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EXCEL - IDEA: XBRL DOCUMENT - SERVICESOURCE INTERNATIONAL, INC.Financial_Report.xls
EX-10.2+ - EXHIBIT 10.2+ - SERVICESOURCE INTERNATIONAL, INC.srev-9302014xexhibit102.htm
EX-31.2 - EXHIBIT 31.2 - SERVICESOURCE INTERNATIONAL, INC.srev-9302014xexhibit312.htm
EX-32.2 - EXHIBIT 32.2 - SERVICESOURCE INTERNATIONAL, INC.srev-9302014xexhibit322.htm
EX-10.1 - EXHIBIT 10.1 - SERVICESOURCE INTERNATIONAL, INC.srev-9302014xexhibit101.htm
EX-31.1 - EXHIBIT 31.1 - SERVICESOURCE INTERNATIONAL, INC.srev-9302014xexhibit311.htm
EX-10.4+ - EXHIBIT 10.4+ - SERVICESOURCE INTERNATIONAL, INC.srev-9302014xexhibit104.htm
EX-32.1 - EXHIBIT 32.1 - SERVICESOURCE INTERNATIONAL, INC.srev-9302014xexhibit321.htm
EX-10.3+ - EXHIBIT 10.3+ - SERVICESOURCE INTERNATIONAL, INC.srev-9302014xexhibit103.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 September 30, 2014
OR
 
¨ 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 001-35108
 SERVICESOURCE INTERNATIONAL, INC.
(Exact name of registrant as specified in our charter)
Delaware
No. 81-0578975
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
 
 
634 Second Street
San Francisco, California
94107
(Address of Principal Executive Offices)
(Zip Code)
(415) 901-6030
(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  x   No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
¨
Accelerated filer
x
Non-accelerated filer
¨  (Do not check if a smaller reporting company)
Smaller reporting company
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x
Indicate number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date:
 
Class
Outstanding as of October 31, 2014
Common Stock
83,786,927




SERVICESOURCE INTERNATIONAL, INC.
Form 10-Q
INDEX
 
 
Page
No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

2


PART I FINANCIAL INFORMATION
 
Item 1.
Financial Statements
SERVICESOURCE INTERNATIONAL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)
 
September 30,
2014
 
December 31,
2013
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
98,922

 
$
170,132

Short-term investments
125,001

 
105,001

Accounts receivable, net
59,988

 
73,113

Deferred income taxes
433

 
412

Prepaid expenses and other
6,583

 
6,295

Total current assets
290,927

 
354,953

Property and equipment, net
27,672

 
27,998

Deferred income taxes, net of current portion
2,152

 
2,035

Goodwill and intangibles, net
15,443

 
6,334

Other assets, net
8,177

 
8,626

Total assets
$
344,371

 
$
399,946

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
2,765

 
$
3,610

Accrued taxes
684

 
1,134

Accrued compensation and benefits
19,238

 
19,610

Deferred revenue
6,109

 
5,905

Accrued liabilities and other
11,884

 
9,509

Total current liabilities
40,680

 
39,768

Convertible notes, net
118,958

 
113,915

Other long-term liabilities
4,892

 
5,566

Total liabilities
164,530

 
159,249

Commitments and contingencies (Note 10)

 

Stockholders’ equity:
 
 
 
Common stock; $0.0001 par value; 1,000,000 shares authorized; 83,519 shares issued and 83,398 shares outstanding as of September 30, 2014; 82,086 shares issued and 81,965 shares outstanding as of December 31, 2013
8

 
8

Treasury stock
(441
)
 
(441
)
Additional paid-in capital
307,178

 
286,526

Accumulated deficit
(127,868
)
 
(46,250
)
Accumulated other comprehensive income
964

 
854

Total stockholders’ equity
179,841

 
240,697

Total liabilities and stockholders’ equity
$
344,371

 
$
399,946

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.


3


SERVICESOURCE INTERNATIONAL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Net revenue
$
64,713

 
$
66,482

 
$
197,526

 
$
195,300

Cost of revenue
49,218

 
39,730

 
145,331

 
116,848

Gross profit
15,495

 
26,752

 
52,195

 
78,452

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
14,343

 
13,731

 
47,225

 
43,906

Research and development
6,402

 
5,500

 
19,999

 
18,542

General and administrative
10,932

 
11,177

 
36,053

 
33,182

Restructuring and other
1,937

 

 
1,937

 

Goodwill impairment
21,000

 

 
21,000

 

Total operating expenses
54,614

 
30,408

 
126,214

 
95,630

Loss from operations
(39,119
)
 
(3,656
)
 
(74,019
)
 
(17,178
)
Other (income) expense:
 
 
 
 
 
 
 
Interest expense
(2,495
)
 
(1,272
)
 
(7,356
)
 
(1,376
)
Other, net
(372
)
 
179

 
(282
)
 
(119
)
Loss before income taxes
(41,986
)
 
(4,749
)
 
(81,657
)
 
(18,673
)
Income tax provision (benefit)
(200
)
 
753

 
(39
)
 
2,190

Net loss
$
(41,786
)
 
$
(5,502
)
 
$
(81,618
)
 
$
(20,863
)
Net loss per share, basic and diluted
$
(0.50
)
 
$
(0.07
)
 
$
(0.99
)
 
$
(0.27
)
Weighted average common shares outstanding, basic and diluted
83,131

 
79,740

 
82,668

 
77,557

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

4


SERVICESOURCE INTERNATIONAL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands)
(Unaudited)
 
 
Three Months Ended
 September 30,
 
Nine Months Ended
 September 30,
 
2014
 
2013
 
2014
 
2013
Net loss
$
(41,786
)
 
$
(5,502
)
 
$
(81,618
)
 
$
(20,863
)
Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Foreign currency translation adjustments
155

 
(180
)
 
489

 
32

Unrealized gain (loss) on short-term investments, net of tax
(235
)
 
254

 
(136
)
 
134

Other comprehensive income (loss), net of tax
(80
)
 
74

 
353

 
166

Total comprehensive loss, net of tax
$
(41,866
)
 
$
(5,428
)
 
$
(81,265
)
 
$
(20,697
)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

5


SERVICESOURCE INTERNATIONAL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
 
Nine Months Ended
 September 30,
 
2014
 
2013
Cash flows from operating activities
 
 
 
Net loss
$
(81,618
)
 
$
(20,863
)
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
 
 
 
Depreciation and amortization
9,670

 
9,010

Amortization of debt discount and issuance costs
5,536

 
960

Accretion of premium on short-term investments and other
72

 
569

Deferred income taxes
(177
)
 
504

Stock-based compensation
16,006

 
17,301

Income tax (benefit) charge from stock-based compensation
(267
)
 
249

Restructuring and other
910

 

Goodwill impairment
21,000

 

Changes in operating assets and liabilities, net of impact of acquisition:
 
 
 
Accounts receivable, net
14,567

 
1,527

Prepaid expenses and other
(108
)
 
(174
)
Accounts payable
(831
)
 
2,581

Accrued taxes
(593
)
 
1,110

Accrued compensation and benefits
(822
)
 
1,227

Accrued liabilities and other
461

 
763

Net cash (used in) provided by operating activities
(16,194
)
 
14,764

Cash flows from investing activities
 
 
 
Acquisition of property and equipment
(7,625
)
 
(3,108
)
Cash paid for acquisition, net of cash acquired
(32,550
)
 

Purchases of short-term investments
(70,430
)
 
(78,502
)
Sales of short-term investments
46,181

 
5,336

Maturities of short-term investments
4,043

 
2,000

Net cash used in investing activities
(60,381
)
 
(74,274
)
Cash flows from financing activities
 
 
 
Proceeds from issuance of convertible notes

 
150,000

Issuance costs related to the issuance convertible senior notes

 
(4,350
)
Payments of convertible note hedges

 
(31,408
)
Proceeds from the issuance of warrants

 
21,763

Repayment on capital leases obligations
(321
)
 
(245
)
Proceeds from common stock issuances
4,380

 
21,969

Income tax benefit (charge) from stock-based compensation
267

 
(249
)
Net cash provided by financing activities
4,326

 
157,480

Net (decrease) increase in cash and cash equivalents
(72,249
)
 
97,970

Effect of exchange rate changes on cash and cash equivalents
1,039

 
136

Cash and cash equivalents at beginning of period
170,132

 
76,568

Cash and cash equivalents at end of period
$
98,922

 
$
174,674

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

6


SERVICESOURCE INTERNATIONAL, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Note 1 — Description of Business and Basis of Presentation
ServiceSource International, Inc. (together with its subsidiaries, the “Company”) is a global leader in recurring revenue management, partnering with technology and technology-enabled companies to optimize maintenance, support and subscription revenue streams, while also improving customer relationships and loyalty. The Company delivers these results via cloud-based solutions and dedicated service teams, leveraging benchmarks and best practices derived from its rich database of service and renewal behavior. By integrating software, managed services and data, the Company provides end-to-end management and optimization of the service-contract renewals process, including data management, quoting, selling and recurring revenue business intelligence. The Company receives commissions from its customers based on renewal sales that the Company generates on their behalf under a pay-for-performance model. In addition, the Company also offers a purpose-built Software-As-A-Service (SaaS) application to maximize the renewal of subscriptions, maintenance and support contracts and a SaaS application that enables information services, media publishing, and SaaS companies to understand how customers engage with their online content. The Company’s corporate headquarters are located in San Francisco, California. The Company has offices in Colorado, Tennessee, Washington, United Kingdom, Ireland, Malaysia, Singapore and Japan.
The accompanying unaudited interim condensed consolidated financial statements (“condensed consolidated financial statements”) include the accounts of ServiceSource International Inc. and its subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation.
These condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“U.S. GAAP” or “GAAP”) for interim financial information, rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial statements, and accounting policies, consistent in all material respects with those applied in preparing our audited annual consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2013. These condensed consolidated financial statements and accompanying notes should be read in conjunction with our annual consolidated financial statements and the notes thereto for the year ended December 31, 2013, included in our Annual Report on Form 10-K. In the opinion of management, these condensed consolidated financial statements reflect all adjustments, including normal recurring adjustments, management considers necessary for a fair statement of our financial position, operating results, and cash flows for the interim periods presented. The results for the interim periods are not necessarily indicative of results for the entire year.
The December 31, 2013 condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. These unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes for the year ended December 31, 2013 included in the Company’s Annual Report on Form 10-K.
Recent Accounting Pronouncements
In June 2013, the Financial Accounting Standard Board ("FASB") determined that an unrecognized tax benefit should be presented as a reduction of a deferred tax asset for a net operating loss (“NOL”) carryforward or other tax credit carryforward when settlement in this manner is available under applicable tax law. This guidance is effective for the Company’s interim and annual periods beginning January 1, 2014. The adoption of this guidance did not have a material impact on the Company's consolidated financial statements.

In May 2014, the FASB issued Accounting Standard Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (Topic 606), which supersedes the revenue recognition requirements in ASC 605, Revenue Recognition.  This ASU is based on the principle that revenue is recognized to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  The ASU also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract.  The effective date will be the first quarter of fiscal year 2017 using one of two retrospective application methods.  The Company has not determined the potential effects on the consolidated financial statements.

In August 2014, the FASB issued new guidance related to the disclosures around going concern. The new standard provides guidance around management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosures. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Early adoption is permitted. The adoption of this standard is not expected to have a material impact on our financial statements.

7



Note 2 — Business Acquisition
On January 22, 2014, the Company acquired Scout Analytics, Inc. (“Scout”), a privately held company. Scout provides cloud-based recurring revenue management solutions that enable information services, media publishing, and SaaS companies to understand how customers engage with their online content.
The acquisition has been accounted for under the acquisition method of accounting in accordance with the FASB's Accounting Standards Codification (“ASC”) Topic 805, Business Combinations. As such, the Scout assets acquired and liabilities assumed are recorded at their acquisition-date fair values. Acquisition-related transaction costs are not included as a component of consideration transferred, but are accounted for as an expense in the period in which the costs are incurred. Any excess of the acquisition consideration over the fair value of assets acquired and liabilities assumed is allocated to goodwill, which is not deductible for tax purposes. Goodwill is attributable primarily to expected synergies and other benefits from combining Scout with the Company including the hiring of Scout's workforce, all of which was allocated to the Cloud and Business Intelligence reporting unit. Refer to Note 3 regarding goodwill impairment during the third quarter of 2014.
The Company's allocation of the total purchase consideration of $32.5 million, net of cash acquired is summarized below (in thousands)

Acquired intangible assets:
 
Developed technology
$
4,330

Customer relationships
3,400

Trade name
1,290

Total acquired intangible assets
9,020

Goodwill
22,653

Accounts receivable
2,679

Other assets (including cash of $211)
520

Deferred revenue
(1,350
)
Capital lease
(283
)
Other liabilities
(477
)
Net Assets Acquired
$
32,762


The fair value measurements for purchase price allocation were based on significant inputs that are not observable in the market and thus represent Level 3 measurements as defined in the accounting standard for fair value measurements.

The developed technology, customer relationships and trade names are being amortized on a straight-line basis over 4 years, 4 years and 4 years, respectively, with a combined weighted-average useful life of 4 years.
Pro-forma results of operations for the acquisition have not been presented because they are not material to the consolidated results of operations.
Note 3 — Goodwill Impairment and Intangible Assets
Goodwill Impairment
The Company performs its annual impairment analysis of goodwill at the reporting unit level in the fourth quarter of each year and between annual tests if events or circumstances indicate that it is more likely than not that the asset is impaired according to the guidance within ASC 350 Intangibles - Goodwill and Other. The guidance requires that the Company perform a two-step impairment test of its goodwill. In the first step, the fair value of each reporting unit is compared to its carrying value. The Company's reporting units, Cloud and Business Intelligence and Managed Services, are consistent with segments identified in Note 13 of Notes to the Unaudited Condensed Consolidated Financial Statements.
Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. Significant judgments required to estimate the fair value of reporting units include estimating future cash flows and

8


determining appropriate discount rates, growth rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value of each reporting unit which could trigger impairment.
The fair value is determined based upon the income approach. Under the income approach, the Company estimates the fair value of the reporting unit based upon the present value of estimated future cash flows. Cash flow projections are determined by management to be commensurate with the risk inherent in current business model. Key assumptions used to estimate the fair value of the reporting units include the discount rate, compounded annual revenue growth rates, operating expense assumptions, and terminal value capitalization rate. The discount rate used is based on the weighted-average cost of capital adjusted for the relevant risk associated with business-specific characteristics and the uncertainty related to the reporting unit's ability to execute on the projected cash flows. The discount rate and terminal value capitalization rate are derived from the use of market data and are classified as a Level 3 within the fair value hierarchy.
If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to the reporting unit, goodwill is not impaired and the Company is not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then step two of the impairment testing must be performed to determine the implied fair value of the reporting unit’s goodwill. The implied fair value of goodwill is calculated by deducting the fair value of all tangible and intangible assets of the reporting unit, excluding goodwill, from the fair value of the reporting unit as determined in the first step. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then an impairment charge equal to the difference is recorded. The inputs used to measure the estimated fair value of goodwill are classified as level 3.
During the third quarter of 2014, the Company’s market capitalization had a significant decline, the Company experienced slowing revenue growth for the Cloud and Business Intelligence (“CBI”) reporting unit in the near term and the company experienced churn of the CBI customer base. Therefore, the Company determined that there were sufficient indicators to require the Company to perform an interim impairment analysis in the third quarter of 2014. The Company compared the fair value of CBI reporting unit as determined under the income approach to its carrying value and determined that the fair value was less than the carrying value. The Company then performed step two of the impairment analysis.
Based on the result of the interim impairment analysis as described above, the Company concluded that an impairment of some of the CBI goodwill had occurred, resulting in a non-cash goodwill impairment charge of $21.0 million during the third quarter of 2014. We continue to monitor the recoverability of our goodwill. Additionally, the continued decline in the Company’s market capitalization, or other events or circumstances could require additional impairment charges to be recorded in future periods for the remaining goodwill.
The changes in the carrying amount of goodwill by operating segment as of September 30, 2014 were as follows:
 
Managed Services
 
Cloud and Business Intelligence
 
Total
 
(in thousands)
Balance as of December 31, 2013
$
6,334

 
$

 
$
6,334

Addition due to acquisition

 
22,653

 
22,653

Impairment
$

 
$
(21,000
)
 
$
(21,000
)
Balance as of September 30, 2014
$
6,334

 
$
1,653

 
$
7,987

Intangible Assets
Intangible Assets consisted of the following:
 
Nine Months Ended September 30, 2014
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
 
(in thousands)
Developed technology
$
4,330

 
$
(751
)
 
$
3,579

Customer relationships
3,400

 
(589
)
 
2,811

Trade name
1,290

 
(224
)
 
1,066

 
$
9,020

 
$
(1,564
)
 
$
7,456


9


Amortization expense for intangibles assets recognized during the three and nine months ended September 30, 2014 was $0.6 million and $1.6 million respectively.
The estimated future amortization expense of purchased intangible assets as of September 30, 2014 was as follows:
 
September 30, 2014
 
(in thousands)
Years ending December 31,
 
2014 (remaining three months)
$
564

2015
2,255

2016
2,255

2017
2,255

2018
127

Total
$
7,456


The Company evaluates the recoverability of its long-lived assets with finite useful lives, including intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. Based on the assessment of various factors noted above in the Cloud and Business Intelligence (“CBI”) reporting unit, the Company determined that there were sufficient indicators to require the Company to perform an impairment analysis of its long-lived assets with finite useful lives, including intangible assets during the third quarter of 2014. We are required to assess impairment at the asset group level where there is identifiable cashflow. Our asset group where we have identifiable cashflows are CBI and Managed Services.

The impairment analysis includes comparing the sum of the undiscounted cash flows to the book value of the assets within the asset group. If the sum of undiscounted cash flows is less than the book value of the assets within the asset group, then the assets within the asset group are impaired. The impairment charge is measured as the difference between the book value and the fair value.

Based on the analysis, the Company concluded that there was no impairment to its developed technology, customer relationships, trade name and property and equipment during the third quarter of 2014.
Note 4 — Cash, cash equivalents and short-term investments
Cash equivalents consist of highly liquid fixed-income investments with original maturities of three months or less at the time of purchase, including money market funds. The Company has cash and cash equivalents held on its behalf by a third party of $0.7 million and $0.5 million as of September 30, 2014 and December 31, 2013, respectively. Short-term investments consist of readily marketable securities with a remaining maturity of more than three months from time of purchase. The Company classifies all of its cash equivalents and short-term investments as “available for sale,” as these investments are free of trading restrictions. These marketable securities are carried at fair value, with the unrealized gains and losses, net of tax, reported as accumulated other comprehensive income and included as a separate component of stockholders’ equity. Gains and losses are recognized when realized. When the Company determines that an other-than-temporary decline in fair value has occurred, the amount of the decline that is related to a credit loss is recognized in earnings. Gains and losses are determined using the specific identification method. The Company’s realized gains and losses in the three and nine months ended September 30, 2014 and 2013 were insignificant.
Cash and cash equivalents and short-term investments consisted of the following as of September 30, 2014 and December 31, 2013 (in thousands):

10


September 30, 2014
 
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Estimated
Fair Value
Description
 
Cash
$
98,287

 
$

 
$

 
$
98,287

Cash equivalents:
 
 
 
 
 
 
 
Money market mutual funds
635

 

 

 
635

Total cash and cash equivalents
98,922

 

 

 
98,922

Short-term investments:
 
 
 
 
 
 
 
Corporate bonds
47,938

 
60

 
(54
)
 
47,944

U.S. agency securities
39,267

 
36

 
(26
)
 
39,277

Asset-backed securities
22,035

 
12

 
(39
)
 
22,008

U.S. Treasury securities
15,740

 
44

 
(12
)
 
15,772

Total short-term investments
124,980

 
152

 
(131
)
 
125,001

Cash, cash equivalents and short-term investments
$
223,902

 
$
152

 
$
(131
)
 
$
223,923

December 31, 2013
 
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Estimated
Fair Value
Description
 
Cash
$
169,968

 
$

 
$

 
$
169,968

Cash equivalents:
 
 
 
 
 
 
 
Money market mutual funds
164

 

 

 
164

Total cash and cash equivalents
170,132

 

 

 
170,132

Short-term investments:
 
 
 
 
 
 
 
Corporate bonds
40,503

 
90

 
(10
)
 
40,583

U.S. agency securities
31,720

 
40

 
(13
)
 
31,747

Asset-backed securities
15,880

 
14

 
(12
)
 
15,882

U.S. Treasury securities
16,742

 
50

 
(3
)
 
16,789

Total short-term investments
104,845

 
194

 
(38
)
 
105,001

Cash, cash equivalents and short-term investments
$
274,977

 
$
194

 
$
(38
)
 
$
275,133

The following table summarizes the cost and estimated fair value of short-term fixed income securities classified as short-term investments based on stated maturities as of September 30, 2014:
 
 
Amortized
Cost
 
Estimated
Fair Value
 
(in thousands)
Less than 1 year
$
15,028

 
$
15,047

Due in 1 to 3 years
109,952

 
109,954

Total
$
124,980

 
$
125,001

As of September 30, 2014 and December 31, 2013, the Company did not consider any of its investments to be other-than-temporarily impaired.
Note 5 — Fair value of financial instruments

11


The Company measures certain financial instruments at fair value on a recurring basis. The Company uses a three-tier fair value hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value:
Level 1 valuations are based on quoted prices in active markets for identical assets or liabilities.

Level 2 valuations are based on inputs that are observable, either directly or indirectly, other than quoted prices included within Level 1. Such inputs used in determining fair value for Level 2 valuations include quoted prices in active markets for similar assets or liabilities, 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 assets or liabilities.
Level 3 valuations are based on information that is unobservable and significant to the overall fair value measurement.
All of the Company’s cash equivalents and short-term investments are classified within Level 1 or Level 2.
The following table presents information about the Company’s financial instruments that are measured at fair value as of September 30, 2014 and indicates the fair value hierarchy of the valuation (in thousands):
 
 
Total
 
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
Description
 
Cash equivalents:
 
 
 
 
 
Money market mutual funds
$
635

 
$
635

 
$

Total cash equivalents
635

 
635

 

Short-term investments:
 
 
 
 
 
Corporate bonds
47,944

 

 
47,944

U.S. agency securities
39,277

 

 
39,277

Asset-backed securities
22,008

 

 
22,008

U.S. Treasury securities
15,772

 

 
15,772

Total short-term investments
125,001

 

 
125,001

Cash equivalents and short-term investments
$
125,636

 
$
635

 
$
125,001

The following table presents information about the Company’s financial instruments that are measured at fair value as of December 31, 2013 and indicates the fair value hierarchy of the valuation (in thousands):
 
 
Total
 
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
Description
 
Cash equivalents:
 
 
 
 
 
Money market mutual funds
$
164

 
$
164

 
$

Total cash equivalents
164

 
164

 

Short-term investments:
 
 
 
 
 
Corporate bonds
40,583

 

 
40,583

U.S. agency securities
31,747

 

 
31,747

Asset-backed securities
15,882

 

 
15,882

U.S. Treasury securities
16,789

 

 
16,789

Total short-term investments
105,001

 

 
105,001

Cash equivalents and short-term investments
$
105,165

 
$
164

 
$
105,001


12



The convertible notes issued by the Company in August 2013 are shown in the accompanying consolidated balance sheets at their original issuance value, net of unamortized discount, and are not marked to market each period. The approximate fair value of the convertible notes as of September 30, 2014 and December 31, 2013 was $113.4 million and $141.2 million respectively. The fair value of the convertible notes was determined using quoted market prices for similar securities, which, due to limited trading activity, are considered Level 2 in the fair value hierarchy.
The Company did not have any financial liabilities measured at fair value or any long-term debt other than the Convertible debt as of September 30, 2014 and December 31, 2013.

Note 6 — Property and Equipment, Net
Property and equipment balances were comprised of the following (in thousands):
 
 
September 30,
2014
 
December 31,
2013
Computers and equipment
$
16,414

 
$
14,675

Software
37,062

 
34,467

Leasehold improvements
12,906

 
11,493

Furniture and Fixture
9,737

 
9,078

 
76,119

 
69,713

Less: accumulated depreciation and amortization
(48,447
)
 
(41,715
)
Property and equipment – net
$
27,672

 
$
27,998

Depreciation and amortization expense for property and equipment during the three and nine months ended September 30, 2014 and the three and nine months ended September 30, 2013, was $3.3 million, $9.6 million, $3.0 million and $9.0 million respectively.
Total property and equipment assets under capital lease at September 30, 2014 and December 31, 2013, were $3.3 million and $3.2 million, respectively. Accumulated depreciation related to assets under capital lease as of these dates was $3.0 million and $2.6 million, respectively.
The Company capitalized internal-use software development costs of $1.0 million and $0 million during the three months ended September 30, 2014 and 2013, respectively and $2.0 million and $0 million during the nine months ended September 30, 2014 and 2013, respectively. As of September 30, 2014 and December 31, 2013, the net value of capitalized costs related to internal-use software, net of accumulated amortization, was $10.6 million and $9.3 million, respectively. Amortization of capitalized costs related to internal-use software for the three and nine months ended September 30, 2014 was $0.6 million and $1.8 million, respectively, and for the three and nine months ended September 30, 2013 was $1.3 million and $3.8 million, respectively.
Note 7 — Accrued Liabilities and Other
Accrued liabilities and other balances were comprised of the following (in thousands):
 
 
September 30,
2014
 
December 31,
2013
Accrued professional fees
$
4,523

 
$
2,527

Deferred rent
865

 
834

Other employee related
536

 
374

ESPP contributions
339

 
892

Obligations under capital lease
191

 
270

Accrued other
5,430

 
4,612

 
$
11,884

 
$
9,509

Note 8 — Credit Facility and Capital Leases
Revolving Credit Facility

13


On July 5, 2012, the Company, entered into a three-year credit agreement which provides for a secured revolving line of credit based on eligible accounts receivable of up to $25.0 million on and before July 5, 2013 and up to $30.0 million thereafter, in each case with a $2.0 million letter of credit sublimit. On June 18, 2013, the Company elected to maintain the revolving commitment at $25.0 million. Proceeds available under the credit agreement may be used for working capital and other general corporate purposes. The Company may prepay borrowing under the agreement in whole or in part at any time without premium or penalty. The Company may terminate the commitments under the credit agreement in whole at any time. Effective June 30, 2013, the quarterly commitment fee, payable in arrears, based on the available commitments is 0.30% per annum.
On August 6, 2013, the Company entered into a second amendment (“Amendment No. 2”) to the credit agreement. Amendment No. 2, among other things, allowed the Company to issue certain unsecured convertible notes and enter into related agreements. 
On January 21, 2014, the Company entered into a third amendment to the credit agreement which amended the financial covenants to allow the Company to acquire Scout.
On May 5, 2014, the Company entered into a fourth amendment to the credit agreement which reduced the secured revolving line of credit from $25.0 million to $10.0 million. The amendment also increased the consideration the Company may pay in connection with an acquisition before it is required to seek prior lender approval under the credit agreement.
Amounts outstanding on the facility at September 30, 2014 consisted of a letter of credit for $575,000 required under an operating lease agreement for office space at the Company’s San Francisco headquarters. Any outstanding loans bear interest, at the Company’s option, at a base rate determined in accordance with the credit agreement, minus 0.5%, or at a LIBOR rate plus 2.0%. Principal, together with all accrued and unpaid interest, is due and payable on July 5, 2015, the maturity date. At September 30, 2014, the interest rate for borrowings under the facility was 2.2%.
The credit agreement contains customary affirmative and negative covenants, as well as financial covenants. Affirmative covenants include, among others, delivery of financial statements, compliance certificates and notices of specified events, maintenance of properties and insurance, preservation of existence, and compliance with applicable laws and regulations. Negative covenants include, among others, limitations on the ability of the Company to grant liens, incur indebtedness, engage in mergers, consolidations, sales of assets and affiliate transactions. The credit agreement requires the Company to maintain a maximum leverage ratio and a minimum liquidity amount, each as defined in the credit agreement.
The credit agreement also contains customary events of default including, among other things, payment defaults, breaches of covenants or representations and warranties, cross-defaults with certain other indebtedness, bankruptcy and insolvency events and a change in control of the Company, subject to grace periods in certain instances. Upon an event of default, the lender may declare the outstanding obligations of the Company under the credit agreement to be immediately due and payable and exercise other rights and remedies provided for under the credit agreement.
On August 1, 2014 and October 29, 2014, the Company entered into a waiver under the Credit Agreement that waived its failure to comply with the consolidated funded debt to EBITDA ratio for the quarter ended June 30, 2014 and September 30, 2014 respectively.
On November 1, 2014, the Company entered into a fifth amendment to the credit agreement where the parties agreed to remove a financial covenant requiring a certain level of consolidated funded debt to EBITDA ratio for the previous four quarters. The Company agreed to a new financial covenant requiring the Company to have an EBITDA loss not exceeding a specified target.
The Company’s obligations under the credit agreement are guaranteed by its subsidiary, ServiceSource Delaware, Inc. (the “Guarantor”) and are collateralized by substantially all of the assets of the Company and the Guarantor.
Capital Leases
The Company has capital lease agreements that are collateralized by the underlying property and equipment and expire through September 2019. The weighted-average imputed interest rates for the capital lease agreements were 5.8% and 2.6% at September 30, 2014 and 2013, respectively.
Future minimum annual payments under capital lease obligations as of September 30, 2014 were as follows (in thousands):

14


 
September 30,
2014
Years Ending December 31,
 
2014 (remaining three months)
$
197

2015
408

2016
342

2017
76

2018
79

Thereafter
59

Total
$
1,161

Note 9 — Debt
Senior Convertible Notes
In August 2013, the Company issued senior convertible notes (the “Notes”) raising gross proceeds of $150.0 million.
The Notes are governed by an Indenture, dated August 13, 2013 (the “Indenture”), between the Company and Wells Fargo Bank, National Association, as trustee. The Notes will mature on August 1, 2018, unless earlier repurchased or converted, and bear interest at a rate of 1.50% per year payable semi-annually in arrears on February 1 and August 1 of each year, commencing February 1, 2014.
The Notes are convertible at an initial conversion rate of 61.6770 of common stock per $1,000 principal amount of Notes, which represents an initial conversion price of approximately $16.21 per share of common stock, subject to anti-dilution adjustments upon certain specified events, including in certain circumstances, upon a make-whole fundamental change (as defined in the Indenture). Upon conversion, the Notes will be settled in cash, shares of the Company’s common stock, or any combination thereof, at the Company’s option.
Prior to February 1, 2018, the Notes are convertible only upon the following circumstances:
during any calendar quarter commencing after December 31, 2013, (and only during such calendar quarter), if for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter, the last reported sale price of common stock on such trading day is greater than or equal to 130% of the applicable conversion price on such trading day.
during the five business day period after any five consecutive trading day period in which the trading price per $1,000 principal amount of the Notes for each trading day of that five consecutive trading day period was less than 98% of the product of the last reported sale price of common stock and the applicable conversion rate on each such trading day; or
upon the occurrence of specified corporate events described in the Indenture.
Holders of the Notes may convert their Notes at any time on or after February 1, 2018, until the close of business on the second schedule trading day immediately preceding the maturity date, regardless of the foregoing circumstances.
The holders of the Notes may require the Company to repurchase all or a portion of their Notes at a cash repurchase price equal to 100% of the principal amount of the Notes being repurchased, plus accrued and unpaid interest, if any, upon a fundamental change (as defined in the Indenture). In addition, upon certain events of default (as defined in the Indenture), the trustee by notice to the Company, or the holders of at least 25% in principal amount of the outstanding Notes by notice to the Company and the trustee, may, and the trustee at the request of such holders shall, declare 100% of the principal amount of the Notes, plus accrued and unpaid interest, if any, on all the Notes to be due and payable. In case of certain events of bankruptcy, insolvency or reorganization involving the Company, 100% of the principal of and accrued and unpaid interest on the Notes will automatically become due and payable.
To account for the Notes at issuance, the Company separated the Notes into debt and equity components pursuant to the accounting standards for convertible debt instruments that may be fully or partially settled in cash upon conversion. The fair value of debt component was estimated using an interest rate for nonconvertible debt, with terms similar to the Notes, excluding the conversion feature. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The excess of the principal amount of the Notes over the fair value of the debt component was recorded as a debt discount and a corresponding increase in additional paid-in capital. The debt discount is accreted to interest expense over the term of the Notes using the interest method. The amount recorded to additional

15


paid-in capital is not to be remeasured as long as it continues to meet the conditions of equity classification. Upon issuance of the $150.0 million of Notes, the Company recorded $111.5 million to debt and $38.5 million to additional paid-in capital.
The Company incurred transaction costs of approximately $4.9 million related to the issuance of the Notes. In accounting for these costs, the Company allocated the costs to the debt and equity components in proportion to the allocation of proceeds from the issuance of the Notes to such components. Transaction costs allocated to the debt component of $3.6 million are deferred as an asset and amortized to interest expense over the term of the Notes. The transaction costs allocated to the equity component of $1.3 million were recorded to additional paid-in capital. The transactions costs allocated to the debt component were recorded as deferred offering costs in other non-current assets.
The net carrying amount of the liability component of the Notes as of September 30, 2014 consists of the following (in thousands):
Principal amount
$
150,000

Unamortized debt discount
(31,042
)
Net carrying amount
$
118,958

The following table presents the interest expense recognized related to the Notes for the nine months ended September 30, 2014 (in thousands):
Contractual interest expense at 1.5% per annum
$
1,688

Amortization of debt issuance costs
470

Accretion of debt discount
5,043

Total
$
7,201

The net proceeds from the Notes were approximately $145.1 million after payment of the initial purchasers' offering expense. The Company used approximately $31.4 million of the net proceeds from the Notes to pay the cost of the Note Hedges described below, which was partially offset by $21.8 million of the proceeds from the Company's sale of the Warrants also described below.
Note Hedges
Concurrent with the issuance of the Notes, the Company entered into note hedges (“Note Hedges”) with certain bank counterparties, with respect to its common stock. The Company paid $31.4 million for the Note Hedges. The Note Hedges cover approximately 9.25 million shares of the Company's common stock at a strike price of $16.21 per share. The Note Hedges will expire upon the maturity of the Notes. The Note Hedges are intended to reduce the potential dilution to the Company's common stock upon conversion of the Notes and/or offset the cash payment in excess of the principal amount of the Notes the Company is required to make in the event that the market value per share of the Company's common stock at the time of exercise is greater than the conversion price of the Notes.
Warrants
Separately, the Company entered into warrant transactions, whereby it sold warrants to the same bank counterparties as the Note Hedges to acquire approximately 9.25 million shares of the Company's common stock at an initial strike price of $21.02 per share (“Warrants”), subject to anti-dilution adjustments. The Company received proceeds of approximately $21.8 million from the sale of the Warrants. If the fair value per share of the Company's common stock exceeds the strike price of the Warrants, the Warrants will have a dilutive effect on earnings per share, unless the Company elects, subject to certain conditions, to settle the Warrants in cash.
The amounts paid and received for the Note Hedges and the Warrants have been recorded in additional paid-in capital. The fair value of the Note Hedges and the Warrants are not remeasured through earnings each reporting period.
Note 10 — Commitments and Contingencies
Operating Leases
The Company leases its office space and certain equipment under noncancelable operating lease agreements with various expiration dates through September 30, 2022. Rent expense for the three months ended September 30, 2014 and 2013 was $2.3 million and $2.0 million, respectively, and for the nine months ended September 30, 2014 and 2013 was $6.9 million and $6.4

16


million, respectively. The Company recognizes rent expense on a straight-line basis over the lease period and accrues for rent expense incurred but not paid.
Future annual minimum lease payments under all noncancelable operating leases as of September 30, 2014 were as follows (in thousands): 
 
September 30, 2014
Years Ending December 31,
 
2014 (remaining three months).
$
2,125

2015
7,244

2016
5,077

2017
4,795

2018
4,450

Thereafter
9,787

Total
$
33,478


Other Contractual Obligations
In August 2013, the Company issued the Notes raising gross proceeds of $150.0 million. The Notes will mature on August 1, 2018, unless earlier repurchased or converted, and bear interest at a rate of 1.50% per year payable semi-annually in arrears on February 1 and August 1 of each year, commencing February 1, 2014.

Litigation
Bionet Systems, LLC, et al. v. Scout Analytics, Inc., et al., in Superior Court, King County, Washington State, and related claims
On January 10, 2014, certain now-former shareholders of Scout Analytics, Inc. (“Scout”) filed a lawsuit against Scout and some of its directors and their employers regarding the then-pending acquisition of Scout by the Company. The plaintiffs have asserted claims against all defendants for breach of fiduciary duty, minority shareholder oppression, corporate waste, injunctive relief and unjust enrichment.  In their complaint, the plaintiffs seek damages and payment of their attorneys’ fees and costs.  On April 17, 2014, the plaintiffs filed a First Amended Complaint, in which they added the Company as a defendant, and asserted claims for tortious interference.

Certain now-former Scout shareholders have also asserted dissenter's rights claims related to the Scout acquisition.  On June 13, 2014, the Company filed a lawsuit in the Superior Court for King County, Washington, in which it seeks a determination by the Court as to the fair value of the shares, and that such shareholder claims have no merit.

The costs of such litigation and dissenter's rights claims are expected to be covered by insurance and/or by either the escrow amounts held back from the merger consideration paid for Scout, or the indemnification obligations of the former Scout shareholders.

The Company may be subject to litigation or other claims in the normal course of business. In the opinion of management, the Company’s ultimate liability, if any, related to any currently pending or threatened litigation or claims is remote, not reasonably possible or not probable, and in any instance, any such liability would not materially affect its consolidated financial position, results of operations, or cash flows.
Note 11 — Stockholders’ Equity
Stock Option Plans
The Company maintains the following stock plans: the 2011 Equity Incentive Plan (the “2011 Plan”), and the 2011 Employee Stock Purchase Plan. The Company’s board of directors and, as delegated to its compensation committee, administers the 2011 Plan and has authority to determine the directors, officers, employees and consultants to whom options or restricted stock may be granted, the option price or restricted stock purchase price, the timing of when each share is exercisable and the duration of the exercise period and the nature of any restrictions or vesting periods applicable to an option or restricted stock grant
Under the 2011 Plan, options granted are generally subject to a four-year vesting period whereby options become 25% vested after a one-year period and the remainder then vests monthly through the end of the vesting period. Vested options may

17


be exercised up to ten years from the vesting commencement date, as defined in the 2011 Plan. Vested but unexercised options expire three months after termination of employment with the Company. The restricted stock units typically vest over four years with a yearly cliff contingent upon employment with the Company on the applicable vesting dates.
The Company has elected to recognize the compensation cost of all stock-based awards on a straight-line basis over the vesting period of the award. Further, the Company applies an estimated forfeiture rate to unvested awards when computing the share compensation expenses. The Company estimates the forfeiture rate for unvested awards based on its historical experience on employee turnover behavior and other factors.
At the end of each fiscal year, the share reserve under the 2011 Plan increases automatically by an amount equal to 4% of the outstanding shares as of the end of that most recently completed fiscal year or 3.8 million shares, whichever is less. On January 1, 2014, 3.3 million additional shares were reserved under the 2011 Equity Incentive Plan pursuant to the automatic increase.
Determining Fair Value of Stock Awards
The Company estimates the fair value of stock option awards at the date of grant using the Black-Scholes option-pricing model. Options are granted with an exercise price equal to the fair value of the common stock as of the date of grant. Compensation expense is amortized net of estimated forfeitures on a straight-line basis over the requisite service period of the options, which is generally four years. Restricted stock, upon vesting, entitles the holder to one share of common stock for each restricted stock and has a purchase price of $0.0001 per share, which is equal to the par value of the Company’s common stock, and vests over four years. The fair value of the restricted stock is based on the Company’s closing stock price on the date of grant, and compensation expense, net of estimated forfeitures, is recognized on a straight-line basis over the vesting period.
The weighted average Black-Scholes model assumptions for the three and nine months ended September 30, 2014 and 2013 were as follows: 
 
Three Months Ended
 September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Expected term (in years)
5.0

 
5.0

 
5.0

 
5.0

Expected volatility
41
%
 
43
%
 
41
%
 
44
%
Risk-free interest rate
1.68
%
 
1.48
%
 
1.63
%
 
0.95
%
Expected dividend yield

 

 

 

Option and restricted stock activity under the 2011 Plan for the nine months ended September 30, 2014 was as follows (shares in thousands)
 
 
 
Options Outstanding
 
Restricted Stock
Outstanding
 
Shares and Units
Available
for Grant
 
Number
of Shares
 
Weighted-
Average
Exercise
Price
 
Number
of Shares
Outstanding — December 31, 2013
5,755

 
8,908

 
$
5.89

 
5,431

Additional shares reserved under the 2011 equity incentive plan
3,279

 

 


 
2,845

Granted
(4,602
)
 
1,757

 
5.13

 
(927
)
Options exercised/ Restricted stock released

 
(514
)
 
5.17

 

Canceled/Forfeited
3,739

 
(1,842
)
 
6.46

 
(1,892
)
Outstanding — September 30, 2014
8,171

 
8,309

 


 
5,457

    
The weighted average grant-date fair value of employee stock options granted during the three months ended September 30, 2014 and 2013 was $1.53 and $4.86 per share, respectively and for the nine months ended September 30, 2014 and 2013 was $1.96 and $3.03 per share, respectively.
The following table summarizes the consolidated stock-based compensation expense included in the condensed consolidated statements of operations (in thousands):
 

18


 
Three Months Ended
 September 30,
 
Nine Months Ended
 September 30,
 
2014
 
2013
 
2014
 
2013
Cost of revenue
$
1,034

 
$
802

 
$
3,168

 
$
2,222

Sales and marketing
1,497

 
2,414

 
4,917

 
7,396

Research and development
695

 
753

 
2,131

 
1,758

General and administrative
1,848

 
1,989

 
5,790

 
5,925

Total stock-based compensation
$
5,074

 
$
5,958

 
$
16,006

 
$
17,301

Employee Stock Purchase Plan
The Company’s 2011 Employee Stock Purchase Plan (the “ESPP”) is intended to qualify under Section 423 of the Internal Revenue Code of 1986. Under the ESPP, employees are eligible to purchase common stock through payroll deductions of up to 10% of their eligible compensation, subject to any plan limitations. The purchase price of the shares on each purchase date is equal to 85% of the lower of the fair market value of the Company’s common stock on the first and last trading days of each twelve month offering period.
The ESPP provides that additional shares are reserved under the plan annually on the first day of each fiscal year in an amount equal to the lesser of (i) 1.5 million shares, (ii) one percent of the outstanding shares of common stock on the last day of the immediately preceding fiscal year, or (iii) an amount determined by the board of directors and/or the compensation committee of the board of directors. On January 1, 2014, 0.8 million additional shares were reserved under the ESPP pursuant to the plan's automatic increase provision. As of September 30, 2014, 1.1 million shares had been issued under the ESPP and 2.1 million shares were available for future issuance.
Note 12 — Income Taxes
The Company files U.S. federal and state and foreign income tax returns in jurisdictions with varying statutes of limitations. In the normal course of business the Company is subject to examination by taxing authorities throughout the world. These audits include questioning the timing and amount of deductions, the allocation of income among various tax jurisdictions and compliance with federal, state, local and foreign tax laws. The Company is currently undergoing examination of the California Franchise Tax Returns relating to California state income taxes of its U.S. operating subsidiary for the years 2008 through 2010.  Accordingly, tax years 2008 through 2013 remain subject to examination in California. The 2009 through 2013 tax years generally remain subject to examination by federal, state and foreign tax authorities. The Company’s gross amount of unrecognized tax benefits was $0.9 million as of December 31, 2013 and as of September 30, 2014, $0.1 million of which, if recognized, would affect the Company’s effective tax rate. It is difficult to predict the final timing and resolution of any particular uncertain tax position. Based on the Company’s assessment of many factors, the Company does not expect that changes in the liability for unrecognized tax benefits for the next twelve months will have a significant impact on the Company’s consolidated financial position or results of operations.
During the quarter ended September 30, 2014, consistent with the Company’s practice in prior periods, management reassessed the realizability of deferred tax assets based on the available evidence, including a history of taxable income and estimates of future taxable income. In performing its evaluation, management placed significant emphasis on guidance in ASC 740, which states that “[a] cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.” Based upon available evidence, management concluded on a more-likely-than-not basis that most of the Company‘s U.S. deferred tax assets were not realizable. Significant negative evidence included U.S. pretax losses (as calculated consistent with ASC 740) in each of the Company's 2014 quarters and for the cumulative twelve-quarter period ended September 30, 2014 . Additionally, Company forecasts indicated a continuation of U.S pretax losses for the remainder of calendar year 2014. The Company also concluded on a more-likely-than-not basis that its Singapore and Ireland deferred tax assets were not realizable, based on cumulative pretax losses incurred for the cumulative twelve-quarter period ended September 30, 2014 and forecast pretax losses for the remainder of the year.
At September 30, 2014 management concluded that the cumulative losses for the most recent three years, as well as the forecast losses for calendar 2014, represented significant negative evidence as to why a valuation allowance was warranted. Management also considered the Company’s near-term financial forecast on a jurisdictional basis which indicated that three-year cumulative loss estimates in the U.S., Singapore and Ireland would not reverse in the near future. Assessing these factors and the fact that that the most objective and verifiable data were the cumulative three-year losses in each jurisdiction through September 30, 2014, management concluded that, on a more-likely-than-not basis, the Company’s U.S., Singapore and Ireland tax deferred tax assets would not be realized. As a result, the Company continued to provide a valuation allowance for

19


all US federal deferred tax assets, net of liabilities, for all Ireland and Singapore net deferred tax assets, and for substantially all of the Company’s state deferred tax assets. The remaining deferred tax assets at September 30, 2014 relate to jurisdictions in which the Company has net adjusted historical pretax profits and sufficient forecast profitability to assure future realization of such deferred tax assets.
Management will continue to assess the realization of the Company’s deferred tax assets at each balance sheet date by applying the provisions of ASC 740. These evaluations will consider all positive and negative factors identified by management at each reporting date.
The Company considers the undistributed earnings of its foreign subsidiaries permanently reinvested in foreign operations and has not provided for U.S. income taxes on such earnings.
Note 13 — Segments
The Company has two operating segments. The information for the three and nine months ended September 30, 2013 has been reclassified to conform to the current presentation.

Managed Services- The Company’s managed services solution consists of end-to-end management and optimization of the recurring revenue process, including quoting, selling and business intelligence. The Company's managed services business is built on its pay-for-performance model, whereby customers pay the Company a commission based on renewal sales that it generates on their behalf. The Company’s managed services offerings include quoting and selling services, in which dedicated service teams have specific expertise in the customers’ businesses, are deployed under the Company's customers’ brands and follow a sales process tailored specifically to increase service contract renewals.

Cloud and Business Intelligence- The Company’s cloud and business intelligence solution consist of its subscription sales and professional services to deploy the Company's solutions. Subscription sales consists of selling subscriptions to Renew OnDemand and Scout Analytics, both SaaS applications. The foundation of the Company’s cloud solution is Renew OnDemand, a SaaS-based renewal management system based on its data warehouse of transactional, analytical and industry data that grows with each service renewal transaction and customer. 
The Company’s Chief Operating Decision Maker (CODM), its Chief Executive Officer, evaluates the performance of its operating segments based on net revenue and gross profit. Gross profit for each segment includes revenues and the related cost of revenue directly attributable to the segment. The Company does not allocate sales and marketing, research and development, or general and administrative expenses to its operating segments because management does not include the information in its measurement of the performance of the operating segments. The Company does not evaluate its operating segments using discrete asset information.
Summarized financial information by reporting segments based on the Company’s internal management reporting and as utilized by the Company’s CODM, is as follows (in thousands):
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Net Revenue
 
 
 
 
 
 
 
 
Managed Services
 
$
56,629

 
$
61,946

 
$
173,773

 
$
183,329

Cloud and Business Intelligence
 
8,084

 
4,536

 
23,753

 
11,971

 
 
64,713

 
66,482

 
197,526

 
195,300

 
 
 
 
 
 
 
 
 
Gross Profit
 
 
 
 
 
 
 
 
Managed Services
 
12,896

 
26,558

 
46,143

 
75,945

Cloud and Business Intelligence
 
2,599

 
194

 
6,052

 
2,507

 
 
15,495

 
26,752

 
52,195

 
78,452

 
 
 
 
 
 
 
 
 
Unallocated operating expenses
 
54,614

 
30,408

 
126,214

 
95,630

Loss from operations
 
$
(39,119
)
 
$
(3,656
)
 
$
(74,019
)
 
$
(17,178
)


20


The Company’s business is geographically diversified. During the third quarter of 2014, 67% of our net revenue was earned in North America and Latin America (“NALA”), 23% in Europe, Middle East and Africa (“EMEA”) and 10% in Asia Pacific-Japan (“APJ”). Net revenue for a particular geography generally reflects commissions earned from sales of service contracts managed from our sales centers in that geography and subscription sales and professional services to deploy the Company's solutions. Predominantly all of the service contracts sold and managed by our sales centers relate to end customers located in the same geography. All of NALA net revenue represents revenue generated in the United States.
Summarized financial information by geographic location based on the Company’s internal management reporting is as follows (in thousands)
 
Three Months Ended
 September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Net revenue
 
 
 
 
 
 
 
NALA
$
43,477

 
$
45,068

 
$
129,434

 
$
125,357

EMEA
15,156

 
15,625

 
49,599

 
51,383

APJ
6,080

 
5,789

 
18,493

 
18,560

Total net revenue
$
64,713

 
$
66,482

 
$
197,526

 
$
195,300



21



Note 14 — Restructuring and Other
The Company announced at the beginning of the third quarter of 2014 a restructuring effort to better align our cost structure with current revenue levels. The restructuring plans are accounted for in accordance with ASC 420, Exit or Disposal Cost Obligations. The Company recognized restructuring and other charges of $1.9 million during the quarter. Restructuring costs include severance related expenses which includes severance payments, related employee benefits and retention bonuses. Other costs include severance related expenses and $0.4 million of charges related to cancellation of contracts with outside vendors. The Company expects to have restructuring and other expenses through 2015, as restructuring activities targeted at reducing the overall cost structure of the business will continue over several quarters.
Restructuring and other reserve activities for the period ended September 30, 2014 is summarized as follows (in thousands):
 
Restructuring
Other
Total
Restructuring and other liability at January 1, 2014
$

$

$

Restructuring and other charge
835

1,102

1,937

Cash paid
329

894

1,223

Restructuring and other liability at September 30, 2014
$
506

$
208

$
714




22


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and with our Annual Report on Form 10-K for the year ended December 31, 2013.
This Quarterly Report on Form 10-Q contains “forward-looking statements” that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. These forward-looking statements include, but are not limited to, statements related to changes in market conditions that impact our ability to generate service revenue on behalf of our customers; errors in estimates as to the service revenue we can generate for our customers; our ability to attract new customers and retain existing customers; risks associated with material defects or errors in our software or the effect of data security breaches; our ability to adapt our solution to changes in the market or new competition; our ability to improve our customers’ renewal rates, margins and profitability; our ability to increase our revenue and contribution margin over time from new and existing customers, including as a result of sales of our next-generation technology platform, Renew OnDemand, on a stand-alone subscription basis; our ability to implement Renew OnDemand or our other SaaS offerings; our strategy with respect to our business services and SaaS businesses and cost allocation and management efforts; the potential effect of mergers and acquisitions on our customer base; business strategies and new sales initiatives; technology development; protection of our intellectual property; investment and financing plans; liquidity, our leverage consisting of convertible notes and related matters concerning our note hedges and warrants; our competitive position; the effects of competition; industry environment; potential growth opportunities; and our expected benefits from the acquisition of Scout. Forward-looking statements are also often identified by the use of words such as, but not limited to, “anticipate,” “believe,” “can,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “project,” “seek,” “should,” “target,” “will,” “would,” and similar expressions or variations intended to identify forward-looking statements. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section of this Quarterly Report on Form 10-Q titled “Risk Factors.” Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.
All dollar amounts expressed as numbers in this MD&A (except per share amounts) are in millions.
OVERVIEW

We are the global leader in recurring revenue management. We offer a cloud application, Renew OnDemand, to automate this highly valuable but typically manual business process. Renew OnDemand and our proven managed services, drive higher subscription, maintenance and support revenue while improving customer retention and increasing business predictability. We manage the service contract renewals process for renewals of maintenance, support and subscription agreements on behalf of our customers. Our integrated solution consists of dedicated service sales teams working under our customers’ brands and our proprietary Renew OnDemand platform and applications. By integrating software, managed services and data, we address the critical steps of the renewals process including data management, quoting, selling and recurring revenue business intelligence. Our business is built on our pay-for-performance model, whereby our revenues are based on the service renewals customers achieve with our solution, although we have been establishing a base of subscription revenue agreements to our technology platform and applications. We also offer our Scout Analytics suite of role-based products that leverage the Scout Platform, a recurring revenue management solution designed to maximize customer value and accelerate growth in revenue and profits. All of the products in the Scout Platform help companies integrate customer data, predict opportunities, and automate customer engagement processes, but each product comes with its own specialized workflows, automation, and reports, designed to solve specific recurring revenue challenges.

Over the past two years, we have devoted significant resources to developing Renew OnDemand. With its launch in
December 2012, we transitioned from a Managed Service business to a software and services company where we unbundled
the two product offerings. We have expanded our professional services, research and development and sales team capabilities to develop and market our SaaS based solution in addition to our existing managed service offering. In addition, our acquisition of Scout Analytics in January 2014 has expanded our product offerings of SaaS based solutions.

Despite a number of customer expansions and additions, our revenue and profitability was adversely impacted in

23


2014 due to execution challenges in our bundled solutions offering. In July 2014, we announced plans to create two business units for our Managed Services (MS) and Cloud & Business Intelligence and to align our customer-facing teams along those different efforts. We also plan to focus on driving improved execution and reducing inefficiencies and cost-to-serve in our core Managed Services business and scaling our Cloud & Business Intelligence business. Finally, we aim to lower overall operating costs by reducing our global expense infrastructure. We expect these improvements to have little impact on our expected financial results for the remainder of 2014, but these efforts are designed to enable us to run our business more efficiently and with more scale across our two business units in 2015 and beyond.
Key Business Metrics
In assessing the performance of our business, we consider a variety of business metrics in addition to the financial metrics discussed below under, “Basis of Presentation.” These key metrics include recurring revenue opportunity under management and number of engagements.
Recurring Revenue Opportunity Under Management. At December 31, 2013, we estimated our opportunity under management to be over $11.6 billion. Recurring revenue opportunity under management (“opportunity under management”) is a forward-looking metric and is our estimate, as of a given date, of the value of all end customer service contracts that we will have the opportunity to sell or provide support on behalf of our customers over the subsequent twelve-month period. Opportunity under management is not a measure of our expected revenue. In addition, opportunity under management reflects our estimate for a forward twelve-month period and should not be used to estimate our opportunity for any particular quarter within that period. The value of end customer contracts actually delivered during a twelve-month period should not be expected to occur in even quarterly increments due to seasonality and other factors impacting our customers and their end customers. We estimate the value of such end customer contracts based on a combination of factors, including the value of end customer contracts made available to us by customers in past periods, the minimum value of end customer contracts that our customers are required to give us the opportunity to sell pursuant to the terms of their contracts with us, periodic internal business reviews of our expectations as to the value of end customer contracts that will be made available to us by customers, the value of end customer contracts included in the Service Performance Analysis (“SPA”) and collaborative discussions with our customers assessing their expectations as to the value of service contracts that they will make available to us for sale. While the minimum value of end customer contracts that our customers are required to give us represents a portion of our estimated opportunity under management, a significant portion of the opportunity under management is estimated based on the other factors described above. As our experience with our business, our customers and their contracts has grown, we have continually refined the process, improved the assumptions and expanded the data related to our calculation of opportunity under management. When estimating recurring revenue opportunity under management, we must, to a large degree, rely on the assumptions described above, which may prove incorrect. These assumptions are inherently subject to significant business and economic uncertainties and contingencies, many of which are beyond our control. Our estimates therefore may prove inaccurate, causing the actual value of end customer contracts delivered to us in a given twelve-month period to differ from our estimate of opportunity under management. These factors include:
the extent to which customers deliver a greater or lesser value of end customer contracts than may be required or otherwise expected;
roll-overs of unsold service contract renewals from prior periods to the current period or future periods;
changes in the pricing or terms of service contracts offered by our customers;
increases or decreases in the end customer base of our customers;
the extent to which the renewal rates we achieve on behalf of a customer early in an engagement affect the amount of opportunity that the customer makes available to us later in the engagement;
customer cancellations of their contracts with us; and
changes in our customers’ businesses, sales organizations, management, sales processes or priorities.
Our managed services revenue also depends on our close rates and commissions. Our close rate is the percentage of opportunity under management that we renew on behalf of our customers. Our commission rate is an agreed-upon percentage of the renewal value of end customer contracts that we sell on behalf of our customers.
Our close rate is impacted principally by our ability to successfully sell service contracts on behalf of our customers. Other factors impacting our close rate include: the manner in which our customers price their service contracts for sale to their end customers; the stage of life-cycle associated with the products and underlying technologies covered by the service contracts offered to the end customer; the extent to which our customers or their competitors introduce new products or underlying technologies; the nature, size and age of the service contracts; and the extent to which we have managed the renewals process for similar products and underlying technologies in the past.

24


In determining commission rates for an individual engagement, various factors, including our close rates, as described above, are evaluated. These factors include: historical, industry-specific and customer-specific renewal rates for similar service contracts; the magnitude of the opportunity under management in a particular engagement; the number of end customers associated with these opportunities; and the opportunity to receive additional performance commissions when we exceed certain renewal levels. We endeavor to set our commission rates at levels commensurate with these factors and other factors that may be relevant to a particular engagement. Accordingly, our commission rates vary, often significantly, from engagement to engagement. In addition, we sometimes agree to lower commission rates for engagements with significant opportunity under management.
Number of Engagements. We track the number of engagements we have with our customers. We often have multiple engagements with a single customer, particularly where we manage the sales of service renewals relating to different product lines, technologies, types of contracts or geographies for the customer. When the set of renewals we manage on behalf of a customer is associated with a separate customer contract or a distinct product set, type of end customer contract or geography and therefore requires us to assign a service sales team to manage the renewals, we designate the set of renewals, and associated revenues and costs to us as a unique engagement. For example, we may have one engagement consisting of a service sales team selling maintenance contract renewals of a particular product for a customer in the United States and another engagement consisting of a sales team selling warranty contract renewals of a different product for the same customer in Europe. These would count as two engagements. We had approximately 150, 145 and 120 engagements as of December 31, 2013, 2012 and 2011 respectively.
Factors Affecting our Performance
Sales Cycle. We sell our integrated solution through our sales organization. At the beginning of the sales process, our quota-carrying sales representatives contact prospective customers and educate them about our offerings. Educating prospective customers about the benefits of our solution can take time, as many of these prospects have not historically relied upon integrated solutions like ours for service revenue management, nor have they typically put out a formal request for proposal or otherwise made a decision to focus on this area. As part of our sales process, we utilize our solutions design team to perform a
SPA of our prospect’s service revenue. The SPA includes an analysis of best practices and benchmarks the prospect’s service revenue against industry peers. Through the SPA process, which typically takes several weeks, we are able to assess the characteristics and size of the prospect’s service revenue, identify potential areas of performance improvement, and formulate our proposal for managing the prospect’s service revenue. The length of our sales cycle for a new customer, inclusive of the SPA process and measured from our first formal discussion with the customer until execution of a new customer contract, is typically longer than six months and has increased in recent periods.
We generally contract with new customers to manage a specified portion of their service revenue opportunity, such as the opportunity associated with a particular product line or technology, contract type or geography. We negotiate the engagement-specific terms of our customer contracts, including commission rates, based on the output of the SPA, including the areas identified for improvement. Once we demonstrate success to a customer with respect to the opportunity under contract, we seek to expand the scope of our engagement to include other opportunities with the customer. For some customers, we manage all or substantially all of their service contract renewals.
For SaaS offerings, the SPA may be more limited and focused on the benefits of the respective technology and therefore may take less time.
Implementation Cycle. After entering into an engagement with a new customer, and to a lesser extent after adding an engagement with an existing customer, we incur sales and marketing expenses related to the commissions owed to our sales personnel. The commissions are based on the estimated total contract value, with a material portion of the commission expensed upfront with the remaining portion expensed ratably over a period of twelve to fourteen months. We also make upfront investments in technology and personnel to support the engagement. These expenses are typically incurred one to three months before we begin generating sales and recognizing revenue. Accordingly, in a given quarter, an increase in new customers, and, to a lesser extent, an increase in engagements with existing customers, or a significant increase in the contract value associated with such new customers and engagements, will negatively impact our gross margin and operating margins until we begin to achieve anticipated sales levels associated with the new engagements, which is typically two-to-three quarters after we begin selling contracts on behalf of our customers.
Although we expect new customer engagements to contribute to our operating profitability over time, in the initial periods of a customer relationship, the near term impact on our profitability can be negatively impacted by slower-than anticipated growth in revenues for these engagements as well as the impact of the upfront costs we incur, the lower initial level of associated service sales team productivity and lack of mature data and technology integration with the customer. As a result, an increase in the mix of new customers as a percentage of total customers may initially have a negative impact on our

25


operating results. Similarly, a decline in the ratio of new customers to total customers may positively impact our near-term operating results.
Contract Terms. Substantially all of our revenue comes from our pay-for-performance model. Under our pay-for-performance model, we earn commissions based on the value of service contracts we sell on behalf of our customers. In some cases, we earn additional performance-based commissions for exceeding pre-determined service renewal targets.
Our new customer contracts have typically had a term of approximately 36 months, although we sometimes have contract terms of up to 60 months. Our contracts generally require our customers to deliver a minimum value of qualifying service revenue contracts for us to renew on their behalf during a specified period. To the extent that our customers do not meet their minimum contractual commitments over a specified period, they may be subject to fees for the shortfall. Our customer contracts are cancelable on relatively short notice, subject in most cases to the payment of an early termination fee by the customer. The amount of this fee is based on the length of the remaining term and value of the contract.
We invoice our customers on a monthly basis based on commissions we earn during the prior month, and with respect to performance-based commissions, on a quarterly basis based on our overall performance during the prior quarter. Amounts invoiced to our customers are recognized as revenue in the period in which our services are performed or, in the case of performance commissions, when the performance condition is determinable. Because the invoicing for our services generally coincides with or immediately follows the sale of service contracts on behalf of our customers, we do not generate or report a significant deferred revenue balance. However, the combination of minimum contractual commitments, our success in generating improved renewal rates for our customers, our customers’ historical renewal rates and the performance improvement potential identified by our SPA process, provides us with revenue visibility.
M&A Activity. Our customers, particularly those in the technology sector, participate in an active environment for mergers and acquisitions. Large technology companies have maintained active acquisition programs to increase the breadth and depth of their product and service offerings and small and mid-sized companies have combined to better compete with large technology companies. A number of our customers have merged, purchased other companies or been acquired by other companies. We expect merger and acquisition activity to continue to occur in the future.
The impact of these transactions on our business can vary. Acquisitions of other companies by our customers can provide us with the opportunity to pursue additional business to the extent the acquired company is not already one of our customers.
Similarly, when a customer is acquired, we may be able to use our relationship with the acquired company to build a relationship with the acquirer. In some cases we have been able to maintain our relationship with an acquired customer even where the acquiring company handles its other service contract renewals through internal resources. In other cases, however, acquirers have elected to terminate or not renew our contract with the acquired company. For example, Oracle terminated our contracts with Sun Microsystems effective as of September 30, 2010.
Economic Conditions and Seasonality. An improving economic outlook generally has a positive, but mixed, impact on our business. As with most businesses, improved economic conditions can lead to increased end customer demand and sales. In particular, within the technology sector, we believe that the recent economic downturn led many companies to cut their expenses by choosing to let their existing maintenance, support and subscription agreements lapse. An improving economy may have the opposite effect.
However, an improving economy may also cause companies to purchase new hardware, software and other technology products, which we generally do not sell on behalf of our customers, instead of purchasing maintenance, support and subscription services for existing products. To the extent this occurs, it would have a negative impact on our opportunities in the near term that would partially offset the benefits of an improving economy.
We believe the current uncertainty in the economy, combined with shifting market forces toward subscription-based models, is impacting a number of our customers and prospective customers, particularly in the traditional enterprise software and hardware segments. These forces have placed pressure on end customer demand for their renewal contracts and also have led to some slower decision making in general. This economic and industry environment has adversely affected the conversion rates for end customers and contracts. To the extent these conditions continue they will impact our future revenues.
In addition to the uncertainty in the macroeconomic environment, we experience a seasonal variance in our revenue typically for the third quarter of the year as a result of lower or flat renewal volume corresponding to the timing of our customers’ product sales particularly in the international regions. The impact of this seasonal fluctuation can be amplified if the economy as a whole is experiencing disruption or uncertainty, leading to deferral of some renewal decisions. As we increase our subscription revenue base, this seasonality will become less apparent. However for at least the next couple years, we would expect this pattern to continue.

26


Establishment of “Software-as-a-Service” Business unit. Within the software industry, there is a growing trend toward providing software to customers using a software-as-a-service (“SaaS”) model. Under this model, SaaS companies provide access to software applications to customers on a remote basis, and provide their customers with a subscription to use the software, rather than licensing software to their customers.
We have two SaaS-based applications that we develop and support -Renew OnDemand (our purpose-built SaaS offering to manage and maximize recurring revenue) and Scout (our Saas offering to help companies with predictive analytics for recurring revenue). Our Research and development costs are primarily related to these two SaaS based applications. We intend to maintain customer support, training and professional service organizations to support deployments of our solutions. Our current spending incorporates a level of investment required for development of our products and are targeted at improving the tools and infrastructure that will make the product easier to deploy and support in the future. We believe that the level of effort to deploy and maintain these applications will decline over time, due to product development investments made this year to improve the application layer of the solutions and to improve the underlying database architecture and reduce the overall cost of our cloud infrastructure. As a result, we expect costs to remain flat for the remainder of 2014 and rise more slowly or at the same pace as revenue growth in future years.
Basis of Presentation
Net Revenue
Substantially all of our net revenue is attributable to commissions we earn from the sale of renewals of maintenance, support and subscription agreements on behalf of our customers. We generally invoice our customers for our services in arrears on a monthly basis for sales commissions, and on a quarterly basis for certain performance sales commissions; accordingly, we typically have no deferred revenue related to these services. We do not set the price, terms or scope of services in the service contracts with end customers and do not have any obligations related to the underlying service contracts between our customers and their end customers.
We also earn revenue from the sale of subscriptions to our cloud based applications. To date, subscription revenue has been a small percentage of total revenue, but we expect revenues generated from subscriptions to Renew OnDemand and our new Scout suite to increase in 2014. Subscription fees are accounted for separately from commissions, and they are billed in advance over a monthly, quarterly or annual basis. Subscription revenue is recognized ratably over the related subscription term.
We have generated a significant portion of our revenue from a limited number of customers. Our top ten customers accounted for 51% and 49% of our net revenue for the nine months ended September 30, 2014 and 2013, respectively.
Cost of Revenue and Gross Profit
Our cost of revenue expenses include employee compensation, technology costs, including those related to the delivery of our cloud-based solutions, and allocated overhead costs. Compensation includes salary, bonus, benefits and stock-based compensation for our dedicated service sales teams. Our allocated overhead includes costs for facilities, information technology and depreciation, including amortization of internal-use software associated with our service revenue technology platform and cloud applications. Allocated costs for facilities consist of rent, maintenance and compensation of personnel in our facilities departments. Our allocated costs for information technology include costs associated with third-party data centers where we maintain our data servers, compensation of our information technology personnel and the cost of support and maintenance contracts associated with computer hardware and software. To the extent our customer base or opportunity under management expands, we may need to hire additional service sales personnel and invest in infrastructure to support such growth. We currently expect that our cost of revenue will fluctuate significantly and may increase on an absolute basis and as a percentage of revenue in the near term, including for the reasons discussed above under, “—Factors Affecting Our Performance—Implementation Cycle”. We are currently taking measures to reduce the costs to deliver our solutions and support our customer engagements, in order to improve our gross profit. We are also evaluating additional measures to further reduce our costs of revenue over the next several quarters.
Operating Expenses
Sales and Marketing. Sales and marketing expenses are the largest component of our operating expenses and consist primarily of compensation and sales commissions for our sales and marketing staff, allocated expenses and marketing programs and events. We sell our solutions through our global sales organization, which is organized across three geographic regions: NALA, EMEA and APJ. Our commission plans provide that payment of commissions to our sales representatives is contingent on their continued employment, and we recognize expense over a period that is generally between twelve and fourteen months

27


following the execution of the applicable contract. We currently expect sales and marketing expenses to increase for 2014 as we build out our SaaS sales team and decrease or remain flat as a percentage of revenue in 2015.
Research and Development. Research and development expenses consist primarily of compensation, allocated costs and the cost of third-party service providers. We focus our research and development efforts on developing new products, including Renew OnDemand, our next-generation technology platform, and adding new features to our existing technology platform. In connection with the development and enhancements of our SaaS applications, we capitalize certain expenditures related to the development and enhancement of internal-use software related to our technology platform. We expect research and development spending to remain flat for the remainder of 2014 and decrease or remain flat as a percentage of revenue in future years.
General and Administrative. General and administrative expenses consist primarily of compensation for our executive, human resources, finance and legal functions, and related expenses for professional fees for accounting, tax and legal services, as well as allocated expenses. We expect that our general and administrative expenses will remain flat on an absolute basis as we streamline our operations across the two business segments.
Restructuring and Other. Restructuring and other expenses consist primarily of employees’ severance payments, related employee benefits, retention bonuses and cancellation of contracts. We expect to have restructuring and other expenses through 2015 as restructuring activities targeted at reducing the overall cost structure of the business continue.
Goodwill impairment. The goodwill impairment charge consists of impairment based on the outcome of an impairment analysis. The Company performs its annual impairment analysis of goodwill in the fourth quarter of each year and between annual tests if events or circumstances indicate that it is more likely than not that the asset is impaired. We recorded a goodwill impairment charge of $21.0 million in the third quarter of 2014. Additionally, the further decline in the Company’s market capitalization or other events or circumstances may require additional impairment charges to be recorded in future periods against any remaining goodwill.
   
Other (Income) Expense
Interest expense. Interest expense consists primarily of interest expense associated with fees related to our our credit facility, our convertible debt; capital lease payments; accretion of debt discount; and amortization of debt issuance costs. We recognize accretion of debt discount and amortization of interest costs using the effective interest method. In fiscal 2014 we expect our interest expense to increase compared to fiscal 2013 from accretion of debt discount, amortization of deferred financing costs and contractual interest costs as a result of our August 2013 issuance of $150 million aggregate principal amount of convertible notes.
Other, Net. Other, net consists primarily of the interest income earned on our cash, cash equivalents and marketable securities investments and foreign exchange gains and losses. We expect other, net to vary depending on the movement in foreign currency exchange rates and the related impact on our foreign exchange gain (loss) and the return of interest on our investments.
Income Tax Provision
We account for income taxes using an asset and liability method, which requires the recognition of taxes payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences of temporary differences that currently exist between the tax basis and the financial reporting basis of our taxable subsidiaries’ assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in operations in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.
We evaluate the need for and amount of any valuation allowance for our deferred tax assets on a jurisdictional basis. This evaluation utilizes the framework contained in ASC 740, Income Taxes, wherein management analyzes all positive and negative evidence available at the balance sheet date to determine whether all or some portion of our deferred tax assets will not be realized. Under this guidance, a valuation allowance must be established for deferred tax assets when it is more likely than not (a probability level of more than 50 percent) that they will not be realized. In assessing the realization of our deferred tax assets, we consider all available evidence, both positive and negative.
In performing our evaluation, we place significant emphasis on guidance contained in ASC 740, which states that “[a] cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.”

28


We account for unrecognized tax benefits using a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. We record an income tax liability, if any, for the difference between the benefit recognized and measured and the tax position taken or expected to be taken on our tax returns. To the extent that the assessment of such tax positions change, the change in estimate is recorded in the period in which the determination is made. The reserves are adjusted in light of changing facts and circumstances, such as the outcome of a tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate.
Results of Operations
The table below sets forth our consolidated results of operations for the periods presented. The period-to-period comparison of financial results presented below is not necessarily indicative of financial results to be achieved in future periods. 
 
Three Months Ended
 September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Net revenue
$
64,713

 
$
66,482

 
$
197,526

 
$
195,300

Cost of revenue
49,218

 
39,730

 
145,331

 
116,848

Gross profit
15,495

 
26,752

 
52,195

 
78,452

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
14,343

 
13,731

 
47,225

 
43,906

Research and development
6,402

 
5,500

 
19,999

 
18,542

General and administrative
10,932

 
11,177

 
36,053

 
33,182

Restructuring and other
1,937

 

 
1,937

 

Goodwill impairment
21,000

 

 
21,000

 

Total operating expenses
54,614

 
30,408

 
126,214

 
95,630

Loss from operations
(39,119
)
 
(3,656
)
 
(74,019
)
 
(17,178
)
Other (income) expense:
 
 
 
 
 
 
 
Interest expense
(2,495
)
 
(1,272
)
 
(7,356
)
 
(1,376
)
Other, net
(372
)
 
179

 
(282
)
 
(119
)
Loss before income taxes
(41,986
)
 
(4,749
)
 
(81,657
)
 
(18,673
)
Income tax provision (benefit)
(200
)
 
753

 
(39
)
 
2,190

Net loss
$
(41,786
)
 
$
(5,502
)
 
$
(81,618
)
 
$
(20,863
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Three Months Ended
 September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Includes stock-based compensation of:
 
 
 
 
 
Cost of revenue
$
1,034

 
$
802

 
$
3,168

 
$
2,222

Sales and marketing
1,497

 
2,414

 
4,917

 
7,396

Research and development
695

 
753

 
2,131

 
1,758

General and administrative
1,848

 
1,989

 
5,790

 
5,925

Total stock-based compensation
$
5,074

 
$
5,958

 
$
16,006

 
$
17,301



The following table sets forth our operating results as a percentage of net revenue:


29


 
Three Months Ended
 September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
 
(as % of net revenue)
Net revenue
100
 %
 
100
 %
 
100
 %
 
100
 %
Cost of revenue
76
 %
 
60
 %
 
74
 %
 
60
 %
Gross profit
24
 %
 
40
 %
 
26
 %
 
40
 %
Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
22
 %
 
21
 %
 
24
 %
 
22
 %
Research and development
10
 %
 
8
 %
 
10
 %
 
9
 %
General and administrative
17
 %
 
17
 %
 
18
 %
 
17
 %
Restructuring and other
3
 %
 
 %
 
1
 %
 
 %
Goodwill impairment
32
 %
 
 %
 
11
 %
 
 %
Total operating expenses
84
 %
 
46
 %
 
64
 %
 
48
 %
Loss from operations
(60
)%
 
(6
)%
 
(38
)%
 
(8
)%


Three months ended September 30, 2014 and September 30, 2013

Net Revenue 
 
Three Months Ended
 September 30,
 
 
 
 
 
2014
 
2013
 
 
 
 
 
Amount
 
% of Net Revenue
 
Amount
 
% of Net Revenue
 
Change
 
% Change
 
(in thousands)
Net revenue
 
 
 
 
 
 
 
 
 
 
 
Managed Services
$
56,629

 
88
%
 
$
61,946

 
93
%
 
$
(5,317
)
 
(9
)%
Cloud and Business Intelligence
8,084

 
12
%
 
4,536

 
7
%
 
3,548

 
78
 %
Total net revenue
$
64,713

 
100
%
 
$
66,482

 
100
%
 
$
(1,769
)
 
(3
)%
Net revenue decreased $1.8 million, or 3%, for the third quarter of 2014, compared to the third quarter of 2013. The overall decrease in revenue in the third quarter of 2014 was due to customer cancellations and reductions in excess of new customer additions in 2014. The customer cancellations and reductions during the third quarter of 2014 were higher than our historical averages.
Managed services revenue decreased by 9% for the third quarter of 2014, compared to the third quarter of 2013 due to the restructuring of certain of the managed services revenue contracts with our installed base customers to include a subscription to our Renew OnDemand SaaS platform, which resulted in a shift of some revenue from managed services to cloud and business intelligence. For the third quarter of 2014, EMEA experienced a decline of revenues of 3% as compared to the third quarter of 2013 due primarily to slow acquisition of new business compounded by certain EMEA customers deciding to bring the renewals inhouse. APJ grew 5% for the third quarter of 2014 compared to the third quarter of 2013 on a relatively small base.
The increase in revenue from our cloud and business intelligence for the third quarter of 2014, compared to the third quarter of 2013, was attributable to the restructuring of certain of the managed services revenue contracts with our installed base customers to include a subscription to our Renew OnDemand SaaS platform and revenue attributable to Scout SaaS solution acquired in January 2014.
Cost of Revenue and Gross Profit 

30


 
Three Months Ended
 September 30,
 
 
 
 
 
2014
 
2013
 
 
 
 
 
Amount
 
% of Net Revenue
 
Amount
 
% of Net Revenue
 
Change
 
% Change
 
(in thousand)
Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
Managed Services
$
43,733

 
68
%
 
$
35,388

 
53
%
 
$
8,345

 
24
%
Clouds and Business Intelligence
5,485

 
8
%
 
4,342

 
7
%
 
1,143

 
26
%
Total cost of revenue
$
49,218

 
76
%
 
$
39,730

 
60
%
 
$
9,488

 
24
%

 
Three Months Ended
 September 30,
 
 
 
 
 
2014
 
2013
 
 
 
 
 
Amount
 
Gross Profit %
 
Amount
 
Gross Profit %
 
Change
 
% Change
 
(in thousand)
Gross profit
 
 
 
 
 
 
 
 
 
 
 
Managed Services
12,896

 
20
%
 
26,558

 
40
%
 
(13,662
)
 
(51
)%
Clouds and Business Intelligence
2,599

 
4
%
 
194

 
%
 
2,405

 
1,240
 %
Total gross profit
15,495

 
24
%
 
26,752

 
40
%
 
(11,257
)
 
(42
)%
The 24% increase in our cost of revenue for our managed services business in the third quarter of 2014 compared to 2013 reflects $7.6 million increase in the compensation of service sales personnel as a result of increased headcount and higher average salaries, and a $0.6 million increase in allocation for information technology and depreciation.
The $1.1 million increase in our cost of revenue for our cloud and business intelligence business in the third quarter of 2014 compared to 2013, reflected a $0.6 million increase in compensation partially due to incremental employees of Scout that was acquired January 2014, and a $0.6 million increase in allocation for information technology, depreciation and amortization.
Gross profit in the third quarter of 2014 was adversely impacted for our managed services business due to the restructuring of some of the managed services contracts with our installed base customers to include a subscription to our SaaS platform. This change had the effect of reducing the revenue for our Managed Services business, without reducing the cost structure to serve the customer in many cases. In addition, to better support our customers, we have increased our investment across several key accounts, both in terms of increased Managed Services and professional services personnel. This increased allocation of resources has continued to compress our gross margins across both of our business segments. The reduction in gross profit driven by the lower revenue, operational challenges faced by Managed Services, and salary increases in primarily in the NALA region.
Gross profit in the third quarter of 2014 increased for our cloud and business intelligence business due to the improved scale in our SaaS business, increase in revenue from restructuring of certain managed services contracts with our installed base customers to include a subscription to our Renew OnDemand SaaS platform and revenue from Scout SaaS solution acquired in January 2014, offset by a shift in expenses from research and development to cost of revenue, as we transitioned from development to customer deployment of these products.


31


Operating Expenses
 
Three Months Ended
 September 30,
 
 
 
 
 
2014
 
2013
 
 
 
 
 
Amount
 
% of Net Revenue
 
Amount
 
% of Net Revenue
 
Change
 
% Change
 
(in thousands)
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Sales and marketing
$
14,343

 
22
%
 
$
13,731

 
21
%
 
$
612

 
4
 %
Research and development
6,402

 
10
%
 
5,500

 
8
%
 
902

 
16
 %
General and administrative
10,932

 
17
%
 
11,177

 
17
%
 
(245
)
 
(2
)%
Restructuring and other
1,937

 
3
%
 

 
%
 
1,937

 
100
 %
Goodwill impairment
21,000

 
32
%
 

 
%
 
21,000

 
100
 %
Total operating expenses
$
54,614

 
84
%
 
$
30,408

 
46
%
 
$
24,206

 
80
 %
Includes stock-based compensation of:
 
 
 
 
 
 
 
Sales and marketing
$
1,497

 
 
 
$
2,414

 
 
 
$
(917
)
 
 
Research and development
695

 
 
 
753

 
 
 
(58
)
 
 
General and administrative
1,848

 
 
 
1,989

 
 
 
(141
)
 
 
Total stock-based compensation
$
4,040

 
 
 
$
5,156

 
 
 
$
(1,116
)
 
 
Sales and marketing expenses
The 4% increase in sales and marketing expenses in the third quarter of 2014 resulted primarily from headcount growth resulting in increased compensation of $1.3 million. The increase was partially offset by lower stock-based compensation of $0.9 million due to true up of expenses for terminations.
Research and development expenses
The increase in research and development expense in the third quarter of 2014 was primarily due to headcount growth due to the acquisition of Scout as well as hiring engineers to support our SaaS products. The increase was partially offset due to capitalization of $1.0 million of labor and third party costs for enhancement of Renew OnDemand and a new Salesforce application developed in the third quarter of 2014 as compared to no capitalized costs in the third quarter of 2013. We expect research and development spending to remain flat for the remainder of 2014 and rise more slowly or at the same pace as revenue growth in future years.
General and administrative expenses
The 2% decrease in general and administrative expense in the third quarter of 2014 as compared to the third quarter of 2013 reflected a $0.3 million decrease in compensation due to slower headcount growth in the third quarter across all geographies and investments in our information technology infrastructure to support our global operations.
Restructuring and other expenses 
The increase in restructuring and other expenses in the third quarter of 2014 is related to the Company recognizing restructuring and other charges of $1.9 million. The charge consists primarily of employees’ severance payments, related employee benefits, retention bonuses and cancellation of contracts. We expect to have restructuring and other expenses through 2015, as restructuring activities targeted at reducing the overall cost structure of the business will continue over several quarters.
Goodwill impairment 
The goodwill impairment charge recorded in the third quarter of 2014 is related to the outcome of interim impairment analysis which resulted in a non-cash goodwill impairment charge of $21.0 million relating to our Cloud and Business Intelligence reporting unit. The Company performs its annual impairment analysis of goodwill in the fourth quarter of each year and between annual tests if events or circumstances indicate that it is more likely than not that the asset is impaired. Additionally, the further decline in the Company’s market capitalization or other event or circumstances may require additional impairment charges to be recorded in future periods remaining goodwill.

32


Other Expense, Net
 
Three Months Ended
 September 30,
 
 
 
 
 
2014
 
2013
 
 
 
 
 
Amount
 
% of Net Revenue
 
Amount
 
% of Net Revenue
 
Change
 
% Change
 
(in thousands)
Interest expense
$
2,495

 
4
%
 
$
1,272

 
2
 %
 
$
1,223

 
96
 %
Other, net
$
372

 
1
%
 
$
(179
)
 
 %
 
$
551

 
(308
)%

Interest expense for the third quarter of 2014 increased by $1.2 million as compared to the same period in 2013 due to accretion of debt discount and the amortization of debt issuance costs of $1.9 million and interest expense of $0.6 million for the convertible notes issued in August 2013.
Income Tax Provision
 
Three Months Ended
 September 30,
 
 
 
 
 
2014
 
2013
 
Change
 
% Change
 
(in thousands)
 
 
 
 
Income tax provision (benefit)
$
(200
)
 
$
753

 
$
(953
)
 
(127
)%
For the third quarter of 2014, we recorded a benefit to income tax expense of $0.2 million.  This amount primarily represents anticipated taxes in jurisdictions where we have profitable operations, including certain U.S. states and foreign jurisdictions, offset by benefits available from foreign losses.  No benefit was otherwise provided for losses incurred in U.S. and Singapore, because those losses are offset by a full valuation allowance. Anticipated tax charges were offset by adjustments for prior year tax filings and for benefits realized from certain US state tax credits.
In the third quarter of 2013, we recorded a charge to income tax expense of $0.8 million. No benefit was otherwise provided for losses incurred in U.S., Singapore and Japan, because those losses were offset by a full valuation allowance.

Nine months ended September 30, 2014 and September 30, 2013

Net Revenue
 
Nine Months Ended
September 30,
 
 
 
 
 
2014
 
2013
 
 
 
 
 
Amount
 
% of Net Revenue
 
Amount
 
% of Net Revenue
 
Change
 
% Change
 
(in thousands)
Net revenue
 
 
 
 
 
 
 
 
 
 
 
Managed Services
$
173,773

 
88
%
 
$
183,329

 
94
%
 
$<