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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2015.

Or

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

For the transition period from             to             

Commission File Number:  000-53205

Diligent Corporation

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (212) 741-8181

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  x Yes   o No

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

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

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

As of August 6, 2015 there were 87,126,026 shares of the Registrant’s Common Stock issued and outstanding.

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CONTENTS

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FORWARD LOOKING STATEMENTS

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

·      As of December 31, 2014 we identified multiple material weaknesses in our internal control over financial reporting and concluded that our disclosure controls were not effective; in connection with preparation of this Form 10-Q we concluded that our disclosure controls were not effective as of June 30, 2015; we must address the material weaknesses in our internal control over financial reporting and our disclosure controls, which otherwise may impede our ability to produce timely and accurate financial statements and periodic reports;

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

·      The anticipated launch of our Diligent Teams offering will require significant investment, may not occur in the timeframe we expect, and may not meet with commercial success;

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

·      Our sales to clients outside the United States and other English-speaking areas of the world are critical to our continued growth and our product may not attain widespread acceptance internationally, which could harm our future growth prospects;

·      We are exposed to risks inherent in international sales, which will increase if we are successful in increasing our international sales;

·      Privacy concerns and laws or other domestic or foreign regulations may reduce the effectiveness of our application suite and harm our business;

·      Interruptions or delays in service from any one of our data center hosting facilities could impair the delivery of our services and harm our business;

·      We are subject to NZX Limited’s (“NZX”) Main Board Listing Rules and compliance with securities and financial reporting laws and regulations in the U.S. and New Zealand and face higher costs and compliance risks than a typical U.S. public company due to the need to comply with these dual regulatory regimes and as previously disclosed, we have failed to comply with certain of these requirements in the past, and could face potential regulatory actions and/or contingent liabilities as a result of past or any future violations;

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

·      We may fail to manage our growth effectively.

We also refer you to Part I, Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2014 (the “2014 Form 10-K”) for an extended discussion of the risks confronting our business. The forward-looking statements in this Quarterly Report on Form 10-Q should be considered in the context of these risk factors.  The Company makes no commitment to revise or update any forward-looking statements in order to reflect events or circumstances after the date any such statement is made, except as otherwise required by the federal securities laws or the NZX Main Board Listing Rules.

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PART I—FINANCIAL INFORMATION

Diligent Corporation

Condensed Consolidated Balance Sheets

(Unaudited)

(in thousands, except share and per share amounts)

See accompanying notes to condensed consolidated financial statements

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Diligent Corporation

Condensed Consolidated Statements of Income

(Unaudited)

(in thousands, except per share amounts)

See accompanying notes to condensed consolidated financial statements

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Diligent Corporation

Condensed Consolidated Statements of Comprehensive Income

(Unaudited)

(in thousands)

See accompanying notes to condensed consolidated financial statements

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Diligent Corporation

Condensed Consolidated Statement of Changes in Stockholders’ Equity

Six months Ended June 30, 2015

(Unaudited)

(in thousands)

See accompanying notes to condensed consolidated financial statements

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Diligent Corporation

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(in thousands)

See accompanying notes to condensed consolidated financial statements

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Diligent Corporation

Notes to Condensed Consolidated Financial Statements

(unaudited)

Note 1. Organization and nature of the business

Diligent Corporation (“we,” “Diligent” or the “Company”) is a Delaware corporation established in 2007 and listed on the NZX Main Board, a regulated New Zealand equities market. In December 2007, the Company, then named Diligent Board Member Services, Inc., completed an offshore public offering in New Zealand in connection with its listing on the NZX Main Board. In June 2015, the Company changed its name to Diligent Corporation. Diligent’s corporate headquarters are located in New York, New York.

Diligent provides one of the world’s most widely-used board portals.  The Company develops and commercializes the Diligent Boards system, a secure software application available online, on iPad and Windows 8.1 supported devices.  The application allows board members, leadership teams and administrative staff to simplify how board materials are produced, delivered, reviewed and voted on.  The Company provides clients with subscription-based access to its software along with associated services, including securely hosting the clients’ data, and customer service and support for the application.

The Company has a wholly-owned subsidiary located in New Zealand, Diligent Board Member Services NZ Limited (“DBMS NZ”), which provides customer support and research and development services for the Company. The Company has a wholly-owned subsidiary in the United Kingdom, Diligent Boardbooks Limited (“DBL”) and a wholly-owned subsidiary in Australia, Diligent Board Services Australia Pty Ltd. (“DBA”), which provide sales, marketing and customer support services in their respective regions. The Company’s Singapore subsidiary, Diligent APAC Board Services Pte. Ltd. (“APAC”) provides sales support in the Asia-Pacific region. The Company’s subsidiary in Hong Kong, Diligent APAC Limited was established in 2012 to support the Company’s Asia-Pacific sales and marketing and commenced operations during the first quarter of 2015. On February 4, 2014, the Company established a German subsidiary, Diligent Boardbooks GmbH (“DBG”), to offer dedicated, private data hosting solutions and data recovery support, primarily for European customers.

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

Note 2. Restatement

In August, 2013, the Company announced that its historical financial statements for the years ended December 31, 2012, 2011 and 2010 and the quarter ended March 31, 2013 would be restated due to revenue recognition errors. The Company completed the restatement process in April of 2014. Costs for the restatement and re-audits incurred during the three and six months ended June 30, 2014 were $0.1 million and $0.9 million, respectively. There were no such costs incurred in 2015. These costs were comprised of professional fees incurred for accounting, auditing and consulting services.

Note 3. Significant accounting policies

Basis of Presentation

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial statements.  The results of operations for the three and six months ended June 30, 2015 are not necessarily indicative of the results to be expected for the full year.

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

Effective January 1, 2015, the Company began allocating facility and related costs and certain costs associated with its Enterprise Resource Planning system to Cost of revenues, Selling and marketing, General and administrative, and Research and

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development.  Previously such costs had been presented within General and administrative expenses.  Such costs are allocated based on a department’s proportionate share of total employee headcount. The Company also changed the presentation of sales-related incentive commissions paid to account management personnel from Cost of revenues to Selling and marketing. The Company determined that these changes would better reflect industry practice and would provide more meaningful information as well as increased transparency of its operations. To conform the 2014 presentation to the current quarter’s presentation, $0.6 million was reclassified from General and administrative, of which $0.1 million was included in Costs of revenues, $0.4 million was included in Selling and marketing, and $0.1 million was included in Research and development for the three months ended June 30, 2014. For the six months ended June 30, 2014, $1.1 million was reclassified from General and administrative, of which $0.1 million was included in Costs of revenues, $0.8 million was included in Selling and marketing, and $0.2 million was included in Research and development. Such reclassifications had no effect on previously reported operating income, net income or retained earnings.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

Cash and Cash Equivalents

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

Fair Value of Financial Instruments

The fair value of the Company’s accounts receivable, accounts payable and accrued expenses and other liabilities approximates book value due to their short term settlements.

Property and Equipment

Property and equipment consists of computer and office equipment, leasehold improvements and purchased internal-use computer software. Property and equipment are carried at cost, less accumulated depreciation and amortization and any impairment losses.

Depreciation and Amortization

Depreciation on property and equipment is computed on a straight line basis at rates adequate to recover the cost of the assets over their estimated useful lives, which range from three to five years. Leasehold improvements are depreciated over estimated useful lives of the assets or the term of the underlying lease, whichever is shorter. Amortization of internal-use computer software is computed on the straight-line method over its estimated useful life, which is three years. Expenditures for repair and maintenance costs are expensed as incurred.

Impairment of Long-Lived Assets

The Company periodically reviews the carrying amounts of its tangible and intangible assets to determine whether events or changes in circumstances indicate the carrying amount of an asset may not be fully recoverable. The carrying amount of a long-lived asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. Measurement of an impairment loss for long-lived assets and certain identifiable intangible assets that management expects to hold and use is based on the fair value of the asset. An impairment loss is measured as the amount by which the carrying amount of the long-lived asset exceeds its fair value.

Revenue Recognition

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

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

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·   There is persuasive evidence of the arrangement;

·   The service has been made available to the customer;

·   The fee is fixed or determinable; and

·   The collectability of the fees is reasonably assured.

Pursuant to the authoritative accounting guidance regarding revenue recognition for arrangements with multiple deliverables, for a deliverable to qualify as a separate unit of accounting, the delivered item must have value to the customer on a standalone basis. The Company has determined that the installation fee does not have standalone value, so accordingly, it accounts for its arrangements as a single unit of accounting.

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

Installation fees paid by customers in connection with the subscription service are deferred and are recognized ratably over the expected life of the customer relationships, generally nine years. In estimating the expected customer relationship period, the Company looked to guidance on the determination of the useful life of an intangible asset for the appropriate factors to be considered in estimating expected customer life and specifically focused on its customer renewal rate. Diligent’s customer contracts contain a standard “autorenew” feature which provides for one-year renewals unless either party provides written notice of termination. In addition, Diligent’s renewal history with its customers has been and remains at very high rates. As a result, we believe that Diligent’s customers will renew numerous times during their tenure with us. Consequently, Diligent has had a very low annual attrition rate which historically has been less than 5.0%. After considering these factors, the Company determined that a nine year estimated customer life was appropriate as of June 30, 2015. The Company evaluates its estimated customer life on an annual basis.

Deferred Revenue

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

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

Accounts Receivable

The Company generally invoices its customers on a quarterly or annual basis. Accounts receivable represents amounts due from Diligent’s customers for which revenue has been recognized. A provision for doubtful accounts is recorded based on management’s assessment of amounts considered uncollectable for specific customers based on the age of the receivable, history of payments and other relevant information. At each of June 30, 2015 and December 31, 2014, the Company has recorded a provision for doubtful accounts of $0.1 million.

Research and Development

Research and development expenses are incurred as the Company upgrades and maintains its software and evaluates and develops other potential applications. Such expenses include compensation and employee benefits of engineering and testing personnel, including share-based compensation, materials, travel and direct costs associated with the design and required testing of the product line. Research and development also includes allocated indirect costs such as facility and related costs that are clearly related to research and development activities.

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Internal-Use Software Development Costs

The Company begins to capitalize costs incurred for computer software developed for internal use when the preliminary development efforts are successfully completed, management has authorized and committed to funding the project, and it is probable that the project will be completed and the software will be used as intended. Capitalization ceases when a computer software project is substantially complete and ready for its intended use. These costs are amortized over the estimated useful life of the related asset. Costs incurred prior to meeting these criteria are expensed as incurred and recorded in research and development expense in the Company’s consolidated statements of income.

Operating Leases

The Company records rental costs, including costs related to fixed rent escalation clauses and rent holidays, on a straight-line basis over the lease term.

Income Taxes

The Company files U.S. federal and state income tax returns. Foreign operations file income tax returns in their respective foreign jurisdictions. The Company accounts for deferred income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. A valuation allowance is recorded if it is considered more likely than not that some or all of a deferred tax asset may not be realized. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

The tax effects of an uncertain tax position taken or expected be taken in income tax returns are recognized only if it is “more likely than not” to be sustained on examination by the taxing authorities, based on its technical merits as of the reporting date. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. The Company recognizes the benefit of an uncertain tax position in the period when it is effectively settled. Previously recognized tax positions are derecognized in the first period in which it is no longer more likely than not that the tax position would be sustained upon examination. The Company recognizes accrued interest and penalties related to uncertain tax positions in income tax expense.

Foreign Exchange

The Company’s wholly-owned subsidiaries, DBL, DBMS NZ, DBG and DBA, utilize the British Pound Sterling (GBP), New Zealand Dollar (NZD), Euro (EUR), and Australian Dollar (AUD), respectively, as their functional currencies. Assets and liabilities of these subsidiaries are translated to U.S. dollars at exchange rates in effect at the balance sheet date, with the resulting translation adjustments directly recorded to a separate component of accumulated other comprehensive income or loss. The functional currency of the Company’s Singapore subsidiary is the U.S. dollar.

Transactions in foreign currencies are reported at the rates of exchange at the transaction date. Assets and liabilities are translated at the rates of exchange in effect at the balance sheet date. All differences are recorded in results of operations.

Share-Based Compensation

The Company measures the cost of employee services received in exchange for an equity-based award using the fair value of the award on the date of the grant, and recognizes the cost over the period that the award recipient is required to provide services to the Company in exchange for the award. The fair value of restricted stock units and performance stock units is estimated using the market price of the Company’s common stock at the date of the grant and we recognize compensation expense for the portion of the award that is expected to vest.

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

Segment Reporting

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated on a regular basis by the chief operating decision-maker (“CODM”), or decision making group, in deciding how to allocate resources to an individual segment and in assessing performance of the segment. In light of the Company’s current product offering

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and the fact that the Company’s CODM, which is the Company’s Chief Executive Officer, monitors and reviews financial information at a consolidated level for assessing operating results and allocation of resources, management has concluded that the Company has one reportable operating segment.

Earnings Per Share

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

Diluted earnings per share reflects the potential dilution that would occur if securities or other contracts to issue common stock were exercised, settled or converted into common stock, unless the effect is anti-dilutive. Stock options and employee share awards are included as potential dilutive securities for the applicable periods, except that 1.4 million stock options have been excluded for the three and six months ended June 30, 2015 and 1.2 million stock options have been excluded for the three and six months ended June 30, 2014, because their effect is antidilutive. 0.9 million and 0.3 million performance share units were also excluded as potential dilutive securities for the three and six months ended June 30, 2015 and 2014,  respectively, as the performance criteria has not been met.

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

Recent Accounting Pronouncements

In May 2014, the FASB issued a new standard related to revenue recognition, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The new standard will replace most of the existing revenue recognition standards in U.S. GAAP when it becomes effective. In July 2015, the FASB decided to delay the effective date by one year to January 1, 2018. Early adoption is permitted no earlier than 2017. The new standard can be applied retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of the change recognized at the date of the initial application in retained earnings. The Company is assessing the potential impact of the new standard on financial reporting and has not yet selected a transition method.

In April 2015, the FASB issued ASU No. 2015-05, “Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement.” The amendments in this update provide guidance to customers about whether a cloud computing arrangement includes a software license. Under application of this guidance, if a cloud computing arrangement includes a software license, the update specifies that the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. A customer should account for a cloud computing arrangement as a service contract if the arrangement does not include a software license. ASU No. 2015-05 is effective for 2016 and early adoption is allowed. The Company is currently assessing the impact of this update and the timing of adoption.

Note 4. Intangible assets

During 2014 the Company acquired certain intangible assets. The Company’s acquired intangible assets are comprised of the following:

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The related amortization expense of intangibles for the three and six months ended June 30, 2015 and 2014 was less than $0.1 million. The Company’s estimate of future amortization expense for acquired intangible assets that exist at June 30, 2015 is as follows:

During the first quarter of 2015, the Company began to capitalize costs related to the development of a new SaaS collaboration tool, Diligent Teams.  The project is expected to substantially complete by the third quarter of 2015. The amount of capitalized costs during the three and six months ended June 30, 2015 was $1.2 million and $2.4 million, respectively. No such costs were capitalized as of December 31, 2014.

Note 5. Fair Value of Financial Instruments

The fair value of a financial instrument is the amount at which the instrument could be exchanged in an orderly transaction between market participants. As of June 30, 2015 and December 31, 2014, the carrying amounts of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses and other liabilities approximated fair value due to the short-term nature of these instruments. ASC 820, Fair Value Measurements and Disclosures, establishes a fair value hierarchy for input into valuation techniques as follows:

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

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

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

Level 1 inputs were utilized to determine the fair value of the Company’s investments in U.S. treasury bills, U.S treasury money market funds, and term deposits.  Due to the short-term nature of these investments, which mature between 90 days and 365 days, amortized cost is used to estimate the fair value.

At June 30, 2015, cash equivalents include investments in U.S. treasury money market funds and treasury bills totaling $9.0 million, which are carried at cost, which approximates fair value. The fair value of money market funds was determined by reference to quoted market prices.

At December 31, 2014, cash equivalents include investments in U.S. treasury money market funds and treasury bills totaling $32.5 million, which are carried at cost, which approximates fair value. The fair value of money market funds was determined by reference to quoted market prices.

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Note 6. Redeemable Preferred Stock

In March 2009, the Company issued 30 million shares of Series A Preferred Stock for $0.10 per share in a private offering, providing aggregate gross proceeds of $3 million. Expenses relating to the share issuance were $0.1 million. The principal terms of the Preferred Shares are as follows:

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

Conversion rights—The Preferred Shares are convertible at any time at the option of the holders into the Company’s common stock on a one-for-one basis. In addition, Preferred Shares will automatically be converted into common stock upon the closing of an underwritten share offering by the Company on a registered stock exchange which realizes at least $40 million of gross proceeds.

Redemption rights—The holders of the Preferred Shares have the option to require the Preferred Shares (including any PIK shares) to be redeemed in cash, at $0.10 per share plus accrued and unpaid dividends, at any time after 60 months from the date of issue of the Preferred Shares. Any redeemed amounts will be paid in four equal quarterly installments commencing 60 days after the redemption request.

Anti-Dilution Provision—In the event of a future offering of the Company’s stock at a price per common share which is less than the Preferred Share conversion rate immediately before such offering, the conversion price for the Preferred Shares is adjusted according to a weighted average formula.

Liquidation preference—In the event of any voluntary or involuntary liquidation of the Company, the holders of Preferred Shares are entitled to an amount per Preferred Share equal to 1.5 times the original issue price of $0.10 plus any accrued but unpaid dividends.

Voting rights—Preferred Shares have equal voting rights (one vote per share) to common stock, except that Preferred Shares do not vote in the general election of directors.

Other provisions—For as long as not less than 15 million Preferred Shares are outstanding, the holders of the Preferred Shares have the right between them to appoint one director, and the Company may not take action relating to certain major transactions without obtaining the consent of not less than 60% of the Preferred Shares or without obtaining the approval of the director appointed by the holder of the Preferred Shares (for matters requiring Board of Directors approval).

Accounting for Preferred Shares—If certain criteria are met, companies must bifurcate conversion options from their host instruments and account for them as free standing derivative instruments. The Company has evaluated the redemption, conversion and contingent conversion features of the Preferred Shares and determined that the embedded conversion option is not required to be bifurcated.

Additionally, the Company analyzed the conversion feature and determined that the effective conversion price was higher than the market price at date of issuance; therefore no beneficial conversion feature was recorded. However, if the Company were to pay Preferred Stock dividends by issuing PIK shares, the issuance of such PIK shares would result in a beneficial conversion feature if the fair value of the Company’s common stock at the dividend declaration date exceeds the per share conversion price of the Preferred Shares. The Company has classified the Preferred Shares as temporary equity because they are redeemable upon the occurrence of an event that is not solely within the control of the issuer. As noted above, the holders of the Preferred Shares may demand redemption at any time after 60 months from the date of issue. The carrying value of the securities, which were initially recorded at their face value net of issuance costs, was increased to the redemption value over the period from the date of issuance to the earliest potential date of redemption.

In 2015, the Company anticipates that accumulated unpaid dividends will be paid in cash on the Series A Preferred Stock.  Accordingly, preferred stock dividends of $0.2 million for the six months ended June 30, 2015 are included in accrued expenses.

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

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Note 7. Stock option and incentive plan

On May 3, 2013, the Board adopted the Diligent Corporation 2013 Incentive Plan (the “Plan”), which was approved by the Company’s stockholders in June 2013. An aggregate of 15.5 million shares of the Company’s common stock may be issued pursuant to the Plan to employees, directors and consultants of the Company and its affiliates as of June 30, 2015. The Company has reserved 4.1 million shares for issuance in connection with the replacement incentive awards issued in accordance with the former CEO Substitute Remuneration Package as discussed below. In April 2015, the shareholders’ approved an increase in the shares reserved for issuance under the Plan of 7,000,000. As of June 30, 2015 6.8 million shares were available for future issuances of awards under the Plan.

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

The Company’s standard remuneration package for non-executive directors consists of both a cash component, designed to compensate members for their service on the Board and its Committees, and an equity component. The total value of the standard remuneration package is $0.1 million per annum, of which 38% is payable in cash and the remainder in common stock.

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

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

On June 12, 2013, the Company entered into an agreement with respect to the options for 250 thousand shares issued to the other officer in excess of the applicable plan cap, under which the 250 thousand options were cancelled, the vesting schedule for the remaining nonvested options were extended over a four and a half year period, and replaced with 150 thousand Restricted Stock Units, with graded vesting over four and a half years. The modification of this award resulted in additional expense of $66 thousand, which was to be recognized on a graded basis through December 2017.

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

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

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

·                  A performance cash award of U.S. $4.2 million, determined based on 1.6 million multiplied by the excess of the Exercise Price of U.S. $2.79 over U.S. $0.14. The former CEO’s right to receive such cash award was contingent on the Company achieving revenue growth of at least 7% during the twelve month period ended June 30, 2014 and his continued employment through such date. This revenue target was achieved and the cash award will be paid in three equal annual installments. The first installment in the amount of $1.4 million was paid in August 2014, the second installment was paid in the first quarter of 2015 and the final installment will be paid in the first quarter of 2016, or, if earlier, upon a change in control of the Company or the former CEO’s separation from service. Effective March 31, 2015, the former CEO became the Company’s Chief Product Strategy Officer. Any payment due on any installment date will be proportionally reduced if the sum of the

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Company’s stock price plus dividends for a measurement period prior to each payment date falls below 75% of the Exercise Price.

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

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

·                  PSUs for up to 250 thousand shares of common stock contingent on Diligent achieving either at least 15% fully diluted EPS growth (adjusted to exclude stock-based compensation expense and extraordinary items) or 15% total stockholder return (“TSR”) growth in four one-year measurement periods beginning April 1, 2013 (the “Level 2 PSU Agreement”). TSR growth is measured based on Diligent’s stock price performance during the 20 trading days prior to the relevant measurement date. The Level 2 PSU Agreement provides that 62.5 thousand shares of common stock (the “Level 2 Performance Shares”) will be earned in each year for which the applicable target is met, with the additional opportunity to earn such shares at the end of the four year performance period if the cumulative fully diluted EPS growth or TSR growth meet the cumulative performance target. The delivery dates for the vested performance shares will be in 2018 or, if earlier, upon a change in control of the Company or the former CEO’s separation from service.

On March 31, 2015, the Company and the former CEO entered into a Deferred Share Award Agreement (the “Deferred Share Award Agreement”) to give effect to the Company’s agreement that the former CEO would have been eligible to receive the first tranche of the Level 2 Performance Shares pursuant to the Level 2 PSU Agreement, after giving effect to the restatement of the Company’s financial statements.  The Company calculated a new baseline EPS for the period beginning April 1, 2013 through March 31, 2014 using post-restatement amounts (the “New Baseline EPS”) and concluded that the former CEO earned the first tranche of 62,500 shares of common stock, based on the achievement of 15% growth of fully diluted EPS during the period from April 1, 2013 through March 31, 2014.

The agreement to utilize the New Baseline EPS is considered an award modification and triggers a revaluation of the Level 2 Performance Shares on the modification date, which in this instance was March 31, 2015.  Consequently, the Company revalued the Level 2 Performance Shares and is expensing the Level 2 Performance Shares based on the grant date fair value of the original award plus the incremental fair value of the modified award.  The incremental expense associated with the revaluation of the Level 2 Performance Shares resulted in an additional expense of $0.3 million to be recognized over their original expected vesting dates.

In connection with the entry into an employment agreement with the Company’s new CEO, and an amendment to the employment agreement of its former CEO, now its Founder and Chief Product Strategy Officer, on March 31, 2015, the Company granted PSUs providing for the issuance of up to an aggregate of 675 thousand shares of common stock, with a grant date fair value of $2.7 million, to the new CEO and the Chief Product Strategy Officer.  The shares of common stock underlying the PSUs are issuable contingent on the Company achieving revenue thresholds based on reported revenue over a trailing 12 month period measured at each quarter end date beginning on March 31, 2015 and ending on March 31, 2021. There are four performance thresholds and the performance share units will vest 25% upon the achievement of each performance threshold. The Company has determined that all four of the performance measures are probable to be met within the next four years and has begun recording compensation expense for each tranche on a graded basis from the grant date through the date each threshold is expected to be achieved. Vesting periods for the above mentioned PSUs range from one year to approximately four years.

The liability for the performance cash award of $1.4 million is recorded in accrued expenses and other current liabilities on the Consolidated Balance Sheets as of June 30, 2015. The Company recorded compensation expense of $0.3 million in the second quarter and $0.7 million during the first six months of 2015 and $1.3 million in the second quarter and $2.7 million during the first six months of 2014 relating to the replacement award. The expense associated with all PSUs are expected to result in compensation expense of $1.0 million for the remainder of 2015, $1.4 million in 2016, $0.7 million in 2017, and $0.2 million in 2018.

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The vesting of the options, performance cash award and PSUs described above will be subject to certain acceleration provisions in the event of a change in control of the Company, upon death or disability or termination without cause or resignation for good reason.

On June 20, 2014, the Company agreed to issue 1,120,000 stock options to executives and employees under the 2013 Plan. These options vest 25% per year over the next four years, as long as such executive or employee remains in the employ of the Company on each vesting date.

On September 15, 2014, the Company agreed to issue 250,000 options to an executive of the Company under the 2013 Plan. These options vest in two equal installments on September 15, 2015 and September 15, 2016, as long as such executive remains in the employ of the Company on each vesting date.

On June 29, 2015, the Company agreed to issue 240,000 stock options to an officer under the 2013 Plan. These options vest 25% per year over the next four years, as long as such officer remains in the employ of the Company on each vesting date.

A summary of stock option activity for the six months ended June 30, 2015 is as follows:

Performance Stock Units

As noted above, in 2013, the Company issued PSUs to its former CEO as part of his substitute compensation package and in 2015 to its new CEO and its Chief Product Strategy Officer.  A summary of PSU activity for the six months ended June 30, 2015 is as follows:

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

Restricted Stock Units

On June 20, 2014, the Company issued 846,000 RSUs to executives and employees under the 2013 Plan. These RSUs, which vest 25% per year over the next four years, as long as such executive or employee remains in the employ of the Company on each vesting date, have a grant date fair market value of $3.84 per share for an aggregate of $3.2 million of share-based compensation to be recognized over the vesting period.

On March 31, 2015, the Company issued an aggregate of 675,000 RSUs to its new CEO and to its Chief Product Strategy Officer under the Plan. These RSUs, which vest 25% per year over the next four years for the Chief Product Strategy Officer and 25%

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after 9 months and 25% each year commencing with the second anniversary of the date of grant for the new CEO, as long as each remains in the employ of the Company on each vesting date. These awards have a grant date fair market value of $4.05 per share for an aggregate of $2.7 million of share-based compensation to be recognized over the vesting period.

On June 29, 2015, the Company issued 120,000 RSUs to an officer of the Company under the Plan. These RSUs, which vest 25% per year over the next four years, as long as such officer remains in the employ of the Company on each vesting date. These awards have a grant date fair market value of $3.84 per share for an aggregate of $0.5 million of share-based compensation to be recognized over the vesting period. A summary of RSU activity is as follows:

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

For the three months ended June 30, 2015, the Company recognized aggregate share-based compensation expense related to stock options, PSUs and RSUs of $0.4 million, $0.6 million and $0.9 million, respectively. For the three months ended June 30, 2014, the Company recognized aggregate share-based compensation expense related to stock options, PSUs and RSUs of $(0.5) million, $0.2 million and $0.1 million, respectively. For the six months ended June 30, 2015, the Company recognized aggregate share-based compensation expense related to stock options, PSUs and RSUs of $1.0 million, $1.1 million and $1.4 million, respectively. For the six months ended June 30, 2014, the Company recognized aggregate share-based compensation expense related to stock options, PSUs and RSUs of $(0.2) million, $0.5 million and $0.2 million, respectively. At June 30, 2015, there was $9.9 million of unrecognized share-based compensation expense which includes $1.8 million for stock options, $3.4 million for PSUs and $4.7 million for RSUs. The weighted average period for this cost to be recognized is 1.20 years.  Such amounts do not include any impact of the former CEO performance cash award.

Note 8. Income taxes

Income tax expense is provided on an interim basis based upon management’s estimate of the annual effective tax rate. The income tax provision for the three and six months ended June 30, 2015 provides income taxes at an effective rate of 40% and 39%, respectively. The Company recorded a net income tax provision for the three months and six months ended June 30, 2014 based on an effective tax rate of 33% and 36%, respectively.

Section 382 of the U.S. Internal Revenue Code generally imposes an annual limitation on the amount of net operating loss carryforwards that can be used to offset taxable income when a corporation has undergone significant changes in stock ownership. Beginning in 2013, the Company’s annual net operating loss carryforward is subject to a limitation of approximately $0.4 million to offset expected taxable income until expiration of the carryforwards. Based on this limitation, the Company expects that approximately $4.9 million of its total net operating loss carryforwards will expire unutilized in 2029. A full valuation allowance had previously been provided on the related deferred tax asset, and therefore the deferred tax asset and valuation allowance relating to the net operating loss carryforwards expected to expire unutilized were written off.

Diligent and its subsidiaries are subject to regular audits by federal, state and foreign tax authorities. These audits may result in additional tax liabilities. The Company’s U.S. federal and state income tax returns for the tax years 2011 and forward are open for examination by the taxing jurisdictions. The Company’s foreign income tax returns are open for examination by the local taxing jurisdictions for the following years: New Zealand — 2009 and forward; U.K. — 2011 and forward; Australia — 2009 and forward.

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Note 9. Contingencies

Sales tax risk

States and some local taxing jurisdictions have differing rules and regulations governing sales and use taxes, and these rules and regulations are subject to varying interpretations that may change over time. In particular, the applicability of sales taxes to our subscription services in various jurisdictions is unclear. The Company’s cumulative provisions as of June 30, 2015 and December 31, 2014 were $2.2 million and $2.1 million, respectively, with respect to sales and use tax liabilities in various states and local jurisdictions. It is possible that the Company could face sales tax audits and that its liability for these taxes could exceed our estimates as state tax authorities could assert that we are obligated to collect additional amounts as taxes from our customers and remit such taxes to those authorities. The Company could also be subject to audits with respect to states and international jurisdictions for which it has not accrued tax liabilities. A successful assertion that the Company should be collecting additional sales or other taxes on its services in jurisdictions where we have not historically done so and do not accrue for sales taxes could result in substantial tax liabilities for past sales, discourage customers from purchasing the Company’s application or otherwise harm our business and operating results.

Litigation and claims

In the ordinary course of business, Diligent is a party to pending legal proceedings and claims. Although the outcome of such items cannot be determined with certainty, management is of the opinion that the final outcome will not have a material effect on the Company’s financial position, results of operations or cash flows.

NZX Main Board Listing Rules

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

In September 2014 the NZ Markets Disciplinary Tribunal approved a settlement reached by the Company and the NZX regarding the breaches of the NZX Main Board Listing Rules by the Company relating to the delayed reports described above. The settlement provided for the payment of fines and costs by the Company, consisting of NZ $100 thousand ($79 thousand USD) as a penalty to the NZX Discipline Fund and NZ $4 thousand ($3 thousand USD) towards the cost of NZXR. These amounts have been paid as of December 31, 2014.

In June 2015, the NZ Markets Disciplinary Tribunal approved a settlement reached by the Company and the NZX regarding the breaches of the NZX Main Board Listing Rules by the Company relating to the Company not having the required minimum of two New Zealand resident directors from the period of April 9, 2015 to April 29, 2015. The settlement provided for the payment of NZ $1 thousand ($1 thousand USD) towards the cost of NZX and the cost of the tribunal which is yet to be determined.

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes that appear elsewhere in this Quarterly Report on Form 10-Q. This discussion contains a number of forward-looking statements, all of which are based on our current expectations and all of which could be affected by uncertainties and risks. Certain amounts from the prior period have been reclassified to conform to the current period presentation. Our actual results may differ materially from the results contemplated in these forward-looking statements as a result of many factors including, but not limited to, those described under “Risk Factors” in Part I, Item 1A of the 2014 Form 10-K.

Overview

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

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

·                  Strengthening the existing product and offering new functionality,

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

·                  Deepening relationships with our existing client base, and

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

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

The SaaS model allows us to differentiate our product through technological innovation and client service while the subscription billing approach results in a predictable and recurring revenue stream. This SaaS model also allows clients to retain control over access to the application while outsourcing to us the support activities, such as managing the IT infrastructure and maintaining the software. We began developing components of Diligent Boards in 1998, culminating in the roll-out of an international sales team in 2007.

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

In February 2015, we announced that we plan to introduce a new SaaS collaboration solution called Diligent Teams during the third quarter of 2015. In 2014, we more than doubled our research and development headcount, partially due to our exploratory work on the design of the Diligent Teams product. During the first six months of 2015, we have continued to increase our investment in research and development, and plan on continuing such investment. Diligent Teams will begin to have beta users in the third quarter of 2015. There can be significant time lags and unexpected development costs incurred between initial beta releases and the commercial availability of new products. While we are enthusiastic about the planned launch of Diligent Teams and believe that the product will be welcomed by many of our existing clients and new clients, Diligent Teams may not be introduced on our expected timetable, or meet with commercial success.

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Critical Accounting Policies and Estimates

The Company’s critical accounting policies and estimates are consistent with those disclosed in our 2014 Form 10-K, except that the Company has begun to capitalize costs associated with the application development stage of a project and will begin amortizing those costs when the software is ready for use and placed in service (see “Note 3—Significant Accounting Policies—Internally Developed Software” to our condensed consolidated financial statements contained in this Quarterly Report on Form 10-Q).  The Company also considers the reclassification of certain indirect costs within the condensed consolidated statements of income to be a change in accounting presentation.  For further information about the reclassification refer to “Note 3—Significant Accounting Policies—Basis of presentation” to our condensed consolidated financial statements contained in this Quarterly Report on Form 10-Q.

Revenue Recognition

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

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

·               There is persuasive evidence of the arrangement;

·               The service has been made available to the customer;

·               The fee is fixed or determinable; and

·               The collectability of the fees is reasonably assured.

Pursuant to the authoritative accounting guidance regarding revenue recognition for arrangements with multiple deliverables, for a deliverable to qualify as a separate unit of accounting, the delivered item must have value to the customer on a standalone basis. The Company has determined that the installation fee does not have standalone value, so accordingly it accounts for its arrangements as a single unit of accounting.

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

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

Deferred Revenue

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

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

The Company also discloses gross deferred revenue which consists of deferred revenue and installation and subscription fees which have been billed to the customer pursuant to an executed subscription agreement but for which payment has not yet been

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received and the criteria for the recognition of revenue has not yet been met. As a result of our subscription-based model and historically high renewal rates, at the end of any period, we generally have subscription contracts in place for a significant percentage of our total revenues for the next 12 months and therefore we believe it is useful to the users of our consolidated financial statements to disclose gross deferred revenues.

Accounts receivable

The Company generally invoices its customers on a quarterly or annual basis. Accounts receivable represents amounts due from our customers for which revenue has been recognized. A provision for doubtful accounts is recorded based on management’s assessment of amounts considered uncollectable for specific customers based on the age of the receivable, history of payments and other relevant information. At each of June 30, 2015 and December 31, 2014, the Company has recorded a provision for doubtful accounts of $0.1 million. The Company also discloses gross accounts receivable which consists of all billings to customers for installation and subscription fees.

The reconciliation of gross accounts receivable and deferred revenue to net accounts receivable and deferred revenue at June 30, 2015, is as follows:

The reconciliation of gross accounts receivable and deferred revenue to net accounts receivable and deferred revenue at December 31, 2014, is as follows:

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

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Cost of Revenues and Operating Expenses

Cost of Revenues (exclusive of depreciation and amortization). Cost of revenues consists of direct expenses related to hosting the Company’s cloud-based application, account management, customer support, data communication expenses, employee bonuses, share-based compensation, and salaries and benefits of account management, customer support and network operations personnel. Costs of revenues also include allocated facility and related costs and certain costs associated with the Company’s Enterprise Resource Planning system. We do not allocate depreciation and amortization to cost of revenues.

Selling and Marketing. Selling and marketing expenses are comprised of sales commissions, salaries and benefits for sales and marketing employees, marketing program expenses, employee bonuses, share-based compensation and direct advertising expenses, including mailings and travel. Selling and marketing also includes allocated facility and related costs and certain costs associated with the Company’s Enterprise Resource Planning system.

General and Administrative. General and administrative expenses consist of compensation and related expenses, inclusive of employee bonuses and share-based compensation, for executive, finance, accounting, administrative and legal personnel, professional fees, other corporate expenses. General and administrative also includes allocated facility and related costs and certain costs associated with the Company’s Enterprise Resource Planning system.

Research and Development. Research and development expenses are incurred as the Company upgrades and maintains Diligent Boards software and evaluates and develops Diligent Teams and other potential software applications. Such expenses include compensation and employee benefits of engineering and testing personnel, including share-based compensation, materials, travel and direct costs associated with the design and required testing of the product line. Research and development also includes allocated indirect costs such as facility and related costs that are clearly related to research and development activities.

Restatement. Restatement costs include the costs related to the restatement of our financial statements and re-audits of the years ended December 31, 2012, 2011 and 2010, which are comprised of audit, accounting and consulting fees.

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

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

Results of Operations for the Three Months Ended June 30, 2015

The growth in total revenues of $3.7 million or 18% for the three months ended June 30, 2015 when compared to 2014 is primarily the result of an increase in new users of Diligent Boards, as well as our retention of existing customers. In the second quarter, our annual revenue retention rate, including upsells into the existing customer base, exceeded 100%. We calculate our annual revenue retention rate as of a period end by starting with the annual contract (ACV) from customers as of 12 months prior to such period end (Prior Period ACV) and a subscription term of at least 12 months. We then calculate ACV from these same customers as of the current period end (Current Period ACV). Finally, we divide the aggregate Current Period ACV for the trailing 12- month period by the aggregate Prior Period ACV for the trailing 12-month period to arrive at our annual revenue retention rate. We have continued to add users each quarter since inception. During the three months ended June 30, 2015, the total number of users increased to over 100,000.  The total number of client agreements (net of cancellations) was approximately 3,350 as of June 30, 2015, compared with approximately 2,600 at June 30, 2014.  North America, EMEA (Europe, Middle East and Africa) and Asia/Pacific accounted for 60%,

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23%, and 17%, respectively, of the contract value of new subscriptions added during the second quarter of 2015 and 63%, 18%, and 19%, respectively, of the contract value of new subscriptions added during the second quarter of 2014. Upgrades from existing customers, which represents the increase during the year in value from existing agreements due primarily to additional users being added to the agreement, represented 35% and 51% of the contract value of new subscriptions added for the three months ended June 30, 2015 and 2014, respectively.

We recognize subscription revenue ratably over the contract period, which is generally at least twelve months. Accordingly, we expect that growth in subscription agreements will be reflected by increases in revenues over the next twelve months.

Cost of Revenues and Operating Expenses

(1) Excluding depreciation and amortization

Cost of revenues is comprised of account management, customer support and network operations personnel. The increase in costs of revenues is due to an increase in hosting fees, internet costs, share-based compensation and salaries, bonuses and other employee costs of $0.2 million, $0.1 million, $0.1 million, and $0.1 million, respectively.

Cost of revenues increased at a slightly lower rate than revenues due to subscription revenue outpacing the related cost of revenue, resulting in a gross margin of 80% for the three months ended June 30, 2015 compared to 78% for the three months ended June 30, 2014.

Selling and marketing expenses consist of $2.7 million of selling expense and $2.8 million of marketing expense. Selling and marketing expenses for the three months ended June 30, 2015 increased $1.1 million and $1.3 million, respectively, when compared to the same period in 2014.

The increase in selling expenses of $1.1 million consists of $0.4 million in the U.S., $0.6 million in EMEA and $0.1 million in Australia. The increase in selling expenses was primarily due to increases to our sales staff headcount. The increase in marketing expenses of $1.3 million consists of $0.7 million in the U.S, $0.4 million in EMEA and $0.2 million in Asia/Pacific. The increase in marketing expenses was partly due to an increase in headcount resulting in an increase of salaries, bonuses and other employee costs of $0.2 million. Other increases included trades shows and events, direct marketing costs and professional fees of $0.4 million, $0.4 million and $0.3 million, respectively.