as the result of expiration or termination of options (provided that the maximum number of shares that may be added to the 2014 Plan pursuant to (a) and (b) is 20,025,189 shares. The number of shares available for grant and issuance under the 2014 Plan will be increased automatically on January 1 of each year commencing with 2016 by the number of shares equal to 3% of our shares outstanding on the immediately preceding December 31, but not to exceed 12,500,000 shares, unless the board of directors, in its discretion, determines to make a smaller increase.


20


2014 Employee Stock Purchase Plan

In April 2014, the board of directors and stockholders approved the 2014 Employee Stock Purchase Plan (the “ESPP”). The ESPP will become effective on the first day that our common stock is publicly traded. A total of 651,000 shares of our common stock are initially reserved for future issuance under the ESPP. The number of shares reserved for issuance under the ESPP will increase automatically on January 1 of each year commencing with 2015 by the number of shares equal to 1% of our shares outstanding immediately preceding December 31, but not to exceed 2,500,000 shares, unless the board of directors, in its discretion, determines to make a smaller increase.

Determination of Fair Value

Employee Stock Plans
For the three and six months ended June 30, 2014 and 2013, the fair value of each stock option granted under the 2011 Plan was estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions and fair value per share:  
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Expected term (in years)
7.0

 
6.2

 
7.7

 
6.4

Risk-free interest rate
2.0
%
 
1.2
%
 
2.3
%
 
1.2
%
Expected volatility
48.1
%
 
51.8
%
 
47.8
%
 
51.1
%
Dividend rate
%
 
%
 
%
 
%

ESPP

There were no stock purchases under the ESPP during the three months ended June 30, 2014.  The following table summarizes the assumptions relating to our ESPP:
 
 
Three Months Ended June 30,
 
 
2014
Expected term (in years)
 
1.4
Risk-free interest rate
 
0.3%
Expected volatility
 
36.3%
Dividend rate
 
—%
As of June 30, 2014, the total unrecognized stock-based compensation expense for unvested ESPP options, net of expected forfeitures, was $5.4 million, which is expected to be recognized over a weighted-average period of 2.1 years.



21


The following table summarizes the option and RSA activity under the 2004 Plan and 2011 Plan and related information:
 
 
 
Options and RSAs Outstanding 
 
 
 
 
 
Shares
Available for
Grant
(in thousands)
 
Number of
Shares
Underlying
Outstanding Options and RSAs
 (in thousands)
 
Weighted-
Average
Exercise
Price
 
Weighted-
Average
Remaining
Contractual
Term (Years) of
Stock Options
 
Aggregate
Intrinsic
Value
of Stock
Options
Outstanding
(in thousands)
Outstanding—December 31, 2013
8,941

 
11,245

 
$
6.82

 
8.8
 
$
254,319

Authorized
6,510

 
 
 
 
 
 
 
 
Options granted
(3,331
)
 
3,331

 
31.40

 
 
 
 
Options exercised

 
(186
)
 
9.01

 
 
 
 
Options canceled
298

 
(298
)
 
8.99

 
 
 
 
Early exercised shares repurchased
8

 

 
6.40

 
 
 
 
Outstanding—June 30, 2014
12,426

 
14,092

 
$
12.56

 
8.6
 
$
702,257

Vested and exercisable—June 30, 2014
 
 
3,051

 
$
4.27

 
7.7
 
$
177,332

Vested and expected to vest—June 30, 2014
 
 
12,280

 
$
11.48

 
8.5
 
$
625,146

 
The weighted-average grant-date fair value of options granted during the six months ended June 30, 2014 was $19.73 per share. The aggregate intrinsic value of options exercised for the six months ended June 30, 2014 was $3.3 million.
As of June 30, 2014, the total unrecognized stock-based compensation expense for unvested stock options, net of expected forfeitures, was $88.8 million, which is expected to be recognized over a weighted-average period of 4.0 years. The total fair value of options vested for the six months ended June 30, 2014 was $4.5 million.
Under the 2004 Plan and 2011 Plan, the options outstanding and vested and exercisable by exercise price at June 30, 2014 are as follows:
 
Options Outstanding and Exercisable
 
Options Vested and Exercisable
Range of Exercise Price
Number of
Shares Underlying
Outstanding
Options
(in thousands)
 
Weighted-
Average
Remaining
Contractual
Life (Years)
 
Weighted-
Average
Exercise Price
per Share
 
Number of
Shares
Underlying
Outstanding
Options
 (in thousands)
 
Weighted-
Average
Exercise Price
per Share
$0.01 – $3.33
2,578

 
7.3
 
$
3.30

 
1,535

 
$
3.28

$4.16 – $4.92
3,723

 
8.1
 
4.39

 
1,219

 
4.41

$7.76 – $10.18
3,945

 
9.0
 
9.19

 
289

 
8.21

$22.49
1,084

 
9.5
 
22.49

 
3

 
22.49

$30.67
1,673

 
9.6
 
30.67

 
1

 
30.67

$34.12 - $38.00
1,089

 
9.8
 
36.88

 
4

 
34.64

 
14,092

 
8.6
 
$
12.56

 
3,051

 
$
4.27

Restricted Stock Awards
A summary of our RSA activity and related information is as follows:
 
Number of
RSA’s
Outstanding
 (in thousands)
 
Weighted-
Average Grant
Date Fair Value
Unvested balance—December 31, 2013
142

 
$
2.42

Vested
(32
)
 
2.50

Unvested balance—June 30, 2014
110

 
$
2.50


22


 
There were no RSAs granted during the six months ended June 30, 2014. As of June 30, 2014, the total unrecognized expense for outstanding RSAs, net of expected forfeitures, was $0.3 million, which is expected to be amortized over a weighted-average period of 2.3 years. As of June 30, 2014, the intrinsic value of the outstanding RSAs based on the estimated fair value of $62.39 per share was $6.6 million.

Early Exercise of Stock Options
We typically allow our employees and directors to exercise options granted under the 2011 Plan and the 2004 Plan prior to vesting. Upon an "early exercise" of these options, the unvested shares acquired through the exercise become options subject to our repurchase right that lapse in accordance with the original option vesting schedule. Upon termination of employment prior to our repurchase rights lapsing in full, we have a right to repurchase the unvested shares at the original purchase price (or the then-current fair market value, if lower). The proceeds initially are recorded in other liabilities from the early exercise of stock options and are reclassified to common stock and paid-in capital as our repurchase right lapse. For the six months ended June 30, 2014, we repurchased 8,282 shares of common stock at the original exercise price due to the termination of the holders of the unvested shares. As of June 30, 2014, shares held by employees and directors that were subject to repurchase were 2.2 million with an aggregate price of $6.6 million.


23


10.    Net Income Per Share Available to Common Stock

The following table sets forth the computation of our basic and diluted net income per share available to common stock (in thousands, except per share amounts):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Numerator:
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
Net income
$
21,618

 
$
10,251

 
$
33,947

 
$
16,862

Less: undistributed earnings allocated to participating securities
(7,406
)
 
(5,303
)
 
(13,962
)
 
(8,799
)
Net income available to common stockholders, basic
$
14,212

 
$
4,948

 
$
19,985

 
$
8,063

Diluted:
 
 
 
 
 
 
 
Net income attributable to common stockholders, basic
$
14,212

 
$
4,948

 
$
19,985

 
$
8,063

Add: undistributed earnings allocated to participating securities
639

 
211

 
1,136

 
309

Net income attributable to common stockholders, diluted
$
14,851

 
$
5,159

 
$
21,121

 
$
8,372

Denominator:
 
 
 
 
 
 
 
Basic:
 
 
 
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
38,491

 
26,926

 
33,834

 
26,607

Diluted:
 
 
 
 
 
 
 
Weighted-average shares used in computing net income per share available to common stockholders, basic
38,491

 
26,926

 
33,834

 
26,607

Add weighted-average effect of dilutive securities:
 
 
 
 
 
 
 
Stock options and RSAs
5,537

 
2,320

 
5,113

 
2,038

Employee stock purchase plan
29

 

 
15

 

Stock purchase rights

 
6

 

 
5

Weighted-average shares used in computing net income per share available to common stockholders, diluted
44,057

 
29,252

 
38,962

 
28,650

Net income per share attributable to common stockholders:
 
 
 
 
 
 
 
Basic
$
0.37

 
$
0.18

 
$
0.59

 
$
0.30

Diluted
$
0.34

 
$
0.18

 
$
0.54

 
$
0.29

 
The following outstanding shares of common stock equivalents were excluded from the computation of diluted net income per share available to common stockholders for the periods presented because including them would have been anti-dilutive (in thousands):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Stock options and RSAs to purchase common stock
2,361

 
1,398

 
2,160

 
828



24


11.     Income Taxes

Provision for income taxes was approximately $10.1 million and $4.2 million for the three months ended June 30, 2014 and 2013 respectively, and $17.2 million and $4.5 million for the six months ended June 30, 2014 and 2013 respectively. The change in our provision for income taxes and effective tax rate was primarily due to increase in profit before income tax, the geographical distribution of the earnings, and the expiration of the federal research and development credit as of December 31, 2013.

The effective tax rate as of December 31, 2013 included the impact of the passage of the American Tax Relief Act of 2012 signed into law on January 2, 2013, which reinstated 2012 and 2013 federal research and development credit. The impact of the 2012 federal research and development tax credit benefit was recorded in the three months ended March 31, 2013.

We operate in a number of tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to U.S. income tax. Generally, the U.S. taxes are reduced by a credit for foreign income taxes paid on these earnings which avoids double taxation. Our tax expense to date consists of federal, state and foreign current and deferred income taxes. As we expand internationally, our marginal tax rate may decrease; however, there can be no certainty that our marginal tax rate will decrease, and we may experience changes in tax rates that are not reflective of actual changes in our business or operations.

12.     Segment Information

We have determined that we operate as one reportable segment. The following table represents revenue based on the customer’s location, as determined by the customer’s shipping address (in thousands):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
United States
$
102,149

 
$
68,819

 
$
195,142

 
$
116,992

Other Americas
1,009

 
660

 
4,216

 
1,447

Europe, Middle East and Africa
20,628

 
9,705

 
32,342

 
17,411

Asia Pacific
14,161

 
4,301

 
23,454

 
8,983

Total revenue
$
137,947

 
$
83,485

 
$
255,154

 
$
144,833


Long lived assets, excluding intercompany receivables, investments in subsidiaries and deferred tax assets, net by location are summarized as follows (in thousands):
 
June 30,
2014
 
December 31,
2013
United States
$
65,204

 
$
63,557

International
3,595

 
3,647

Total
$
68,799

 
$
67,204



25


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

You should read the following discussion and analysis of our financial condition and results of operations together with the consolidated financial statements and related notes that are included elsewhere in this Quarterly Report on Form 10-Q and our prospectus filed on June 6, 2014 (the "Prospectus"), pursuant to Rule 424(b) under the Securities Act of 1933, as amended ("the Securities Act"), with the U.S. Securities and Exchange Commission (the "SEC"). This discussion contains forward-looking statements based upon current plans, expectations and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q.

Overview
    
We are a leading supplier of cloud networking solutions that use software innovations to address the needs of large-scale Internet companies, cloud service providers and next-generation data centers for enterprises, based on market share. Our cloud networking solutions consist of our Extensible Operating System, or EOS, a set of network applications and our 10/40/100 Gigabit Ethernet switches. Our cloud networking solutions deliver industry-leading performance, scalability, availability, programmability, automation and visibility. Since we began shipping our products, we have grown rapidly, and, according to Crehan Research, we have achieved the second largest market share in data center 10/40/100 Gigabit Ethernet switch ports, excluding blade switching, sold in 2013.

At the core of our cloud networking platform is EOS, which was purpose-built to be fully programmable and highly modular. The programmability of EOS has allowed us to create a set of software applications that address the requirements of cloud networking, including workflow automation, network visibility and analytics, and has also allowed us to rapidly integrate with a wide range of third-party applications for virtualization, management, automation, orchestration and network services.
We were founded in 2004 to address the limitations of legacy networking products and to create a cloud networking platform that is open and programmable. From 2004 to 2008, our activities were focused on the development of our software, which resulted in the commercial release of our first product, the 7100 Series switches based on our EOS software, in 2008. Since then, we have continued to introduce new products utilizing EOS, including our 7500 Series switch and our 7050 Series switch in 2010, the second generation of our 7500 Series switch, called the 7500E modular switch, in May 2013 and our 7300 Series switch in November 2013. As of June 30, 2014, we have shipped more than two million switch ports.

We have experienced rapid revenue growth over the last several years, increasing our revenue at a compound annual growth rate of 71.4% from 2010 to 2013. As we have grown the functionality of our EOS software, expanded the range of our switching portfolio and increased the size of our sales force, our revenue has continued to grow rapidly. To support revenue growth, we have increased our international presence to include offices in nine countries as of June 30, 2014, including Canada, China, India, Ireland, Japan, South Korea, Malaysia, Singapore and Taiwan. Our 2013 revenue grew 86.8% when compared to 2012. Our revenue for the three and six months ended June 30, 2014 was $137.9 million and $255.2 million, an increase of 65.2% and 76.2%, respectively, when compared to the same period in 2013. We have been profitable and cash flow positive for each year since 2010.

We believe that our cloud networking platform addresses the large and growing cloud networking segment of data center switching, which remains in the early stage of adoption. We expect to continue rapidly growing our organization to meet the needs of new and existing customers as they increasingly realize the performance and cost benefits of our cloud networking solutions and as they expand their cloud networks. We intend to continue to invest in our research and development organization to enhance the functionality of our existing cloud networking platform, introduce new products and features and build upon our technology leadership. We believe one of our greatest strengths lies in our rapid development of new features and applications. By investing in research and development, we believe we will be well positioned to continue our rapid growth and take advantage of our large market opportunity. We also intend to continue to expand our sales and marketing teams and programs, with a particular focus on expanding our network of international channel partners and carrying out associated marketing activities in key geographies. In order to support our strong growth, we have accelerated our investment in infrastructure, such as enterprise resource planning software and other technologies to improve the efficiency of our operations. As a result, we expect our levels of operating profit could decline in the short to medium term. For a description of factors that may impact our future performance, see the disclosure in the section titled "Factors Affecting Our Performance" below.

26




Our Business Model

We derive revenue from sales of products and services. We generate revenue primarily from sales of our switching products which incorporate our EOS software. We also generate services revenue from post contract support, or PCS, which end customers typically purchase in conjunction with our products.

Since shipping our first products in 2008, our cumulative end-customer base has grown rapidly. Between December 31, 2010 and June 30, 2014, our cumulative end-customer base grew from approximately 570 to approximately 2,700. Our end customers span a range of industries and include large Internet companies, service providers, financial services organizations, government agencies, media and entertainment companies and others.
    
To continue to grow our revenue, it is important that we both obtain new customers and sell additional products to existing customers. For example during the year ended December 31, 2013, approximately 85.2% of our revenue was received from our existing end customers.
    
Our development model is focused on the development of new products based on our EOS software and enhancements to EOS. We engineer our products to be agnostic to the underlying merchant silicon architecture. Today, we combine our EOS software with merchant silicon into a family of switching products. This enables us to focus our research and development resources on our software core competencies and to leverage the investments made by merchant silicon vendors to achieve cost-effective solutions. We currently procure certain merchant silicon components from multiple vendors, and we continue to expand our relationships with these and other vendors. We work closely with third parties to manufacture and deliver our products. Our third-party silicon vendors deliver these components directly to our contract manufacturers, who manufacture and assemble our products and deliver them to us for labeling, quality assurance testing, final configuration and shipment to our customers.

We market and sell our products through our direct sales force and in partnership with channel partners, including distributors, value-added resellers, systems integrators, original equipment manufacturer, or OEM, partners and in conjunction with various technology partners, depending on the application. To facilitate channel coordination and increase productivity, we have created a partner program, the Arista Partner Program, to engage partners who provide value-added services and extend our reach into the marketplace. Authorized training partners provide technical training to our channel partners. Our partners commonly receive an order from an end customer prior to placing an order with us, and we confirm the identification of the end customer prior to accepting such orders. Our partners generally do not stock inventory received from us. Our sales organization is supported by systems engineers with deep technical expertise and responsibility for pre-sales technical support and engineering for our end customers. Each sales team is responsible for a geographic territory, has responsibility for a number of major direct end-customer accounts or has assigned accounts in a specific vertical market. During three and six months ended June 30, 2014, 74.8% and 78.1% of our revenue was generated from the Americas, substantially all from the United States, 15.0% and 12.7% from Europe, the Middle East and Africa and 10.2% and 9.2% from the Asia-Pacific region, respectively.

Factors Affecting Our Performance

We believe that our future success will depend on many factors, including our ability to expand sales to our existing customers as well as to add new end customers. While these areas present significant opportunity, they also present risks that we must manage to ensure successful results. See the section titled “Risk Factors.” Additionally, we face intense competition especially from larger, well-established companies, and we must continue to expand the capabilities of our cloud networking platform to succeed in our market. If we are unable to address these challenges, our business could be adversely affected.

Increasing Adoption of Cloud Networks. Networks are subject to increasing performance requirements due to growing numbers of connected devices as well as new enterprise and consumer applications. Computing architectures are evolving to meet the need for constant connectivity and access to data and applications. We believe that cloud networks will continue to replace legacy network technologies. Our business and results of operations will be significantly affected by the speed with which organizations implement cloud networks.

Expanding Sales to Existing Customer Base. We expect that a substantial portion of our future sales will be follow-on sales to existing end customers. As noted above, one of our sales strategies is to target specific projects at our current end customers because they are familiar with the operational and economic benefits of our cloud networking solutions, thereby reducing the sales cycle into these customers. We believe this opportunity with current end customers to be significant given their existing and expected infrastructure spend. Our business and results of operations will depend on our ability to sell additional products to our growing base of customers.


27


Adding New End Customers. We believe that the cloud networking market is still in the early stages of adoption. We intend to target new end customers by continuing to invest in our field sales force and extending our relationships with channel partners. To date, we have primarily targeted end customers with the largest cloud data centers. A typical initial order involves the education of prospective customers about the technical merits and capabilities and potential cost savings of our products as compared to our competitors’ products. Our results of operations will depend on our ability to continue to add new customers. We believe that customer references have been, and will continue to be, an important factor in winning new business.

Selling More Complex and Higher-Performance Configurations. Our results of operations have been, and we believe will continue to be, affected by our ability to sell more complex and higher-performance configurations of our products. Going forward, we aim to grow our revenue by enabling end customers to transition from previously deployed 1 Gigabit Ethernet switches to 10, 40 and eventually 100 Gigabit Ethernet switches. Our ability to sustain our revenue growth will depend, in part, upon our continued sales of more robust configurations of our products, and quarterly results of operations can be significantly impacted by the mix of products and product configurations sold during the period.

Leveraging Channel Partners. We expect to continue to derive a growing portion of our sales through our channel partners as they develop new end customers and expand sales to our existing end customers. We plan to continue to invest in our network of channel partners to empower them to reach new end customers more effectively, increase sales to existing customers and provide services and support effectively. We believe that increasing channel leverage will extend and improve our engagement with a broad set of customers. Our business and results of operations will be materially affected by our success in leveraging our channel partners.

Investing in Research and Development for Growth. We believe that the market for cloud networking is still in the early stages of adoption and we intend to continue investing for long-term growth. We expect to continue to invest heavily in software development in order to expand the capabilities of our cloud networking platform, introduce new products including new releases and upgrades to our EOS software and new applications and build upon our technology leadership. We believe one of our greatest strengths lies in the speed of our product development efforts. By investing in research and development, we believe we will be well positioned to continue our rapid growth and take advantage of our large market opportunity. We expect that our results of operations will be impacted by the timing and size of these investments.

Customer Concentration and Timing of Large Orders. During the years ended December 31, 2011, 2012 and 2013, sales to our 10 largest end customers accounted for approximately 32.4%, 39.3% and 43.0% of our revenue, respectively. During the years ended December 31, 2011, 2012 and 2013, our largest end customer accounted for 10.4%, 15.3% and 21.9% of our revenue, respectively. We have also experienced and continue to experience customer concentration on a quarterly basis. In addition, we have experienced increases in the size of our orders, including orders from existing customers, which could result in future increased customer concentration, depending on the timing of the fulfillment of those orders. We have also experienced unpredictability in the timing of large orders, especially with respect to our large end customers, due to the complexity of orders, the time it takes end customers to evaluate, test and qualify our products and factors specific to our end customers. Due to these factors, we expect continued variability in our customer concentration and timing of sales on a quarterly and annual basis. In addition, we have provided, and may in the future provide, pricing discounts to large end customers, which may result in lower margins for the period in which such sales occur. Our gross margins may also fluctuate as a result of the timing of such sales to large end customers.

Basis of Presentation

Revenue

We generate revenue primarily from sales of our switching products which incorporate our EOS software. We also derive a small but growing portion of our revenue from sales of PCS. We generate PCS revenue from sales of technical support services contracts that are typically purchased in conjunction with our products and subsequent renewals of those contracts. We offer PCS services under renewable, fee-based contracts, which include 24-hour technical support, hardware repair and replacement parts, bug fixes, patches and unspecified upgrades on a when-and-if available basis. We expect our revenue may vary from period to period based on, among other things, the timing and size of orders and delivery of products, the impact of significant transactions with unique terms and conditions that may require deferral of revenue and cyclicality of orders being placed by our customers. Additionally, we expect our PCS revenue to increase in absolute dollars as we expand our installed base. Our ability to expand our installed base and increase our revenue is subject to numerous risks and uncertainties. See the section titled “Risk Factors.” We report revenue net of sales taxes.

Cost of Revenue

Cost of revenue primarily consists of amounts paid to our third-party contract manufacturers and merchant silicon vendors, warranty expenses, excess inventory write-offs and personnel and other costs in our manufacturing operations department. Our cost of product revenue also includes product testing costs, allocated costs and shipping costs. We expect our cost of product revenue to

28


increase as our product revenue increases. Cost of providing PCS services consists of personnel costs for our global customer support organization. We expect our cost of service revenue to increase as our PCS revenue increases.

Gross Margin

Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including sales to large end customers who generally receive lower pricing, the average sales price of our offerings, manufacturing costs, merchant silicon costs and the mix of products sold. We expect our gross margins to fluctuate over time, depending on the factors described above and others. See the section titled “Risk Factors.”

Operating Expenses

Our operating expenses consist of research and development, sales and marketing and general and administrative expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of wages, benefits, bonuses and, with respect to sales and marketing expenses, sales commissions. Personnel costs also include stock-based compensation and travel expenses. We expect operating expenses to continue to increase in absolute dollars as well as a percentage of revenue in the near term as we continue to invest in the growth of our business.

Research and Development Expenses

Research and development expenses consist primarily of personnel costs, with the remainder being prototype expenses, third-party engineering and contractor support costs, an allocated portion of facility and IT costs and depreciation. Our research and development efforts are focused on maintaining and developing additional functionality for our existing products and on new product development, including new releases and upgrades to our EOS software and applications. We expense research and development costs as incurred. We expect our research and development expenses to increase in absolute dollars as well as a percentage of revenue as we continue to invest heavily in software development in order to expand the capabilities of our cloud networking platform, introduce new products and features and build upon our technology leadership.

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of personnel costs and also include costs related to marketing and promotional activities, with the remainder being an allocated portion of facility and IT costs and depreciation. We expect our sales and marketing expenses to increase in absolute dollars and may fluctuate as a percentage of revenue from period to period as we expand our sales and marketing efforts worldwide and expand our relationships with current and future channel partners and end customers.

General and Administrative Expenses

General and administrative expenses consist primarily of personnel costs, professional fees, an allocated portion of facility and IT costs and depreciation. General and administrative personnel costs include those for our executive, finance, IT, human resources and legal functions. Our professional fees consist primarily of accounting, external legal and IT and other consulting costs. We expect our general and administrative expenses to increase in absolute dollars as well as a percentage of revenue to support our growing infrastructure needs and as we assume the reporting requirements and compliance obligations of a public company.

Other Income (Expense), Net

Interest Expense
    
Interest expense consists of interest expense on our subordinated convertible promissory notes, including our related party subordinated convertible promissory notes.

Interest and Other Income (Expense)
    
Interest and other income (expense) consist of interest expense from our lease financing obligation, gain on our notes receivable, write-off of debt discount on notes payable and foreign currency exchange gains and losses. Our foreign currency exchange gains and losses relate to transactions and asset and liability balances denominated in currencies other than the U.S. dollar. We expect our foreign currency gains and losses to continue to fluctuate in the future due to changes in foreign currency exchange rates.




29


Provision for Income Taxes

We operate in a number of tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to U.S. income tax. Generally, the U.S. taxes are reduced by a credit for foreign income taxes paid on these earnings which avoids double taxation. Our tax expense to date consists of federal, state and foreign current and deferred income taxes. As we expand internationally, our marginal tax rate may decrease; however, there can be no certainty that our marginal tax rate will decrease, and we may experience changes in tax rates that are not reflective of actual changes in our business or operations.

Results of Operations

The following table summarizes historical results of operations for the periods presented and as a percentage of revenue for those periods. We have derived the data for the three and six months ended June 30, 2014 and 2013 from our unaudited condensed consolidated financial statements (in thousands, except for percentage of revenue).
    
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Revenue
$
137,947

 
$
83,485

 
$
255,154

 
$
144,833

Cost of revenue (1)
44,567

 
29,584

 
80,460

 
48,804

Gross profit
93,380

 
53,901

 
174,694

 
96,029

Operating expenses (1):
 
 
 
 
 
 
 
Research and development
34,888

 
21,086

 
68,334

 
40,600

Sales and marketing
20,711

 
13,045

 
39,366

 
23,180

General and administrative
7,126

 
3,506

 
14,357

 
7,242

Total operating expenses
62,725

 
37,637

 
122,057

 
71,022

Income from operations
30,655

 
16,264

 
52,637

 
25,007

Other income (expense), net:
 
 
 
 
 
 
 
Interest expense
(1,435
)
 
(1,772
)
 
(3,206
)
 
(3,523
)
Interest and other income (expense), net
2,472

 
(1
)
 
1,708

 
(100
)
Total other income (expense), net
1,037

 
(1,773
)
 
(1,498
)
 
(3,623
)
Income before provision for income taxes
31,692

 
14,491

 
51,139

 
21,384

Provision for income taxes
10,074

 
4,240

 
17,192

 
4,522

Net income
$
21,618

 
$
10,251

 
$
33,947

 
$
16,862


30



 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
(as a percentage of revenue)
Revenue
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Cost of revenue
32.3

 
35.4

 
31.5

 
33.7

Gross margin
67.7

 
64.6

 
68.5

 
66.3

Operating expenses:
 
 
 
 
 
 
 
Research and development
25.3

 
25.3

 
26.8

 
28.0

Sales and marketing
15.0

 
15.6

 
15.4

 
16.0

General and administrative
5.2

 
4.2

 
5.6

 
5.0

Total operating expenses
45.5

 
45.1

 
47.8

 
49.0

Income from operations
22.2

 
19.5

 
20.7

 
17.3

Other income (expense), net:
 
 
 
 
 
 
 
Interest expense
(1.0
)
 
(2.1
)
 
(1.3
)
 
(2.4
)
Interest and other income (expense), net
1.8

 

 
0.7

 
(0.1
)
Total other income (expense), net
0.8

 
(2.1
)
 
(0.6
)
 
(2.5
)
Income before provision for income taxes
23.0

 
17.4

 
20.1

 
14.8

Provision for income taxes
7.3

 
5.1

 
6.7

 
3.1

Net income
15.7
 %
 
12.3
 %
 
13.4
 %
 
11.7
 %
 
(1) Includes stock-based compensation expense as follows:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Cost of revenue
$
301

 
$
83

 
$
512

 
$
150

Research and development
3,527

 
1,134

 
5,994

 
2,130

Sales and marketing
1,931

 
612

 
3,359

 
1,094

General and administrative
946

 
244

 
1,622

 
441

           Total stock-based compensation
$
6,705

 
$
2,073

 
$
11,487

 
$
3,815


Three and Six Months Ended June 30, 2014 Compared to Three and Six Months Ended June 30, 2013

Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages)

 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2014
 
2013
 
Change
 
2014
 
2013
 
Change
 
 
$
 
$
 
$
 
%
 
$
 
$
 
$
 
%
Revenue
 
$
137,947

 
$
83,485

 
$
54,462

 
65.2
%
 
$
255,154

 
$
144,833

 
$
110,321

 
76.2
%
Cost of Revenue
 
44,567

 
29,584

 
14,983

 
50.6

 
80,460

 
48,804

 
31,656

 
64.9

       Gross profit
 
$
93,380

 
$
53,901

 
$
39,479

 
73.2
%
 
$
174,694

 
$
96,029

 
$
78,665

 
81.9
%
       Gross margin
 
67.7
%
 
64.6
%
 
 
 
 
 
68.5
%
 
66.3
%
 
 
 
 

31




Revenue

Revenue increased $54.5 million, or 65.2% for the three months ended June 30, 2014 compared to the same period in 2013. The increase in revenue predominantly included an increase in sales of switch products and related accessories of $48.7 million, or 63.2%, primarily to existing customers, and, to a lesser extent, new customers. The increase in product revenue was largely driven by the number of switch ports shipped, which increased by 51.6% during the three months ended June 30, 2014 compared to the same period in 2013, partially offset by a reduction of 4.0% in the average selling price per port shipped. In addition, we had an increase in revenue of $13.1 million related to changes in deferred product revenue. During the second quarter ended June 30, 2013, we had net product deferrals totaling $7.6 million, primarily from the deferral of a few large customer orders, while in the second quarter ended June 30, 2014 we recognized $5.5 million, net of product deferrals, primarily from the recognition of two large customer orders that were previously deferred.

Revenue increased $110.3 million, or 76.2%, for the six months ended June 30, 2014 compared to the same period in 2013. The increase in revenue predominantly included an increase in sales of switch products and related accessories of $97.2 million, or 72.4%, primarily to existing customers, and, to a lesser extent, new customers. The increase in product revenue was largely driven by the number of switch ports shipped which increased by 59.2%, partially offset by a reduction of 2.7% in average selling price per port shipped. In addition, we had an increase in revenue of $22.5 million related to changes in deferred product revenue. During the six months ended June 30, 2013, we had net product deferrals totaling $8.6 million, primarily from the deferral of a few large customer orders, while in the six months ended June 30, 2014 we recognized $13.9 million, net of product deferrals, primarily from the recognition of a few large customer orders that were previously deferred.

Cost of Revenue

Cost of revenue increased $15.0 million, or 50.6%, for the three months ended June 30, 2014 compared to the same period in 2013. The increase in cost of revenue was primarily due to the corresponding increase in revenue as our shipment volume significantly increased during the three months ended June 30, 2014 resulting in an increase in product costs of $14.3 million in the three months ended June 30, 2014 compared to the same period in 2013.

Cost of revenue increased $31.7 million, or 64.9%, for the six months ended June 30, 2014 compared to the same period in 2013. The increase in cost of revenue was primarily due to the corresponding increase in revenue as our shipment volume significantly increased during the six months ended June 30, 2014 resulting in an increase in product costs of $29.7 million in the six months ended June 30, 2014 compared to the same period in 2013.

Gross Margin

Gross margin increased from 64.6% for the three months ended June 30, 2013 to 67.7% for the three months ended June 30, 2014. The increase in gross margins was primarily the result of a decrease in product warranty and inventory obsolescence charges totaling $3.5 million from significant charges during the second quarter of 2013 from product defect issues and the impairment of obsolete products due to the introduction of new products. This increase was partially offset by a decrease in product margins due to an increase in the size of contracts with large end customers having higher volume discounts.

Gross margin increased from 66.3% for the six months ended June 30, 2013 to 68.5% for the six months ended June 30, 2014. The increase in gross margins was primarily the result of a decrease in product warranty charges of $5.1 million resulting from improved product quality and from a benefit of $2.2 million resulting from a cash settlement received from one of our suppliers due to a product defect issue. This increase was partially offset by a decrease in product margins due to an increase in the size of contracts with large end customers h