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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 September 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:  000-53205

Diligent Board Member Services, Inc.

(Exact name of registrant as specified in its charter)

1385 Broadway, 19th Floor

New York, NY 10018

(Address of principal executive offices) (Zip Code)

(212) 741-8181

(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.  x Yes  o No

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

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

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

THE NUMBER OF SHARES OF THE REGISTRANT’S COMMON STOCK OUTSTANDING AS OF November 5, 2014 WAS 86,802,226.

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CONTENTS

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FORWARD LOOKING STATEMENTS

This document contains forward-looking statements within the meaning of the safe harbor provision of the Securities Litigation Reform Act of 1995. Terms such as “expect,” “believe,” “continue,” and “intend,” as well as similar comments, are forward-looking in nature.  There are numerous risks and uncertainties that could cause actual results and the timing of events to differ materially from those anticipated by the forward-looking statements in this Quarterly Report on Form 10-Q. Such risks and uncertainties may give rise to future claims and increase our exposure to contingent liabilities. These risks and uncertainties arise from the following issues (among other factors):

·                  As of December 31, 2013, we identified material weaknesses in our internal controls over financial reporting and concluded that our disclosure controls were not effective as of such date;  in connection with the preparation of this Form 10-Q we concluded that our disclosure controls were not effective as of September 30, 2014;  we must address the material weaknesses in our internal controls and our disclosure controls, which otherwise may impede our ability to produce timely and accurate financial statements and periodic reports;

·                  As described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 (as amended, the “2013 Form 10-K”), we had to restate certain of our historical financial statements and as a result were not able to timely file periodic reports with the New Zealand Stock Exchange (the “NZX”) or the United States Securities and Exchange Commission (the “SEC”)  for certain fiscal periods in 2013 and 2014;

·                  We face the risk of litigation or governmental investigations or proceedings relating to the restatement and the matters covered by a Special Committee investigation concluded in 2013, which identified a number of instances in which we were not, or may not have been, in compliance with applicable New Zealand and U.S. regulatory obligations;

·                  Certain of our past stock issuances and stock option grants may expose us to potential contingent liabilities, including potential rescission rights;

·                  We are subject to New Zealand Stock Exchange Listing Rules and compliance with securities and financial reporting laws and regulations in the U.S. and New Zealand and face higher costs and compliance risks than a typical US public company due to the need to comply with these dual regulatory regimes;

·                  If our security measures are breached and unauthorized access is obtained to a client’s data or our data or our IT systems, our services may be perceived as not being secure, clients may curtail or stop using our services and we may incur significant legal and financial exposure and liabilities;

·                  Our business is highly competitive and we face the risk of declining customer renewals or upgrades;

·                  If we do not successfully develop or introduce new product offerings, or enhancements to our existing Diligent Boardbooks offering, or keep pace with technological changes that impact the use of our product offerings, we may lose existing customers or fail to attract new customers; and

·                  We may fail to manage our growth effectively.

We also refer you to Part I, Item 1A, “Risk Factors” in our 2013 Form 10-K for an extended discussion of the risks confronting our business. The forward-looking statements in this Quarterly Report on Form 10-Q should be considered in the context of these risk factors.  The Company makes no commitment to revise or update any forward-looking statements in order to reflect events or circumstances after the date any such statement is made, except as otherwise required by the federal securities laws or the NZX Listing Rules.

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PART I—FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements.

Diligent Board Member Services, Inc.

Condensed Consolidated Balance Sheets

(Unaudited)

(in thousands, except share and per share amounts)

See accompanying notes to condensed consolidated financial statements

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Diligent Board Member Services, Inc.

Condensed Consolidated Statements of Income

(Unaudited)

(in thousands, except per share amounts)

See accompanying notes to condensed consolidated financial statements

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Diligent Board Member Services, Inc.

Condensed Consolidated Statements of Comprehensive Income

(Unaudited)

(in thousands)

See accompanying notes to condensed consolidated financial statements

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Diligent Board Member Services, Inc.

Condensed Consolidated Statement of Changes in Stockholders’ Equity

Nine Months Ended September 30, 2014

(Unaudited)

(in thousands)

See accompanying notes to condensed consolidated financial statements

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Diligent Board Member Services, Inc.

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(in thousands)

See accompanying notes to condensed consolidated financial statements

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Diligent Board Member Services, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

1)                                     Organization and nature of the business

Diligent Board Member Services, Inc. (“we”, “Diligent” or the “Company”) provides one of the world’s most widely used board portals. The Company develops and commercializes Diligent Boardbooks®, a secure software application available online, on iPad and Windows 8.1 supported devices. The application allows board members, management and administrative staff to simplify how board materials are produced, delivered, reviewed and voted on. We provide clients with subscription-based access to our software along with associated services including securely hosting the clients’ data, and customer service and support for the application.

The Company was incorporated in the State of Delaware on September 27, 2007 and is listed on the New Zealand Stock Exchange (the “NZSX”).  On December 12, 2007, Diligent completed an offshore public offering in connection with its listing on the NZSX.  Diligent’s corporate headquarters are located in New York, New York.

The Company has a wholly-owned subsidiary located in New Zealand, Diligent Board Member Services NZ Limited (“DBMS NZ”), which provides research and development services for the Company.  The Company has a wholly-owned subsidiary in the United Kingdom, Diligent Boardbooks Limited (“DBL”) and a wholly-owned subsidiary in Australia, Diligent Board Services Australia Pty Ltd. (“DBA”), which provide sales, marketing and customer support services in their respective regions.  The Company’s Singapore subsidiary, Diligent APAC Board Services Pte. Ltd.  (“APAC”) provides sales support in the Asia-Pacific region.  The Company’s subsidiary in Hong Kong, Diligent APAC LTD. was established in 2012 to support its Asia-Pacific sales and marketing and has had no operations to date. In February 2014, the Company established a German subsidiary, Diligent Boardbooks GmbH, to offer dedicated, private data hosting solutions and data recovery support, primarily for European customers.

Diligent’s condensed consolidated financial statements are presented in U.S. dollars, which is the Company’s functional and reporting currency.

2)                                     Investigations and restatement

Special Committee

In December 2012, the Board of Directors (the “Board”) of Diligent appointed a Special Committee of independent directors to examine certain of Diligent’s past stock issuances and stock option grants that may not have been issued in compliance with the relevant stock option and incentive plans. The Special Committee’s members were not on the Board at the time of the issuance of such grants, were not involved in their issue, and are not the recipients of any option grants. The Special Committee was delegated broad powers from the Board to take all such action in respect of the issuances as it deemed necessary and advisable.

The Special Committee, assisted by attorneys in the U.S. and New Zealand, conducted a thorough review and analysis of all stock issuances and stock option grants during the relevant period.  As discussed in Note 7, the Special Committee found that three option awards exceeded the applicable plan caps on the number of shares covered by an award issued to a single recipient in a particular year. The Special Committee was delegated the authority to develop appropriate alternative compensation packages for the affected employees.  These awards were determined by the Board to be reasonable compensation at the time, and were an important incentive component of the employees’ compensation packages.

As part of its work, the Special Committee also reviewed the Company’s compliance with applicable regulations, including U.S. and New Zealand securities regulations and the NZSX Listing Rules. The Special Committee identified a number of instances where it appears that Diligent was not, or may not have been, in compliance with its U.S. and New Zealand regulatory obligations.

The Special Committee determined that these instances of non-compliance were inadvertent and attributable in part to the constrained resources of Diligent in a period of financial difficulty in the years following its listing on the NZSX, and the complex regulatory and compliance obligations across multiple jurisdictions with differing regulations and requirements. It recommended, and the Board fully endorsed, that the Company work with its regulators to resolve these issues. In September 2013 the NZ Markets Disciplinary Tribunal approved a settlement reached by the Company and the New Zealand Stock Exchange regarding the previously disclosed breaches of the NZSX Listing Rules by the Company. The settlement provided for the payment of fines and costs by the Company, consisting of NZ $15 thousand as a penalty to the NZX Discipline Fund and NZ $4 thousand towards the costs of NZSX.

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Costs for the Special Committee for the three and nine months ended September 30, 2013 were $0 and $2.3 million, respectively. An additional $0.3 million was incurred in the fourth quarter of 2012.  Included in Special Committee expenses were professional fees incurred for legal, accounting and compensation consultants, NZX penalties and compensation paid to Special Committee members. During the second quarter of 2013, the Special Committee was disbanded and the Company is in the process of implementing the recommendations of the Special Committee to remediate the compliance and internal control weaknesses identified.

Audit Committee Investigation

On July 2, 2013, the Audit Committee of the Board engaged outside company counsel to investigate the accounting errors that gave rise to the need to restate the Company’s financial statements, as well as other historical accounting practices impacting the timing of recognition of revenue. In connection with the investigation, it was determined that the Company included in its financial results certain customer agreements that, while having an effective date within a quarter, had not been signed by all parties within the quarter, as would be required to commence revenue recognition under U.S. GAAP. The early inclusion of such contracts did not have a material impact on previously reported revenue for fiscal quarters including the first quarter of 2010 through the first quarter of 2013. The Audit Committee investigation resulted in no finding of intentional misconduct or fraud. Costs of the investigation for the three months ended September 30, 2014 and 2013 were $0 and $0.2 million, respectively. Costs of the investigation for the nine months ended September 30, 2014 and 2013 were $0 and $2.5 million, respectively.

Restatement and Re-audit Engagements

In August, 2013, we announced that Diligent’s historical financial statements for the years ended December 31, 2012, 2011 and 2010 and the quarter ended March 31, 2013 would be restated due to revenue recognition errors. The Company completed the restatement process in April 2014. Costs for the restatement and re-audits incurred during the three months ended September 30, 2014 and 2013 were $0 and $0.8 million, respectively. Costs for the restatement and re-audits incurred during the nine months ended September 30, 2014 and 2013 were $0.9 and $0.8 million, respectively. These costs are comprised of professional fees incurred for accounting, auditing and consulting services and restatement bonuses.

3)                                     Significant accounting policies

Basis of presentation — The accompanying interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information pursuant to the rules and regulations of the SEC.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to SEC rules. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the 2013 Form 10-K.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial statements.  The results of operations for the three and nine months ended September 30, 2014 are not necessarily indicative of results expected for the full year.

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions made by management include the deferral and recognition of revenue, the fair value of share-based compensation, accounting for income taxes, including the realization of deferred tax assets and uncertain tax positions, and the useful lives of tangible and intangible assets. Actual results could differ from those estimates.

Principles of consolidation — The condensed consolidated financial statements include the accounts of Diligent and its wholly-owned subsidiaries.  All significant intercompany balances and transactions have been eliminated.

Cash and cash equivalents — The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents.  The Company invests its excess cash primarily in bank and money market funds of major financial institutions.  Accordingly, its cash equivalents are subject to minimal credit and market risk.

Short-term investments — Short-term investments consist of U.S. treasury bills with original maturities of more than three months at the time of purchase and term deposits with banks, with maturities greater than three months at inception.

Fair value of financial instruments — The fair value of Diligent’s accounts receivable, accounts payable and accrued expenses and other liabilities approximates book value due to their short term settlements.

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Revenue Recognition — Diligent derives revenues primarily from subscription fees and installation fees, including training. The Company sells subscriptions to Diligent’s cloud-based application that are generally one year in length. Diligent’s arrangements do not include a general right of return and automatically renew unless the Company is notified 30 days prior to the expiration of the subscription term. Diligent’s subscription agreements do not provide the customer the right to take possession of the software that supports the application. Installation fees consist of the configuration of the Company’s service and training of its customers.

Revenue recognition commences when all of the following conditions are met:

·                                          There is persuasive evidence of the arrangement;

·                                          The service has been made available to the customer;

·                                          The fee is fixed or determinable; and

·                                          The collectability of the fees is reasonably assured.

To qualify as a separate unit of accounting, the delivered item in a multiple element arrangement must have value to the customer on a standalone basis. The Company has determined that the installation fee does not have standalone value, so accordingly it accounts for its arrangements as a single unit of accounting.

Revenue from Diligent’s subscription service is recognized on a daily basis over the subscription term as the services are delivered. The service is considered delivered, and hence revenue recognition commences, when the customer has access to the Diligent Boardbooks product. Revenue is recorded ratably through the end of the subscription term, which is generally twelve months from the date of the contract.

Installation fees paid by customers in connection with the subscription service are deferred and are recognized ratably over the expected life of the customer relationships, generally nine years. In estimating the expected customer relationship period, the Company looked to guidance on the determination of the useful life of an intangible asset for the appropriate factors to be considered in estimating expected customer life and specifically focused on its customer renewal rate. Diligent’s customer contracts contain a standard “autorenew” feature which provides for one-year renewals unless either party provides written notice of termination. In addition, Diligent’s renewal history with its customers has been and remains at very high rates. As a result, we believe that Diligent’s customers will renew numerous times during their tenure with us.  Consequently, Diligent has had a very low annual attrition rate which historically has been less than 5.0%. After considering these factors, we determined that a nine year estimated customer life was appropriate as of September 30, 2014.  The Company evaluates its estimated customer life on an annual basis.

Deferred Revenue — Deferred revenue represents installation and subscription fees for which cash has been received but for which we have not yet delivered services or the criteria for the recognition of revenue have not yet been met.  Deferred revenues presented in the consolidated balance sheet do not include amounts receivable (both billed and unbilled) for executed subscription agreements for which we have not yet received payment.  Accordingly, the deferred revenue balance does not represent the total contract value of annual, non-cancelable subscription agreements.

Long term deferred revenue consists of installation fees that will be recognized over the estimated life of the customer relationship which is generally nine years.  Installation fees expected to be recognized within the next 12 months of the balance sheet date are included in the current portion of deferred revenue.

Accounts receivable —The Company generally invoices our customers on an annual or quarterly basis.  Accounts receivable represents amounts due from Diligent’s customers for which revenue has been recognized.  A provision for doubtful accounts is recorded based on management’s assessment of amounts considered uncollectable for specific customers based on age of the receivable, history of payments and other relevant information.  At each of September 30, 2014 and December 31, 2013, the Company recorded a provision for doubtful accounts of $100 thousand.

Research and development — Research and development expenses are incurred as we upgrade and maintain the Diligent Boardbooks software, and develop product enhancements.  Such expenses include compensation and employee benefits of engineering and testing personnel, materials, travel and direct costs associated with the design and required testing of the product line.  Diligent does not allocate indirect overhead to research and development. Direct development costs related to software enhancements that add functionality have been expensed as incurred as we have not historically maintained sufficiently detailed records of development efforts to be able to capitalize such costs.

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Share-based compensation — Diligent measures the cost of employee services received in exchange for an equity-based award using the fair value of the award on the date of the grant, and recognizes the cost over the period that the award recipient is required to provide services to the Company in exchange for the award. The fair value of restricted stock units and performance stock units are estimated using the market price of Diligent’s common stock at the date of the grant and we recognize compensation expense for the portion of the award that is expected to vest. Diligent measures compensation cost for awards granted to non-employees based on the fair value of the award at the measurement date, which is the date performance is satisfied or services are rendered by the non-employee.

Earnings per share - Basic earnings per share is computed by dividing the net income attributable to common stockholders, after deducting accrued preferred stock dividends, by the weighted average number of common and preferred shares outstanding for the period. The preferred stockholders are entitled to participate on an “as converted” basis in any dividends paid on Diligent’s common stock, and as such are considered participating securities to which earnings should be allocated using the two-class method.

Diluted earnings per share reflects the potential dilution that would occur if securities or other contracts to issue common stock were exercised, settled or converted into common stock, unless the effect is anti-dilutive. Stock options and employee share awards are included as potential dilutive securities for the applicable periods, except 1.5 million stock options which have been excluded for the three and nine months ended September 30, 2014, respectively because their effect is anti-dilutive. There were 360,000 anti-dilutive equity instruments for the comparable three and nine month periods in 2013.

The computation of shares used in calculating basic and diluted earnings per common share are as follows:

Recent accounting pronouncements — In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, to clarify the principles used to recognize revenue for all entities. The new guidance is effective for annual and interim periods beginning after December 15, 2016 with no early adoption permitted. The Company is currently evaluating the impact, if any, the adoption of this guidance will have on Diligent’s financial position, results of operations and cash flows.

From time to time, new accounting pronouncements are issued by the FASB and are adopted as of the specified effective date. Unless otherwise discussed, the impact of other recently issued accounting pronouncements are not expected to have a material impact on the consolidated financial position, results of operations, and cash flows, or do not apply to the Company’s operations.

4)                                   Obligations Under Capital Leases

During the first nine months of 2013, we entered into two capital leases for computer equipment which mature in February 2016.  The leases have a total obligation of $1.3 million and bear interest at rates of 5.449% and 3.804%, with monthly payments of $28 thousand and $14 thousand, respectively.  We did not enter into any new capital leases during the first nine months of 2014.

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5)                                    Fair Value of Financial Instruments

The fair value of a financial instrument is the amount at which the instrument could be exchanged in an orderly transaction between market participants. As of September 30, 2014 and December 31, 2013, the carrying amounts of cash and cash equivalents, accounts receivables, accounts payable and accrued expenses and other liabilities approximated fair value due to the short-term nature of these instruments. ASC 820, Fair Value Measurements and Disclosures, establishes a fair value hierarchy for input into valuation techniques as follows:

i.                                          Level 1 input - unadjusted quoted prices in active markets for identical instrument;

ii.                                       Level 2 input - observable market data for the same or similar instrument but not Level 1, including quoted prices for identical or similar assets or liabilities in markets that are active or not active or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and

iii.                                    Level 3 input - unobservable inputs developed using management’s assumptions about the inputs used for pricing the asset or liability.

Level 2 inputs were utilized to determine the fair value of the Company’s investments in U.S. treasury bills, U.S treasury money market funds, and term deposits.  Due to the short-term nature of these investments, which mature between 90 days and 365 days, amortized cost is used to estimate the fair value.

At September 30, 2014, cash equivalents include investments in U.S. treasury money market funds and treasury bills totaling $31 million, which are carried at cost, which approximates fair value. The fair value of money market funds was determined by reference to quoted market prices.

At December 31, 2013, cash and cash equivalents include investments in U.S. treasury bills of $4.5 million and U.S. treasury money market funds of $23 million, which are carried at cost, which approximates fair value. The fair value of money market funds was determined by reference to quoted market prices. At December 31, 2013, short-term investments include investments in U.S. treasury bills of $12.5 million, which are carried at cost which approximates fair value.

6)                                     Redeemable Preferred Stock

On March 11, 2009, Diligent issued 30 million shares of Series A Preferred Stock at $0.10 per share in a private offering, for aggregate gross proceeds of $3.0 million.  Expenses relating to the preferred stock issuance were $139 thousand.

The carrying value of the Preferred Stock at September 30, 2014 and December 31, 2013 was as follows:

The Preferred Stock is entitled to a fixed, cumulative, dividend of 11% per annum (adjusted for stock splits, consolidation, etc.).  The dividend, which is due on the first business day of each calendar year for the prior year, may (at the Company’s option) be paid either in cash or in kind by the issuance of additional Preferred Stock (paid-in-kind shares), to be issued at the same issue price as the Series A Preferred Stock of $0.10 per share.  The 11% annual dividend on the Preferred Stock will have preference over the declaration or payment of any dividends on the Company’s common stock.  In addition to the 11% preferred dividend, the holders of the Preferred Stock will also be entitled to participate pro rata in any dividend paid on the Company’s common stock.

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In 2014, Diligent anticipates that accumulated unpaid dividends will be paid in cash on the Series A Preferred Stock.  Accordingly, preferred stock dividends of $83 thousand and $253 thousand for the three and nine months ended September 30, 2014 are included in accrued expenses.

Spring Street Partners, L.P., a holder of the Series A Preferred Stock, waived its right to the preferred stock dividend payable on January 3, 2013 of $240 thousand.  This was recorded as a capital contribution in 2013 when waived. The founder and managing partner of Spring Street Partners, L.P. is also the Chairman of the Board and the holder of 5.9 million shares of common stock of the Company.

On March 3 and 5, 2014, Carroll Capital Holdings and Spring Street Partners, L.P. converted 889,219 and 1,777,904 shares of Series A Preferred Stock, respectively, to an equivalent number of shares of common stock.

7)                                     Stock option and incentive plan

On May 3, 2013, the Board adopted the Diligent Board Member Services, Inc. 2013 Incentive Plan (the “2013 Plan”), which was approved by the Diligent’s stockholders in June 2013. An aggregate of 8.5 million shares of the Company’s common stock may be issued pursuant to the Plan to employees, directors and consultants of Diligent and its affiliates. Of the shares available under the Plan, 4.1 million were utilized in connection with the replacement incentive awards issued in accordance with the CEO Replacement Grant Agreement as discussed below. Upon approval of the 2013 Plan the Company discontinued the use of the Company’s 2007 Stock Option and Incentive Plan (the “2007 Plan”) and the 2010 Stock Option and Incentive Plan (the “2010 Plan”).

Awards under the 2013 Plan may be made in the form of stock options (which may constitute incentive stock options or nonqualified stock options), share appreciation rights, restricted shares, restricted share units, performance awards, bonus shares and other awards.  In addition, certain awards under the 2013 Plan may be denominated or settled in cash, including performance awards.

In 2013, the Board and the Company’s stockholders approved a remuneration package for non-executive directors for the 2013 and subsequent fiscal years (the “New Remuneration Package”). The New Remuneration Package consists of both a cash component, designed to compensate members for their service on the Board and its Committees, and an equity component. The total value of the New Remuneration Package for standard board service is $130 thousand per annum, $50 thousand of which will be payable in cash.

Diligent’s non-executive directors, other than the chairman of the Board, are to receive an annual stock grant with a total value of $80 thousand, which would generally be paid to such non-executive directors in equal installments at the end of each quarter of the calendar year. In connection with the non-executive directors’ 2013 service, on March 14, 2014, the Company issued 86.5 thousand restricted shares to its directors based on the volume weighted average trading price of our common stock on its primary trading market for the 20 trading days immediately prior to such date. In connection with the non-executive directors’ 2014 service, on April 9, 2014, the Company issued 27 thousand restricted shares to its directors and on July 10, 2014, the Company issued 24 thousand restricted shares to its directors, in each case based on the volume weighted average trading price of our common stock on its primary trading market for the 20 trading days immediately prior to such date. The grants for 2013 and 2014 services were pro-rated for any director who served on the Board for less than the full calendar year.

In December of 2012 Diligent’s Board authorized a Special Committee of independent directors to conduct a review of certain of the Company’s past stock issuances and stock option grants to determine whether they were in accordance with the relevant incentive plans.  The Special Committee found that three option awards exceeded the applicable plan caps on the number of shares covered by an award issued to a single recipient in a particular year. Specifically, a 2009 award to the chief executive officer exceeded the cap in the 2007 Plan by 1.6 million shares, a 2011 award to the chief executive officer exceeded the cap in the 2010 Plan by 2.5 million shares, and a 2011 award to another employee exceeded the cap in the 2010 Plan by 250 thousand shares.

In May 2013, we entered into a Replacement Grant Agreement with our CEO providing for the cancellation of certain stock options and the issuance of a replacement award, which was to become effective upon the occurrence of certain future events.

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On June 12, 2013, Diligent entered into an agreement providing for the cancellation of options for 250 thousand shares issued to the other employee in excess of the applicable plan cap, under which the vesting schedule for the remaining nonvested options was extended over a four and a half year period and replaced with 150 thousand restricted stock units, with graded vesting over four and a half years.  The modification of this award resulted in additional expense of $66 thousand, which will be recognized on a graded basis through December 2017.

On December 23, 2013, we entered into an Amendment to Replacement Grant Agreement with our CEO which finalized the terms of the incentive compensation package to be provided to our CEO in substitution for certain awards that exceeded the applicable plan caps.

Under the terms of the Amendment to Replacement Grant Agreement, on December 23, 2013 (the “Grant Date”), our CEO’s fully vested option to purchase 2.4 million shares of Diligent’s common stock for an exercise price of U.S. $0.14 per share was cancelled to the extent it was in excess of the applicable plan cap, consisting of 1.6 million of such shares. In exchange for the cancellation of the relevant portion of the award, our CEO received:

·                 An option to purchase 1.6 million shares of common stock having an exercise price of U.S. $2.79, which was the Company’s closing price per share expressed in U.S. dollars on the last trading day on the NZSX immediately prior to the Grant Date (the “Exercise Price”) of December 23, 2013. The option vested on December 31, 2013, and will have a term of ten years from the Grant Date.

·                  A performance cash award of U.S. $4.2 million, determined based on 1.6 million multiplied by the excess of the Exercise Price of U.S. $2.79 over U.S. $0.14. The CEO’s right to receive such cash award was contingent on the Company achieving revenue growth of at least 7% during the twelve month period ended June 30, 2014 and his continued employment through such date. This revenue target was achieved and the cash award will be paid in three equal annual installments. The first installment in the amount of $1.4 million was paid in August 2014, the second installment will be paid in the first quarter of 2015 and the final installment will be paid in the first quarter of 2016, or, if earlier, upon a change in control of the Company or the CEO’s separation from service. Any payment due on any installment date will be proportionally reduced if the sum of our stock price plus dividends for a measurement period prior to each payment date falls below 75% of the Exercise Price.

In addition, the CEO held an option to purchase 3 million shares of Diligent’s common stock for an exercise price of U.S. $0.82 per share, which remained subject to vesting. Under the terms of the Amendment to Replacement Grant Agreement, we cancelled the portion of such option in excess of the applicable plan cap, consisting of 2.5 million of such shares. In exchange for the cancellation of the relevant portion of the award, the CEO received:

·                                     Performance share units for 2.25 million shares of common stock contingent on Diligent achieving revenue growth of at least 7% during the twelve month period ended June 30, 2014. For purposes of clarification, performance share units in this context are units of common stock issued to Diligent’s CEO upon satisfaction of the performance criteria outlined herein. Effective June 30, 2014, the Company’s revenues met the performance requirement of at least seven percent (7%) growth over the performance period as compared to the period from July 1, 2012 through June 30, 2013. The performance share units were determined to be earned and the award will vest in four equal installments based on continued employment, commencing June 30, 2015, with full vesting occurring on June 30, 2018. The delivery dates for the vested performance shares will be 50% in 2018 and 50% in 2019 or, if earlier, upon a change in control of the Company or the CEO’s separation from service.

·                                    Performance share units for up to 250 thousand shares of common stock contingent on Diligent achieving either at least 15% fully diluted EPS growth (adjusted to exclude stock-based compensation expense and extraordinary items) or 15% total stockholder return (“TSR”) growth in four one-year measurement periods beginning April 1, 2013. As of June 30, 2014, the first TSR performance goal was not achieved. TSR growth is measured based on Diligent’s stock price performance during the 20 trading days prior to the relevant measurement date. Performance share units for 62.5 thousand shares of common stock will be earned in each year for which the applicable target is met, with the additional opportunity to earn such shares at the end of the four year performance period if the cumulative fully diluted EPS growth or TSR growth meet the cumulative performance target. The delivery dates for the vested performance shares will be in 2018 or, if earlier, upon a change in control of the Company or the CEO’s separation from service.

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The vesting of the options, performance cash award and performance stock units described above will be subject to certain acceleration provisions in the event of a change in control of the Company, upon death or disability or if the CEO is terminated without cause or resigns for good reason.

$1.4 million of the liability for the performance cash award is recorded in “Accrued expenses and other current liabilities” and $1.4 million is recorded in “Other non-current liabilities” on the Condensed Consolidated Balance Sheet as of September 30, 2014. At December 31, 2013, $1.6 million of the liability for the performance cash award was recorded in “Accrued expenses and other current liabilities” and $0.6 million was recorded in “Other non-current liabilities” on the Condensed Consolidated Balance Sheet.

The Company recorded performance stock and cash award compensation expense of $0.2 million and $2.8 million during the three and nine months ended September 30, 2014, respectively, and $2.9 million in 2013 relating to the replacement award. The replacement award is expected to result in compensation cost of $0.2 million for the remainder of 2014, $0.7 million in 2015, $0.4 million in 2016, $0.2 million in 2017 and $0.1 million in 2018.

On July 24, 2014, Diligent entered into an agreement providing for the cancellation of 250 thousand shares issued to an employee and replaced with 217,760 restricted stock units, under the 2013 Plan. The restricted stock units vest in five equal installments, the first vesting on the grant date and the remaining installments vesting on each anniversary of December 9, 2013.

On September 15, 2014, the Company entered into a new employment agreement with an executive, pursuant to which the Company issued options to purchase 250 thousand shares of stock and 125 thousand restricted stock units under the 2013 Plan. The options have an exercise price of $3.79 per share and vest in two equal installments on September 15, 2015 and September 15, 2016. The restricted stock units also vest in two equal installments on September 15, 2015 and September 15, 2016, upon which the vested portion will convert into an equal number of shares of common stock.

Stock Options — On June 20, 2014, the Company agreed to issue 1,120,000 stock options to executives and employees under the 2013 Plan. These options vest 25% per year over the next four years, as long as such executive or employee remains in the employ of the Company on each vesting date. On September 15, 2014, the Company agreed to issue 250,000 options to an executive of the Company under the 2013 Plan. These options vest in two equal installments on September 15, 2015 and September 15, 2016, as long as such executive remains in the employ of the Company on each vesting date. Upon the final vesting date, the vested portion will convert into an equal number of shares of common stock. A summary of stock option activity for the nine months ended September 30, 2014 is as follows:

Performance Stock Units — As noted above, in 2013, the Company issued Performance Stock Units (“PSUs”) to its CEO as part of his substitute compensation package.  A summary of activity in PSUs for the nine months ended September 30, 2014 is as follows:

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The Company estimates the fair value of the PSU’s as of the grant date utilizing the closing price of its common stock on that date.

Restricted Stock Units — As noted above, in June 2013, the Company agreed to issue 150,000 Restricted Stock Units (“RSUs”) as replacement compensation for the 250,000 stock options issued to an employee of the Company in excess of the 2010 Plan cap. In June 2013, the shareholders of the Company approved the 2013 Plan, under which the Company had agreed to issue 164,000 RSUs to two officers, which vest 25% per year over the next four years, as long as the officers remain in the employ of the Company on each vesting date. 110,000 of these awards were forfeited as of June 30, 2014.  The fair market value of the stock on the date of grant of the RSUs was $5.38 per share.

On June 20, 2014, the Company issued 846,000 RSUs to executives and employees under the 2013 Plan. These RSUs, which vest 25% per year over the next four years, as long as such executive or employee remains in the employ of the Company on each vesting date, have a grant date fair market price of $3.84 per share for an aggregate of $3.3 million to be recognized over the vesting period. On July 24, 2014, the Company agreed to issue 217,760 RSUs to an employee of the Company as replacement compensation for 250,000 stock options which were cancelled. These RSUs have a grant date fair market price of $3.57 per share and did not result in any incremental stock compensation expense. On September 15, 2014, the Company issued 125,000 RSUs to an executive under the 2013 plan. These RSUs vest in two equal installments on September 15, 2015 and September 15, 2016 and have a grant date fair market price of $3.79 per share for an aggregate of $474 thousand to be recognized over the vesting period.

A summary of RSU activity for the nine months ended September 30, 2014 is as follows:

The Company estimates the fair value of the RSUs as of the grant date utilizing the closing price of Diligent’s common stock on the grant date.

For the three months ended September 30, 2014, the Company recognized aggregate share-based compensation expense related to stock options, PSUs and RSUs of $495 thousand, $238 thousand and $459 thousand, respectively, which is included in General and administrative expenses in the Condensed Consolidated Statement of Income. For the nine months ended September 30, 2014, Diligent recognized aggregate share-based compensation expense related to stock options, PSUs and RSUs of $578 thousand, $771 thousand and $419 thousand, respectively, which is included in general and administrative expenses in the Condensed Consolidated Statement of Income. Awards granted to the Company’s former CFO were forfeited upon his resignation during the second quarter of 2014 resulting in expense adjustments in the amount of $570 thousand. Total share-based compensation expense recognized for the three and nine months ended September 30, 2013 was $433 thousand and $1.0 million, respectively, which was entirely related to outstanding stock options. At September 30, 2014, there was $8.0 million of unrecognized share-based

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compensation expense which includes $3.0 million for stock options, $1.6 million for PSUs and $3.4 million for RSUs. The weighted average period for this cost to be recognized is 1.26 years.  Such amounts do not include any impact of the CEO performance cash award.

8)                                     Income taxes

Income tax expense is provided on an interim basis based upon management’s estimate of the annual effective tax rate.  The income tax provision for the three and nine months ended September 30, 2014 provides income taxes at an effective rate of 44% and 39%, respectively.  The tax rate increased compared to comparable periods in 2013 primarily due to discrete events that are recorded in the period in which they occur. The Company recorded an income tax provision for the three and nine months ended September 30, 2013, based on an effective tax rate of 38% and 38%, respectively.

Section 382 of the U.S. Internal Revenue Code generally imposes an annual limitation on the amount of net operating loss carryforwards that can be used to offset taxable income when a corporation has undergone significant changes in stock ownership.  Beginning in 2013, the Company’s annual net operating loss carryforward is subject to a limitation of approximately $350 thousand to offset expected taxable income until expiration of the carryforwards. Based on this limitation, the Company expects that approximately $4.9 million of its total net operating loss carryforwards will expire unutilized in 2029. A full valuation allowance had previously been provided on the related deferred tax asset, and therefore the deferred tax asset and valuation allowance relating to the net operating loss carryforwards expected to expire unutilized were written off.

Diligent and its subsidiaries are subject to regular audits by federal, state and foreign tax authorities.  These audits may result in additional tax liabilities.  The Company’s U.S. federal and state income tax returns for the tax years 2010 and forward are open for examination by the taxing jurisdictions. The Company’s foreign income tax returns are open for examination by the local taxing jurisdictions for the following years: New Zealand — 2009 and forward; U.K. — 2010 and forward; Australia — 2012.

9)                                     Contingencies

Sales tax risk - States and some local taxing jurisdictions have differing rules and regulations governing sales and use taxes, and these rules and regulations are subject to varying interpretations that may change over time. In particular, the applicability of sales taxes to the Company’s subscription services in various jurisdictions is unclear. The Company’s cumulative provisions as of September 30, 2014, related to uncollected sales tax is $1.9 million. The provision increased by $0.1 million and $0.4 million during the three and nine months ended September 30, 2014, respectively. The Company recorded a provision related to uncollected sales tax of $183 thousand and $549 thousand for the three and nine months ended September 30, 2013, respectively.  The cumulative provision related to uncollected sales tax was $1.3 million at September 30, 2013. It is possible that the Company could face sales tax audits and that its liability for these taxes could exceed its estimates as state tax authorities could still assert that it is obligated to collect additional amounts as taxes from its customers and remit those taxes to those authorities. The Company could also be subject to audits with respect to states and international jurisdictions for which it has not accrued tax liabilities. A successful assertion that Diligent should be collecting additional sales or other taxes on its services in jurisdictions where it has not historically done so and does not accrue for sales taxes could result in substantial tax liabilities for past sales, discourage customers from purchasing its application or otherwise harm our business and operating results.

NZSX Listing Rules - On June 13, 2014, New Zealand time, the Company received notification from the NZX Limited (“NZX”) in respect to alleged breaches of the NZSX Listing Rules for the delayed release of the 2013 annual report, the 2013 half year preliminary announcement and the 2013 interim report. The notification informed the Company that the NZX has determined to refer the Company’s alleged breaches to the NZ Markets Disciplinary Tribunal. Any actions by the NZX Limited, and any action taken by the NZX Markets Disciplinary Tribunal, does not foreclose the risk of litigation or other regulatory actions relating to the historical instances of non-compliance identified. Due to the instances of non-compliance, we may be subject to an increased risk of regulatory actions, claims or litigation, the defense of which would require the Company’s management to devote significant attention and to incur significant legal expense and which could require us to pay substantial judgments, settlements, fines or other penalties.

In September 2014 the NZ Markets Disciplinary Tribunal approved a settlement reached by the Company and the New Zealand Stock Exchange regarding the previously disclosed breaches of the NZSX listing rules by the Company relating to the delayed reports described above. The settlement provided for the payment of fines and costs by the Company, consisting of NZ $100 thousand as a penalty to the NZX Discipline Fund which is included in accrued expenses and other liabilities in the Condensed Consolidated Balance Sheet.

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes that appear elsewhere in this Quarterly Report on Form 10-Q. This discussion contains a number of forward-looking statements, all of which are based on our current expectations and all of which could be affected by uncertainties and risks. Our actual results may differ materially from the results contemplated in these forward-looking statements as a result of many factors including, but not limited to, those described under “Risk Factors” in Part I, Item 1A of the 2013 Form 10-K.

Overview

We develop and commercialize Diligent Boardbooks®, a secure software application available online, on iPad and Windows 8.1 supported devices. This is one of the world’s most widely used board portal, allowing board members, management and administrative staff to simplify how board materials are produced, delivered, reviewed and voted on. We provide clients with subscription-based access to our software along with associated services including securely hosting the client’s data, and customer service and support for the application.

Our goal is to help companies streamline the creation and delivery of board materials through an easy-to-use and secure online software platform. Key elements of our strategy include:

·                  Strengthening the existing product and offering new functionality,

·                  Further building our existing client base through geographic expansion and new client acquisition,

·                  Deepening relationships with existing client base, and

·                  Minimizing client cancellations by offering superior customer service and support.

We use the Software-as-a-Service (“SaaS”) model to distribute our Diligent Boardbooks application to the market and maintain the security and integrity of our clients’ data. Under this model, we offer annual renewable subscriptions for client access to our Diligent Boardbooks product which is hosted on our secure servers, and offers a complete suite of related services including training, support, data migration and data security/backup.

The SaaS model allows us to differentiate our product through technological innovation and client service while the subscription billing approach results in a predictable and recurring revenue stream. This SaaS model also allows clients to retain control over access to the application while outsourcing to us the support activities, such as managing the IT infrastructure and maintaining the software.

Our SaaS model addresses several difficulties found in the traditional software model and offers the following critical advantages for our company:

·                  Highly scalable operations. Because our clients’ boards do not ordinarily meet on a daily or monthly basis, our system has the capability to support many more boards without absorbing increased costs associated with customer growth.

·                  Better revenue visibility. By offering renewable annual subscriptions instead of one-time perpetual licenses, we have much better revenue foresight. This high revenue visibility allows us to undertake better planning and budgeting, with significant advantages for corporate strategy and profitability.

·                  Lower cost of development. We have developed an application that is cost-effectively shared across thousands of end users. This is considerably less expensive than developing all the permutations (databases, operating systems, etc.) needed by clients who want to run the software on their own premises.  These economies allow us to spend resources on developing increased functionalities for our Diligent Boardbooks application instead of on creating multiple versions of the same code.

·                  Longer corporate life. The SaaS model has a long tail of recurring revenue that reduces investment risk, simplifies corporate planning and leads to extended corporate life.

·                  Optimal expense planning. Because of the recurring nature of the SaaS model our revenue is more predictable and that allows us to better plan expenses.

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We began developing components of the Diligent Boardbooks system in 1998, culminating in the roll-out of an international sales force in 2007.

On December 12, 2007 we completed an offshore offering of 24,000,000 shares of our common stock in conjunction with a listing of our stock on the New Zealand Stock Exchange under the symbol “DIL.”  As a result, we are subject to the regulation and reporting requirements imposed by the New Zealand Stock Exchange.  While our common stock trades on a periodic basis on the over-the counter bulletin board (“OTCBB”), there is no established public trading market for our common stock in the United States.  However, because Diligent is a U.S. company incorporated in Delaware with over 500 shareholders, it is also treated as a public company in the United States and is subject to the reporting and regulatory requirements of the SEC and the Securities Exchange Act of 1934.  We are subject to the Listing Rules of the New Zealand Stock Exchange, New Zealand securities and financial reporting laws and United States securities laws and regulations applicable to a U.S. public company not listed on a U.S. national securities exchange.  Our need to comply with both New Zealand and U.S. regulatory regimes increases the focus we must place on compliance as well as the cost of compliance.

Critical Accounting Policies and Estimates

There have been no changes to our critical accounting policies during the three and nine months ended September 30, 2014 from those disclosed in our 2013 Form 10-K.

Revenue Recognition —We derive our revenues primarily from subscription fees and installation fees, including training. We sell subscriptions to our cloud-based application that are generally one year in length. Our arrangements do not include a general right of return and automatically renew unless we are notified 30 days prior to the expiration of the subscription term. Our subscription agreements do not provide the customer the right to take possession of the software that supports the application. Installation fees consist of the configuration of our service and training of our customers.

Revenue recognition commences when all of the following conditions are met:

·                                          There is persuasive evidence of the arrangement;

·                                          The service has been made available to the customer;

·                                          The fee is fixed or determinable; and

·                                          The collectability of the fees is reasonably assured.

To qualify as a separate unit of accounting, the delivered item in a multiple element arrangement must have value to the customer on a standalone basis. We have determined that the installation fee does not have standalone value, so accordingly we account for our arrangements as a single unit of accounting.

Revenue from our subscription service is recognized on a daily basis over the subscription term as the services are delivered. The service is considered delivered, and hence revenue recognition commences, when the customer has access to the Diligent Boardbooks product. Revenue is recorded ratably through the end of the subscription term, which is generally twelve months from the date of the contract.

Installation fees paid by customers in connection with the subscription service are deferred and are recognized ratably over the expected life of our customer relationships which is generally nine years. In estimating the expected customer relationship period, we looked to guidance on the determination of the useful life of an intangible asset for the appropriate factors to be considered in estimating expected customer life and specifically focused on its customer renewal rate. Our customer contracts contain a standard “autorenew” feature which provides for one-year renewals unless either party provides written notice of termination. In addition, our renewal history with our customers has been, and remains, at very high rates. As a result, we believe that our customers will renew numerous times during their tenure with us.  Consequently, we believe we will have a very low annual attrition rate. After considering these factors, we determined that a nine year estimated customer life was appropriate as of September 30, 2014.

Deferred Revenue — Deferred revenue represents installation and subscription fees for which cash has been received but for which we have not yet delivered services or the criteria for the recognition of revenue have not yet been met.  Deferred revenues presented in the Condensed Consolidated Balance Sheet do not include amounts receivable (both billed and unbilled) for executed subscription agreements for which we have not yet received payment.  Accordingly, the deferred revenue balance does not represent the total contract value of annual, non-cancelable subscription agreements.

Long term deferred revenue consists of installation fees that will be recognized over the estimated life of the customer relationship, generally nine years.  Installation fees expected to be recognized within the next 12 months of the balance sheet date are included in the current portion of deferred revenue.

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We also provide gross deferred revenue which consists of deferred revenue and installation and subscription fees which have been billed to the customer pursuant to an executed subscription agreement, but for which payment may have not yet been received and the criteria for the recognition of revenue has not yet been met.  As a result of our subscription-based model and historically high renewal rates, at the end of any period, we generally have subscription contracts in place for a high percentage of our total revenues for the next 12 months.  Therefore, we believe it is useful to provide gross deferred revenues.

Accounts receivable — We generally invoice our customers on an annual or quarterly basis.  Accounts receivable represents amounts due from our customers for which revenue has been recognized.  A provision for doubtful accounts is recorded based on management’s assessment of amounts considered uncollectable for specific customers based on age of the receivable, history of payments and other relevant information.  At each of September 30, 2014 and December 31, 2013, we have recorded a provision for doubtful accounts of $100 thousand.  We also provide gross accounts receivable which consists of all billings to customers for installation and subscription fees.

The reconciliation of gross accounts receivable and deferred revenue to net accounts receivable and deferred revenue at September 30, 2014, is as follows:

The reconciliation of gross accounts receivable and deferred revenue to net accounts receivable and deferred revenue at December 31, 2013, is as follows:

(1) Represents installation and subscription fees which have been billed to customers but for which payment has not been received and the criteria for revenue recognition has not been met.

Cost of Revenues and Operating Expenses

Cost of Revenues (exclusive of depreciation and amortization). Cost of revenues consists of direct expenses related to account management, customer support and IT services. We do not allocate depreciation, amortization or indirect overhead to cost of revenues.

Selling and Marketing. Selling and marketing expenses are comprised of sales commissions, salaries for sales and marketing employees, and direct advertising expenses, including mailings and travel. We do not allocate indirect overhead to selling and marketing.

General and Administrative. General and administrative expenses consist of compensation and related expenses for executive, finance, accounting, administrative and legal personnel, professional fees, other corporate expenses and costs such as office space and utilities. We have also included in general and administrative expense, all corporate bonus plans, all office rental expense and all share based compensation.

Research and Development. Research and development expenses are incurred as we upgrade and maintain our software, and develop product enhancements. Such expenses include compensation and employee benefits of engineering and testing personnel, materials, travel and direct costs associated with the design and required testing of our product line.

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We do not allocate indirect overhead to research and development. Direct development costs related to software enhancements that add functionality are permitted to be capitalized and amortized over their useful lives, however we have not historically maintained sufficient detail records of our development efforts to be able to capitalize such costs.

Investigations and Restatement. Our Board of Directors authorized and empowered a Special Committee of independent directors to conduct a review of our past stock issuances and stock option grants to determine if they were in accordance with the relevant incentive plans. Included in investigations and restatement are the expenses relating to the Special Committee investigation, including professional fees incurred for legal, accounting and compensation consultants and compensation to be paid to Special Committee members. Investigation and restatement costs also include the costs of our Audit Committee’s investigation of the accounting errors that gave rise to the need to restate our financial statements and the costs related to the restatement of our financial statements and re-audits of the years ended December 31, 2012, 2011 and 2010, which are comprised of legal, accounting and consulting fees.

Share-Based Compensation.  Share-based compensation consists of restricted stock units, stock options and other share-based compensation awards issued to employees and contractors for services rendered. We measure the cost of employee services received in exchange for an equity-based award using the fair value of the award on the date of the grant, and recognize the cost over the period that the award recipient is required to provide services to us in exchange for the award.  The fair value of restricted stock units and performance stock units are estimated using the market price of our common stock at the date of the grant and we recognize compensation expense for the portion of the award that is expected to vest.

We measure compensation cost for awards granted to non-employees based on the fair value of the award at the measurement date, which is the date performance is satisfied or services are rendered by the non-employee.

Results of Operations for the three months ended September 30, 2014 and 2013

Total Revenues

The growth in total revenues of $4.2 million or 24% for the third quarter of 2014 when compared with the third quarter of 2013 is primarily the result of the increase in new users, as well as our retention of existing customers.  Our customer retention rate continues to exceed 95% for the trailing twelve months ended September 30, 2014. We have continued to add users each quarter since inception.  At September 30, 2014, the total number of users was 87,782 compared with 72,632 at December 31, 2013, and 68,448 at September 30, 2013. North America, EMEA (Europe, Middle East and Africa) and Asia/Pacific accounted for 59%, 22%, and 19%, respectively, of the dollar value of new subscriptions added in the third quarter. Upgrades from existing customers represented 31% and 58% of new sales for the three months ended September 30, 2014 and 2013, respectively.

We recognize subscription revenue ratably over the contract period, which is generally twelve months.  Accordingly, the majority of the impact of growth in new user subscription agreements will be recognized over the next twelve months.

Cost of Revenues and Operating Expenses

(1) Excluding depreciation and amortization

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Cost of revenues is comprised of account management, customer support and information technology (“IT”) services.  The increase in costs of revenues is predominantly due to the increase in headcount in IT services in support of our larger client base.  Worldwide employee salaries and incentive pay increased by $0.4 million, consisting of $0.3 million in IT services and $0.1 million in customer support.  Costs relating to hosting increased by $0.2 million due to the increase in capacity of our existing centers along with the addition of a hosting center in Germany.  Additional increases to cost of revenues include IT expenses of $0.2 million and miscellaneous expenses of $0.1 million.

Cost of revenues increased at a consistent rate with revenue, resulting in a gross profit margin of 81% for the three months ended September 2014, and 2013, respectively.