FORESCOUT TECHNOLOGIES, INC - FORM 10-Q

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EX-32.2 - EXHIBIT 32.2 - FORESCOUT TECHNOLOGIES, INC	a9302017exhibit322.htm
EX-32.1 - EXHIBIT 32.1 - FORESCOUT TECHNOLOGIES, INC	a9302017exhibit321.htm
EX-31.2 - EXHIBIT 31.2 - FORESCOUT TECHNOLOGIES, INC	a9302017exhibit312.htm
EX-31.1 - EXHIBIT 31.1 - FORESCOUT TECHNOLOGIES, INC	a9302017exhibit311.htm
EX-3.2 - EXHIBIT 3.2 - FORESCOUT TECHNOLOGIES, INC	exhibit32bylaws.htm
EX-3.1 - EXHIBIT 3.1 - FORESCOUT TECHNOLOGIES, INC	exhibit31certificateofinco.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, 2017




¨	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 001-38253

———————————————

FORESCOUT TECHNOLOGIES, INC.

(Exact name of registrant as specified in its charter)

———————————————



Delaware	51-0406800
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
190 West Tasman Drive San Jose, California 95134 (Address of principal executive offices, including zip code)

(408) 213-3191

(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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

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,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):



Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	x	Smaller reporting company	¨
(Do not check if a smaller reporting company)		Emerging growth company	x
		If an emerging growth company, indicate by checkmark if the registrant has not elected to use the extended transition period for complying with any new or revised financial accounting standards providing pursuant to Section 7(a)(2)(B) of the Securities Act	x

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

The number of shares outstanding of the registrant’s common stock as of December 5, 2017 was 37,906,920.

TABLE OF CONTENTS






		Page
	PART I - FINANCIAL INFORMATION	5
Item 1.	Financial Statements	5
	Condensed Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016	5
	Condensed Consolidated Statements of Operations and Comprehensive Loss for the Three and Nine Months Ended September 30, 2017 and 2016	6
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2017 and 2016	7
	Notes to Condensed Consolidated Financial Statements	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	38
Item 4.	Controls and Procedures	38

	PART II - OTHER INFORMATION	40
Item 1.	Legal Proceedings	40
Item 1A.	Risk Factors	40
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	64
Item 6.	Exhibits	64
	Signatures

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended, which statements involve substantial risks and uncertainties. Forward-looking statements generally relate to future events or our future financial or operating performance. In some cases, you can identify forward-looking statements because they contain words such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these words or other similar terms or expressions that concern our expectations, strategy, plans or intentions. Forward-looking statements contained in this Quarterly Report on Form 10-Q include, but are not limited to, statements about:


•	the evolution of the cyberthreat landscape facing enterprises in the United States and other countries;


•	developments and trends in the domestic and international markets for network security products and related services;


•	our expectations regarding the size of our target market;


•	our ability to educate prospective end-customers about our technical capabilities and the use and benefits of our products, and to achieve increased market acceptance of our solution;


•	our beliefs and objectives regarding our prospects and our future results of operations and financial condition;


•	the effects of increased competition in our target markets and our ability to compete effectively;


•	our business plan and our ability to manage our growth effectively;


•	our expectations concerning the productivity of our expanding sales force as our sales representatives become more seasoned;


•	our growth strategy to maintain and extend our technology leadership, expand and diversify our end-customer base, deepen our existing end-customer relationships, and attract and retain highly skilled security professionals;


•	our ability to enhance our existing products and technologies and develop or acquire new products and technologies;


•	our plans to attract new end-customers, retain existing end-customers, and increase our annual revenue;


•	our expectations concerning renewal rates for services and maintenance by existing end-customers and growth of our recurring revenue retention;


•	our expectations regarding our relationships with third parties, including further development of our relationships with our manufacturer, value-added resellers and channel partners, alliance partners, and our technology and distribution partners;


•	our plans to expand our international operations;


•	our expectations regarding future acquisitions of, or investments in, complementary companies, services, or technologies;


•	our ability to continue to generate a significant portion of our revenue from public sector customers;


•	the effects on our business of evolving information security and data privacy laws and regulations, government export or import controls and any failure to comply with the U.S. Foreign Corrupt Practices Act and similar laws;


•	our ability to maintain, protect, and enhance our brand and intellectual property;


•	fluctuations in our quarterly results of operations and other operating measures;


•	our expectations regarding changes in our cost of revenue, gross margins, and operating costs and expenses;


•	our expectations regarding the portions of our revenue represented by product revenue and maintenance and professional services revenue;


•	our expectations concerning the impact on our results of operations of development of our distribution programs and sales through our channel partners;


•	the impact on our revenue, gross margin, and profitability of future investments in the enhancement of ForeScout CounterACT, ForeScout Enterprise Manager, and ForeScout Extended Modules and expansion of our sales and marketing programs;


•	sufficiency of our existing liquidity sources to meet our cash needs; and


•	our potential use of foreign exchange forward contracts to hedge our foreign currency risk.

We caution you that the foregoing list may not contain all of the forward-looking statements made in this Quarterly Report on Form 10-Q.

You should not rely upon forward-looking statements as predictions of future events. We have based the forward-looking statements contained in this Quarterly Report on Form 10-Q primarily on our current expectations and projections about future events and trends that we believe may affect our business, financial condition, operating results, cash flows or prospects. The outcome of the events described in these forward-looking statements is subject to risks, uncertainties and other factors described in the section titled “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks and uncertainties emerge from time to time and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements contained in this Quarterly Report on Form 10-Q. We cannot assure you that the results, events and circumstances reflected in the forward-looking statements will be achieved or occur, and actual results, events or circumstances could differ materially from those described in the forward-looking statements.

The forward-looking statements made in this Quarterly Report on Form 10-Q relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statements made in this Quarterly Report on Form 10-Q to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect new information or the occurrence of unanticipated events, except as required by law. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments we may make.

PART I. FINANCIAL INFORMATION




ITEM 1.	FINANCIAL STATEMENTS

FORESCOUT TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

(Unaudited)



	September 30, 2017			December 31, 2016
Assets
Current assets:
Cash and cash equivalents	$	72,344		$	79,665
Accounts receivable	49,080			44,694
Inventory	132			890
Prepaid expenses and other current assets	8,431			8,592
Total current assets	129,987			133,841
Property and equipment, net	23,264			24,536
Severance pay deposits	1,987			1,704
Restricted cash	4,137			4,011
Other assets	4,951			3,334
Total assets	$	164,326		$	167,426

Liabilities, redeemable convertible preferred stock and stockholders' deficit
Current liabilities:
Accounts payable	$	1,889		$	5,210
Accrued compensation	21,106			17,286
Accrued expenses	11,002			12,903
Customer deposits	6,506			718
Deferred revenue	91,216			68,844
Notes payable	7,224			7,163
Total current liabilities	138,943			112,124
Warrant liabilities	5,216			4,874
Deferred revenue - non-current	56,712			40,070
Notes payable - non-current	17,398			22,824
Accrued severance pay liability	2,524			2,033
Other liabilities	9,340			10,244
Total liabilities	230,133			192,169
Commitments and Contingencies
Redeemable convertible preferred stock	283,854			283,854
Stockholders' deficit:
Common stock, $0.001 par value; 50,000,000 shares authorized;
6,175,126 and 5,854,147 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively	6			6
Additional paid-in capital	98,555			84,792
Accumulated deficit	(448,222		)	(393,395		)
Total stockholders’ deficit	(349,661		)	(308,597		)
Total liabilities, redeemable convertible preferred stock and stockholders' deficit	$	164,326		$	167,426

See Notes to Condensed Consolidated Financial Statements.

FORESCOUT TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(In thousands, except share and per share amounts)

(Unaudited)



	Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016
Revenue:
Product	$	39,192		$	30,799		$	83,889		$	68,861
Maintenance and professional services	25,164			17,941			71,026			48,550
Total revenue	64,356			48,740			154,915			117,411
Cost of revenue:
Product	7,201			6,563			17,117			13,754
Maintenance and professional services	8,688			6,945			25,662			19,304
Total cost of revenue	15,889			13,508			42,779			33,058
Total gross profit	48,467			35,232			112,136			84,353
Operating expenses:
Research and development	10,985			8,509			32,634			22,352
Sales and marketing	34,957			35,759			104,515			94,316
General and administrative	9,148			7,967			27,265			23,081
Total operating expenses	55,090			52,235			164,414			139,749
Loss from operations	(6,623		)	(17,003		)	(52,278		)	(55,396		)
Interest expense	(290		)	(702		)	(953		)	(2,072		)
Other income (expense), net	160			(226		)	(66		)	(354		)
Change in fair value of warrant liabilities	—			(224		)	(342		)	379
Loss before income taxes	(6,753		)	(18,155		)	(53,639		)	(57,443		)
Income tax provision	412			157			1,221			517
Net loss and comprehensive loss	$	(7,165	)	$	(18,312	)	$	(54,860	)	$	(57,960	)
Net loss per share attributable to common stockholders, basic and diluted	$	(1.17	)	$	(3.18	)	$	(9.09	)	$	(10.46	)
Weighted-average shares used to compute net loss per share attributable to common stockholders, basic and diluted	6,139,876			5,749,930			6,032,427			5,539,012

See Notes to Condensed Consolidated Financial Statements.

FORESCOUT TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



	Nine Months Ended September 30,
	2017			2016
Cash flows from operating activities
Net loss	$	(54,860	)	$	(57,960	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities
Stock-based compensation	12,060			12,862
Depreciation	4,264			2,279
Loss on disposal of property and equipment	187			19
Amortization of discount on debt	259			554
Change in fair value of warrant liabilities	342			(379		)
Changes in operating assets and liabilities
Accounts receivable	(4,386		)	(2,562		)
Inventory	835			125
Prepaid expenses and other current assets	177			(4,516		)
Other assets	(131		)	(1,723		)
Accounts payable	(3,319		)	(1,630		)
Accrued compensation	3,820			4,725
Accrued expenses	(567		)	1,855
Customer deposits	5,788			(709		)
Deferred revenue	39,014			10,085
Severance pay, net	208			151
Other liabilities	(128		)	6,429
Net cash provided by (used in) operating activities	3,563			(30,395		)
Cash flows from investing activities
Purchases of property and equipment	(3,386		)	(19,959		)
Purchases of short-term investments	—			(23,983		)
Proceeds from maturities of short-term investments	—			12,000
Proceeds from sales of short-term investments	—			11,979
Change in restricted cash	(126		)	(199		)
Net cash used in investing activities	(3,512		)	(20,162		)
Cash flows from financing activities
Repayments of notes payable	(5,624		)	—
Net proceeds from issuance of redeemable convertible preferred stock	—			2,399
Proceeds from exercise of stock options	960			907
Payments of deferred offering costs	(2,708		)	—
Net cash (used in) provided by financing activities	(7,372		)	3,306
Net change in cash and cash equivalents for period	(7,321		)	(47,251		)
Cash and cash equivalents at beginning of period	79,665			126,846
Cash and cash equivalents at end of period	$	72,344		$	79,595
Noncash disclosure of investing and financing activities:
Change in liability for early exercise of stock options, net of vested portion	$	776		$	812
Leasehold improvements paid by lessor	$	—		$	338
Purchases of property and equipment recorded in accounts payable and accrued expenses	$	144		$	1,037
Deferred offering costs included in accrued expenses	$	501		$	—

See Notes to Condensed Consolidated Financial Statements.

FORESCOUT TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Description of Business and Summary of Significant Accounting Policies

Company and Background

ForeScout Technologies, Inc. (the “Company”) was incorporated in the State of Delaware and commenced operations in April 2000. The Company provides an agentless approach to network security to protect organizations against the emerging threats that exploit billions of Internet of Things (“IoT”) devices connected to an organization’s networks. The Company offers its solution across three products: (i) ForeScout CounterACT^®, (ii) ForeScout CounterACT Enterprise Manager and (iii) ForeScout Extended Modules. The Company’s CounterACT product provides visibility and policy-based mitigation of security issues. The Company’s CounterACT Enterprise Manager is a centralized security management solution for global control of all CounterACT products. The Company’s Extended Modules expand CounterACT’s see and control capabilities by sharing contextual device data with third-party systems and by automating policy enforcement across those disparate systems.

The Company sells its products, maintenance and professional services to end-customers through distributors and resellers, who are supported by the Company’s sales and marketing organization, and to a lesser extent directly to end-customers.

Initial Public Offering

On October 31, 2017, the Company closed its initial public offering (“IPO”), in which it issued and sold 6,072,000 shares of common stock inclusive of the underwriters’ option to purchase additional shares that was exercised in full. The price per share to the public was $22.00. The Company received aggregate proceeds of $124.2 million from the IPO, net of underwriters’ discounts and commissions, and before deducting offering costs of approximately $3.5 million. Upon the closing of the IPO, all shares of the Company's outstanding redeemable convertible preferred stock automatically converted into 25,370,616 shares of common stock. Total outstanding shares after closing of the IPO and after conversion of all shares of the Company's outstanding redeemable convertible preferred stock was 37,861,342 at October 31, 2017.

Basis of Presentation

The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information using accounting policies that are consistent with those used in the preparation of the Company’s audited consolidated financial statements for the year ended December 31, 2016. Our condensed consolidated financial statements include the results of ForeScout Technologies, Inc. and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

The condensed consolidated financial statements are unaudited and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of our quarterly results. The condensed consolidated balance sheet as of December 31, 2016 was derived from the audited consolidated financial statements at that date but does not include all the disclosures required by GAAP for the annual financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements as of and for the year ended December 31, 2016, which are included in the Company’s prospectus related to the Company’s initial public offering, filed October 27, 2017 (the “Prospectus”), pursuant to Rule 424 (b) under the Securities Act of 1933, as amended (the “Securities Act”) with the Securities and Exchange Commission (the “SEC”).

The preparation of interim condensed consolidated financial statements in conformity with GAAP requires management to make use of estimates and assumptions that affect the reported amounts in the condensed consolidated financial statements and accompanying notes. These estimates form the basis of judgments made about carrying values of assets and liabilities, which are not readily apparent from other sources. The areas where management has made

estimates requiring judgment include, but are not limited to, the allocation of revenue in multiple element arrangements, sales return reserve, accruals, stock-based compensation including the fair value of common stock, redeemable convertible preferred stock warrant liabilities, and provision for income taxes including related reserves. Actual results could differ materially from those estimates.

Reverse Stock Split

On October 16, 2017, the Company amended its amended and restated certificate of incorporation to effect a two-to-one reverse stock split of its common stock and convertible preferred stock (the “Reverse Stock Split”). Upon the filing of the amended and restated certificate of incorporation in the state of Delaware, (i) each two shares of outstanding convertible preferred stock and each two shares of outstanding common stock were exchanged and combined into one share of convertible preferred stock and one share of common stock, respectively; (ii) the number of shares of common stock issuable under each outstanding option to purchase common stock and issuable upon vesting under each restricted stock unit was proportionately reduced on a two-to-one basis; (iii) the exercise price of each outstanding option to purchase common stock was proportionately increased on a two-to-one basis; (iv) the number of shares of convertible preferred stock issuable under outstanding warrants was proportionally reduced on a two-to-one basis and the exercise price of such warrants was proportionally increased on a two-to-one basis; and (v) corresponding adjustments in the per share conversion prices, dividend rates and liquidation preferences of the convertible preferred stock were made on a two-to-one basis. Accordingly, all share and per share information presented in the condensed consolidated financial statements herein, and notes thereto, have been retroactively adjusted to reflect the Reverse Stock Split.

Summary of Significant Accounting Policies

There have been no material changes to our significant accounting policies as compared to those described in the Prospectus.

Inventory

Inventory primarily consists of finished goods hardware appliances and is stated at the lower of cost or market determined using the specific identification method. Inventory that is obsolete or in excess of forecasted demand is written down to its estimated realizable value. Inventory write-downs, once established, are not reversed as they establish a new cost basis for the inventory.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09 (Topic 606), Revenue from Contracts with Customers (“ASU 2014-09”), related to revenue from contracts with customers, which, along with amendments issued in 2015 and 2016, will supersede nearly all current GAAP guidance on this topic and eliminate industry-specific guidance. Under the new standard, revenue is recognized when a customer obtains control of promised goods or services and is recognized in an amount that reflects the consideration that the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.

The guidance permits two methods of adoption: retrospectively to each prior reporting period presented (“full retrospective method,”) or retrospectively with the cumulative effect of applying the guidance recognized in retained earnings as of the date of adoption (“modified retrospective method”). The Company currently anticipates adopting the standard using the full retrospective method to restate each prior reporting period presented. The Company’s ability to adopt the full retrospective method is dependent upon system readiness and the Company’s ability to gather sufficient data to timely assess the impact on prior period financial statements. The Company plans to adopt the new standard effective January 1, 2018.

The Company is currently evaluating the impacts of the new standard on its accounting policies, processes, and system requirements and has assigned internal resources, in addition to the engagement of third party service providers, to assist in the evaluation. While the Company is continuing to assess all potential impacts of this standard, the Company currently believes that the most significant impacts relate to the accounting for Software Products, which include Virtual Appliances, Enterprise License Software sold without hardware, and Extended Modules as software deliverables, and

contract acquisition costs. For Software Products, sold prior to January 1, 2016, vendor-specific objective evidence of fair value (“VSOE”) for support and maintenance on Software Products was not established, and the Company recorded all Software Product related revenue ratably over the contractually committed support and maintenance period. Professional services sold in conjunction with such Software Products were also recognized ratably over the contractually committed support and maintenance period. Under the new standard the requirement to have VSOE for undelivered elements is eliminated and an entity may be required to recognize Software Product revenue at the time of delivery, and any related professional services revenue as services are provided to the customers. For contract acquisition costs, the new standard requires the capitalization of such costs, which is primarily sales commissions, and amortization of these costs over the contract period or estimated customer life, which will result in the recognition of a deferred charge on the Company’s balance sheets. The Company currently expenses all sales commissions and other incremental costs to acquire contracts as they are incurred. Additionally, the Company expects revenue allocated from future deliverables (primarily support and maintenance) to Physical Appliances, which include CounterACT and Enterprise Manager hardware appliances embedded with the Company’s software, to be recognized upon delivery under the new guidance when the standalone selling price is different from the contract price. Such differences are currently recognized over the contractual support and maintenance period.

While the Company continues to assess the potential impacts of the new standard, including the areas described above, and anticipates that this standard could have a material impact on its consolidated financial statements, it does not know or cannot reasonably estimate quantitative information related to the impact of the new standard on the financial statements at this time.

In February 2016, the FASB issued ASU No. 2016-02 (Topic 842), Leases. The new guidance requires lessees to recognize right-of-use assets and lease liabilities for those leases classified as operating leases under previous U.S. GAAP. The standard is effective for annual and interim periods within those fiscal years, beginning after December 15, 2018, and will be applied on a modified retrospective basis, with the option to elect certain practical expedients. Early adoption is permitted. The Company is currently evaluating the timing and impact of the adoption of this standard on its consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09 (Topic 718), Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”). This standard is intended to simplify several areas of accounting for stock-based compensation arrangements, including the income tax impact, classification on the statement of cash flows and forfeitures. ASU 2016-09 is effective for annual and interim periods within those fiscal years, beginning after December 15, 2016. The Company adopted this standard in the first quarter of 2017 and elected to account for forfeitures as they occur, rather than estimate expected forfeitures. The change has been applied on a modified retrospective basis that resulted in a $34,000 cumulative-effect adjustment to accumulated deficit as of January 1, 2017, the date of adoption. The adoption of this guidance also requires that excess tax benefits and tax deficiencies be recorded in the statement of operations as opposed to additional paid-in capital when the awards vest or are settled, and has been applied on a prospective basis. As a result, deferred tax assets increased by $2.3 million as of January 1, 2017, offset by valuation allowance, due to tax deductions related to equity compensation greater than compensation recognized for financial reporting.

In November 2016, the FASB issued ASU No. 2016-18 (Topic 230), Statement of Cash Flows: Restricted Cash. The new standard requires an entity to show the changes in the total of cash, cash equivalents, restricted cash and restricted cash equivalents in the statement of cash flows, and an entity will no longer present transfers between cash and cash equivalents and restricted cash and restricted cash equivalents in the statement of cash flows. The standard is effective for annual and interim periods within those fiscal years, beginning after December 15, 2017, and should be applied retrospectively. Early adoption is permitted. The Company is currently evaluating the timing and impact of the adoption of this standard on its consolidated financial statements.

In May 2017, the FASB issued ASU 2017-09 (Topic 718), Compensation-Stock Compensation: Scope of Modification Accounting. This standard provides guidance on when to account for a change to the terms or conditions of a share-based payment award as a modification. Under this new standard, modification accounting is required only if the fair value, the vesting conditions or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. This standard is effective for annual and interim periods within those

fiscal years, beginning after December 15, 2017, with early adoption permitted. The Company does not expect the adoption of this standard to have a material impact on its consolidated financial statements.

Note 2. Fair Value Measurements

Financial assets and liabilities are recorded at fair value on the consolidated balance sheets and are categorized based upon the level of judgment associated with inputs used to measure their fair value.

Fair value reflects the price that would be received on the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining fair value measurements, the Company considers the principal or most advantageous market and also market-based risk.

The accounting guidance for fair value measurements requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The accounting guidance also establishes a fair value hierarchy based on the independence of the source and objective evidence of the inputs used. There are three fair value hierarchies based upon the level of inputs that are significant to fair value measurement:

•Level 1—Observable inputs that reflect quoted prices in active markets for identical assets or liabilities.

•Level 2—Observable inputs that reflect quoted prices for identical assets and liabilities in markets that are not active, quoted prices for similar assets or liabilities in active markets, inputs other than quoted prices that are observable for the assets or liabilities, or inputs that are derived principally from or corroborated by observable market data by correlation or other means.

•Level 3—Inputs that are generally unobservable and are supported by little or no market activity, and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability.

There have been no transfers between fair value measurement levels during the periods presented. The following table presents the fair value of the Company’s financial assets and liabilities according to the fair value hierarchy (in thousands):



	September 30, 2017				December 31, 2016
Financial Assets	Level 1		Level 3		Level 1		Level 3
Cash and cash equivalents:
Cash	$	34,986	$	—	$	42,499	$	—
Money market accounts	37,358		—		37,166		—
Total cash and cash equivalents	72,344		—		79,665		—
Restricted cash (current and non-current)	4,339		—		4,212		—
Total financial assets	$	76,683	$	—	$	83,877	$	—
Financial Liabilities
Warrant liabilities	$	—	$	5,216	$	—	$	4,874

The Company’s Level 3 financial liabilities consist of warrant liabilities on redeemable convertible preferred stock and common stock. The following table presents the activity for the warrant liabilities (in thousands):



	Level 3
Balance as of December 31, 2016	$	4,874
Change in fair value of warrant liabilities	342
Balance as of September 30, 2017	$	5,216

Note 3. Equity Award Plans

Stock Option Activity

The following table summarizes option activity under the 2000 Plan and related information (in thousands, except share, per share and contractual life amounts):



	Options Outstanding
	Number of Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Life (Years)	Aggregate Intrinsic Value
Balance—December 31, 2016	9,587,515		$	10.13	8.0	$	61,865
Options granted	458,099		$	18.46
Options exercised	(222,447	)	$	4.32
Options forfeited	(410,026	)	$	14.31
Balance—September 30, 2017	9,413,141		$	10.49	7.4	$	87,637
Options vested and expected to vest—September 30, 2017	9,413,141		$	10.49	7.4	$	87,637
Options vested and exercisable—September 30, 2017	5,014,239		$	8.34	6.8	$	57,377

As of September 30, 2017, total unrecognized compensation cost related to unvested options was $28.8 million, which was expected to be amortized on a straight-line basis over a weighted-average period of approximately 2.2 years.

Restricted Stock Unit (“RSU”) Activity

The following table summarizes RSU activity under the 2000 Plan and related information (in thousands, except share, per share and contractual life amounts):



	RSUs Outstanding
	Number of Shares		Weighted- Average Grant Date Fair Value Per Share		Weighted- Average Remaining Contractual Life (Years)	Aggregate Intrinsic Value
Balance—December 31, 2016	1,898,623		$	14.83	1.7	$	30,720
RSUs granted	1,155,350		$	19.25
RSUs forfeited	(22,750	)	$	20.18
Balance—September 30, 2017	3,031,223		$	16.48	1.8	$	59,958
RSUs vested and expected to vest—September 30, 2017	3,029,970		$	17.22	1.8	$	59,933

As of September 30, 2017, total unrecognized compensation cost related to unvested RSUs was $2.5 million, excluding RSUs with a performance condition, and are expected to be amortized on a straight-line basis over a weighted-average period of approximately 1.4 years.

Stock-Based Compensation

Stock-based compensation expense for both employees and non-employees included in the accompanying condensed consolidated statements of operations and comprehensive loss is as follows (in thousands):



	Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016
Cost of revenue:
Product	$	19	$	6	$	60	$	16
Maintenance and professional services	286		317		930		809
Research and development	630		613		2,043		1,645
Sales and marketing	1,602		1,543		4,868		6,469
General and administrative	1,372		1,339		4,159		3,923
Total	$	3,909	$	3,818	$	12,060	$	12,862

As of September 30, 2017, the Company had a total of 294,160 options outstanding to employees and non-employees, with exercise prices ranging from $0.43 to $1.47, that will only vest upon the completion of an IPO or change in control. As of September 30, 2017, the Company had a total of 2,420,273 restricted stock units outstanding with a performance condition dependent upon completion of an IPO or a change in control. If an IPO or a change in control had occurred as of September 30, 2017, the Company would have recorded stock-based compensation expense of approximately $22.1 million and the unrecognized compensation cost related to these performance-based stock options and RSUs would have been $31.0 million to be amortized over a weighted-average period of approximately 1.9 years. Upon the closing of the IPO on October 31, 2017, the Company recognized stock-based compensation expense of approximately $24.1 million related to the performance-based stock options and RSUs.

In September 2017, the Company amended its Chief Executive Officer's (“CEO”) employment agreement to provide for accelerated vesting of all of the CEO’s equity awards upon his termination due to death or disability while executing his employment duties. As a result of this modification to the CEO’s vesting terms, the Company expects to record an incremental $7.6 million in stock-based compensation expense over the service period beginning in October 2017 following the completion of the Company's IPO.

Determining the Fair Value of Stock Options

The fair value of stock option awards is estimated using the Black-Scholes option-pricing model.

The assumptions used to determine the grant date fair value of employee stock options for the periods presented are as follows:



	Three Months Ended September 30,		Nine Months Ended September 30,
	2017	2016	2017	2016
Fair value of common stock	$19.78 – $19.78	$18.18 – $19.56	$16.73 – $19.78	$15.78 – $19.56
Risk-free interest rate	1.9% – 2.0%	1.2% – 1.3%	1.9% – 2.1%	1.2% – 1.6%
Expected term (in years)	6.0 – 6.1	6.1 – 6.2	6.0 – 6.1	6.0 – 8.1
Volatility	47% – 48%	50% – 51%	47% – 49%	47% – 51%
Dividend yield	—%	—%	—%	—%

Note 4. Income Taxes

The Company estimates its annual effective tax rate each quarter and specific events are discretely recognized as they occur under the provisions of ASC 740-270. For the three and nine months ended September 30, 2017, the Company recorded a tax provision of $412,000 and $1.2 million, respectively, representing an effective tax rate of (6.1)% and (2.3)%, respectively. The Company’s effective tax rates for these periods were negative as it has maintained a valuation allowance on the U.S. losses. The key components of the income tax provision primarily consist of foreign income taxes, income tax reserves, and U.S. state minimum taxes. As compared to the same periods last year, the difference in the effective tax rate is primarily due to change in the uncertain tax positions as a result of a statutory income tax and withholding tax audit in one of our foreign subsidiaries.

For the three and nine months ended September 30, 2016, the Company recorded a tax provision of $157,000 and $517,000, respectively, representing an effective tax rate of (0.9)% for each period. The Company’s effective tax rates for these periods were negative as it maintained a valuation allowance on the U.S. losses. The key components of the income tax provision primarily consisted of foreign income taxes, income tax reserves, and U.S. state minimum taxes.

Note 5. Net Loss Per Share

Net loss per share of common stock is computed using the two-class method required for participating securities based on their participation rights. All series of redeemable convertible preferred stock are participating securities as the holders are entitled to participate in common stock dividends with common stock on an as-converted basis. The holders of the Company’s redeemable convertible preferred stock are also entitled to noncumulative dividends prior and in preference to common stock and do not have a contractual obligation to share in the losses of the Company. In accordance with the two-class method, earnings allocated to these participating securities, which include participation rights in undistributed earnings with common stock, are subtracted from net loss to determine net loss attributable to common stockholders.

Basic net loss per share is computed by dividing net loss attributable to common stockholders by basic weighted-average shares outstanding during the period. All participating securities are excluded from basic weighted-average shares outstanding. In computing diluted net loss attributable to common stockholders, undistributed earnings are re-allocated to reflect the potential impact of dilutive securities. Diluted net loss per share attributable to common stockholders is computed by dividing net loss attributable to common stockholders by diluted weighted-average shares outstanding, including potentially dilutive securities, unless anti-dilutive.

The following table presents the computation of basic and diluted net loss per share attributable to common stockholders (in thousands, except share and per share amounts):



	Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016

Net loss attributable to common stockholders	$	(7,165	)	$	(18,312	)	$	(54,860	)	$	(57,960	)
Weighted-average shares used to compute net loss per share attributable to common stockholders, basic and diluted	6,139,876			5,749,930			6,032,427			5,539,012
Net loss per share attributable to common stockholders, basic and diluted	$	(1.17	)	$	(3.18	)	$	(9.09	)	$	(10.46	)

The following securities were excluded from the computation of diluted net loss per share attributable to common stockholders for the periods presented because their inclusion would reduce the net loss per share.



	As of September 30,
	2017	2016

Options to purchase common stock	9,413,141	9,403,045
Unvested early exercised common shares	231,423	364,800
Unvested restricted stock units	3,031,223	1,039,121
Warrants to purchase common stock	233,023	233,023
Redeemable convertible preferred stock	24,788,362	24,788,362
Warrants to purchase redeemable convertible preferred stock	292,862	292,862

Note 6. Segment Information

The Company’s business is conducted globally. The Company’s chief operating decision maker, who is the CEO, reviews financial information presented on a consolidated basis accompanied by information regarding revenue by geographic region for purposes of allocating resources and evaluating financial performance. There is one business activity and there are no segment managers who are held accountable for operations, operating results, and plans for levels, components, or types of products or services below the consolidated unit level. Accordingly, the Company has a single reporting segment and operating unit structure.

Revenue by geographic area is attributed based on the billing address of the customer and is as follows (in thousands):



	Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016
Revenue:
Americas
United States	$	50,348	$	39,877	$	119,409	$	92,486
Other Americas	1,602		1,481		3,989		3,421
Total Americas	51,950		41,358		123,398		95,907
Europe, Middle East, and Africa (“EMEA”)	8,071		4,350		21,275		13,820
Asia Pacific and Japan (“APJ”)	4,335		3,032		10,242		7,684
Total revenue	$	64,356	$	48,740	$	154,915	$	117,411

Long-lived assets, net by geographic area are attributed based on legal entity structure and are as follows (in thousands):



	As of
	September 30, 2017		December 31, 2016
Long-lived assets, net:
United States	$	19,682	$	21,141
Israel	3,034		3,051
Other	548		344
Total long-lived assets, net	$	23,264	$	24,536

Note 7. Subsequent Events

On October 16, 2017, as an inducement for the holders of Series G redeemable preferred stock to convert their shares of Series G preferred stock into common stock immediately prior to the IPO, the Company amended and restated its amended and restated certificate of incorporation to adjust the conversion rate for the Series G redeemable preferred stock in the event the IPO price was less than $29.66 per share. On October 31, 2017, based on an IPO price of $22.00 per share, the Company issued 582,254 additional shares of common stock to the holders of shares of Series G redeemable

preferred stock upon conversion of Series G redeemable preferred stock into shares of common stock immediately prior to the closing of the IPO. The stock issuance was accounted for as a stock dividend at the time of issuance.

On October 16, 2017, the Company’s stockholders approved the Company’ s 2017 Equity Incentive Plan (the “2017 Plan”), and the Company’ s 2017 Employee Stock Purchase Plan (the “ESPP”). The 2017 Plan provides for the grant of incentive stock options, nonstatutory stock options, restricted stock, restricted stock units, stock appreciation rights, performance stock units, performance shares, and performance awards. A total of 3,800,000 shares of the Company’s common stock are reserved for future issuance pursuant to the 2017 Plan. In addition, shares subject to outstanding awards granted under the Company’s 2000 Plan (the “2000 Plan”), that are canceled, expire, or otherwise terminate without having been exercised in full and shares previously issued under the 2000 Plan that are forfeited to the Company, tendered to or withheld by the Company for the payment of an award’s exercise price or for tax withholding, or repurchased by the Company, may be added to the 2017 Plan (provided that the maximum number of shares that may be added to the Company’s 2017 Plan pursuant to the provision in this sentence is 12,500,000 shares). The number of shares available for future issuance under the Company’s 2017 Plan also includes automatic annual increases on the first day of the Company’s fiscal year beginning with 2018, equal to the least of: 3,800,000 shares; 5% of the outstanding shares of common stock as of the last day of the Company’s immediately preceding fiscal year; or such lower number of shares as determined by the administrator of the 2017 Plan.

The ESPP allows eligible employees to purchase shares of the Company’s common stock through payroll deductions and is intended to qualify under Section 423 of the Internal Revenue Code. A total of 800,000 shares of the Company’s common stock are available for sale under the ESPP. The number of shares available for issuance under the Company’s ESPP will also include an automatic, annual increase on the first day of each fiscal year of the Company beginning in 2018, equal to the lesser of: 800,000 shares; 1% of the total number of shares of the Company’s common stock outstanding on the last day of the Company’s immediately preceding fiscal year; or such lower number of shares as determined by the administrator of the ESPP. The ESPP provides for consecutive, overlapping six month offering periods. The offering periods are scheduled to start on the first trading day on or after May 20 and November 20 of each year, except for the first offering period which began on October 26, 2017 and will end on the first trading day on or after May 20, 2018. Participants may purchase the Company’s common stock through payroll deductions, of up to a maximum of 15% of their eligible compensation. Participation will end automatically upon termination of employment with the Company. The purchase price of the shares will be 85% of the lower of the fair market value of the Company’s common stock on the first trading day of each offering period or on the exercise date.

On October 24, 2017, Network Security Technologies, LLC, or NST, filed a lawsuit against the Company alleging patent infringement. NST is seeking compensatory damages and attorneys’ fees. The Company believes it has meritorious defenses and intends to vigorously defend the claims against the Company. This litigation is still in its early stages and the final outcome, including any estimated liability, if any, with respect to these claims, is uncertain. At present, the Company is unable to estimate a reasonably possible range of loss, if any, that may result from this matter.

On October 27, 2017 and November 1, 2017, warrants to purchase the Company's common stock were exercised for a total 442,648 shares at exercise prices of $6.00 and $6.62 per share. In lieu of payment of the aggregate warrant price, the warrant holders elected a "cashless exercise", whereby a portion of the shares equal to the aggregate warrant price were withheld. The average fair market value at the time exercise was $25.73, which resulted in 335,838 shares being issued by the Company.




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 appearing elsewhere in this Quarterly Report on Form 10-Q and with our Management’s Discussion and Analysis of Financial Condition and Results of Operations and financial statements included in our Prospectus filed on October 27, 2017, pursuant to Rule 424(b) under the Securities Act with the SEC. This discussion contains forward-looking statements based upon current plans, expectations and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. See “Special Note Regarding Forward-Looking Statements” above.

Unless expressly indicated or the context requires otherwise, the terms "ForeScout," "we," "us," and "our" in this document refer to ForeScout Technologies, Inc., a Delaware corporation, and, where appropriate, its wholly owned subsidiaries.

Overview

We generate revenue from sales of our products and associated maintenance and professional services. Our products include: ForeScout CounterACT, ForeScout Enterprise Manager, and ForeScout Extended Modules. Our CounterACT and Enterprise Manager products are sold as hardware appliances embedded with our software, or Physical Appliances, or as software only, or Virtual Appliances. We recently started offering, in limited quantities to a small number of large enterprises, CounterAct and Enterprise Manager together as a software-only license, or Enterprise License Software. Our Enterprise License Software is either sold with separate hardware or without hardware, depending on the end-customer’s selection. Our Extended Modules are sold as software add-ons to the CounterACT and Enterprise Manager products. All of our products are sold with a perpetual license. End-customers typically purchase maintenance and professional services when they purchase one or more of our products. Our support and maintenance contracts typically have a one-year or three-year term. We offer a portfolio of professional services and extended support contract options to assist with additional deployment and ongoing advanced technical support. We market and sell our products, maintenance, and professional services through a direct touch, channel-fulfilled model. Our direct sales force is responsible for cultivating relationships and selling solutions to enterprise and public sector accounts globally. We leverage the global breadth and reach of our channel ecosystem, including value-added resellers and distributors, to fulfill orders and sell to our mid-market end-customers.

Our CounterACT products are priced based on the number of devices managed on each Physical or Virtual Appliance. Our largest Physical and Virtual Appliance can manage up to 10,000 devices while our smallest Physical and Virtual Appliance can manage up to 100 devices. Our Enterprise License Software generally manages a minimum of 100,000 devices and increases the number of managed devices in increments of 100 depending on the end-customer’s requirements. Our Enterprise Manager is priced based on the number of CounterACT Physical and Virtual Appliances managed. Our high-end Enterprise Manager product can manage up to 200 CounterACT Physical and Virtual Appliances while our low-end Enterprise Manager product can manage up to five Physical and Virtual Appliances. Our Extended Modules are sold in units of 100 managed devices today.

Third Quarter 2017 Financial Highlights

As of September 30, 2017, we have sold to over 2,600 end-customers in 80 countries including 17% of the Global 2000, since our inception. For the three months ended September 30, 2017 and 2016, we sold to 6% and 5% of the Global 2000, respectively. Our end-customers represent a broad range of industries, including public sector entities, financial services, healthcare, technology, manufacturing, services, energy, and retail.

We have experienced rapid growth in recent periods. For the three months ended September 30, 2017 and 2016, our revenue was $64.4 million and $48.7 million, respectively, representing period-over-period growth of 32%. For the nine months ended September 30, 2017 and 2016, our revenue was $154.9 million and $117.4 million, respectively, representing period-over-period growth of 32%.


•	Product revenue was $39.2 million for the three months ended September 30, 2017, an increase of 27% from the three months ended September 30, 2016. Maintenance and professional services revenue was

$25.2 million for the three months ended September 30, 2017, an increase of 40% from the three months ended September 30, 2016.


•	For the three months ended September 30, 2017, gross profit was $48.5 million, or 75% of total revenue, compared to $35.2 million, or 72% of total revenue in the three months ended September 30, 2016.


•	For the three months ended September 30, 2017, operating loss was $6.6 million, or 10% of total revenue, compared to an operating loss of $17.0 million, or 35% of total revenue in the three months ended September 30, 2016.


•	For the three months ended September 30, 2017, net loss was $7.2 million compared to a net loss of $18.3 million in three months ended September 30, 2016.


•	Net cash provided by operating activities was $2.3 million for the three months ended September 30, 2017, compared to $20.4 million net cash used in operating activities in the three months ended September 30, 2016.

Factors Affecting Our Performance

We believe that the growth of our business and our future success are dependent upon many factors, including our ability to extend the reach of our sales force footprint to engage more end-customers, to continue to increase the efficiency by which our sales force engages our end-customers and to retain and continue sales to existing end customers. While each of these areas presents significant opportunities for us, they also pose significant risks and challenges that we must successfully address in order to sustain the growth of our business and improve our results of operations.

Extending the Reach of Our Sales Footprint

We have made substantial investments in our sales force in recent periods in order to address the significant enterprise opportunity caused by an increase in unmanaged devices coming onto networks. We have almost tripled the size of our quota-bearing sales representatives from the beginning of 2015 to September 30, 2017. We expect to continue to make investments in our sales force to increase adoption within the Global 2000 and public sector.

Increasing the Efficiency by which Our Sales Force Engages Our End-Customers

We are focused on increasing the efficiency of our sales force. We have increased hiring in sales enablement and marketing, enhanced sales training activities, and implemented company-wide standards for product positioning in order to instill a culture of success and discipline in our sales organization. Our sales strategy depends on attracting top talent from security organizations, expanding our sales coverage, increasing our pipeline of business, and enhancing productivity. We focus on productivity per quota-carrying sales representative across different levels within the sales organization, and the time it takes our sales representatives to reach productivity. We manage our pipeline on a quarterly basis, by sales representative, to ensure sufficient coverage of our bookings targets. Our ability to manage our sales productivity and pipeline are important factors to the success of our business.

Retain and Continue Sales to Existing End-Customers

We believe the net-recurring revenue retention rate on our support and maintenance contracts is an important metric to measure our ability to retain and increase sales to our existing end-customers. We calculate the net-recurring revenue retention rate on support and maintenance contracts as the trailing 12 month annualized value of support and maintenance contracts renewed plus the trailing 12 month annualized value of support and maintenance contracts not subject to renewal because the scheduled expiration date of the multi-year support and maintenance contract falls outside of the 12 month period under measurement plus the annualized value of new support and maintenance contracts from end-customers acquired one year prior, in the aggregate, divided by the aggregate of the trailing 12 months annualized value of support and maintenance contracts scheduled to terminate or renew during the trailing 12 period plus the trailing 12 month annualized value of support and maintenance contracts not subject to renewal because the scheduled expiration date of the multi-year support and maintenance contract falls outside of the 12 month period under measurement. We believe this metric is an indication of the continuing value we provide to our end-customers because it shows the renewal of their support and maintenance contracts on their existing IP-based devices and the expanded value to our end-

customers demonstrated by increases in the number of IP-based devices. Our net-recurring revenue retention rate on support and maintenance contracts as of September 30, 2017, December 31, 2016, and December 31, 2015 were 123%, 127%, and 116%, respectively. A net retention rate over 100% indicates that our products are expanding within our end-customer base, whereas a rate less than 100% indicates that our products are constricting within our end-customer base. Additionally, this calculation includes all changes to the annualized value of the recurring revenue from support and maintenance contracts for the designated set of support and maintenance contracts used in the calculation, which includes scheduled expiration periods, stub periods, changes in pricing, additional products purchased, lost end-customers, early renewals, decreases in the number of Physical or Virtual Appliances, decreases in the number of devices and hardware included in our Enterprise Software License and Extended Modules under contract. This metric does not take into account product revenue or professional services revenue. The annualized value of our support and maintenance contracts is a legal and contractual determination made by assessing the contractual terms with our end-customers. The annualized value of our support and maintenance contracts is not determined by reference to historical revenue, deferred revenue or any other GAAP financial measure over any period.

Key Financial Metrics

Non-GAAP Operating Loss and Free Cash Flow

In addition to our results determined in accordance with U.S. generally accepted accounting principles, or GAAP, we monitor the non-GAAP financial metrics described below to evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and measure and assess operational efficiencies.

We define non-GAAP operating loss as loss from operations excluding stock-based compensation expense. We consider non-GAAP operating loss to be a useful metric for investors and other users of our financial information in evaluating our operating performance because it excludes the impact of stock-based compensation, a non-cash charge that can vary from period to period for reasons that are unrelated to our core operating performance. This metric also provides investors and other users of our financial information with an additional tool to compare business performance across companies and periods, while eliminating the effects of items that may vary for different companies for reasons unrelated to core operating performance.

We define free cash flow as net cash (used in) provided by operating activities less purchases of property and equipment. We consider free cash flow to be an important metric because it measures the amount of cash we use or generate and reflects changes in working capital.

A reconciliation of non-GAAP operating loss to loss from operations, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016
	(In thousands)
Non-GAAP operating loss:
Loss from operations	$	(6,623	)	$	(17,003	)	$	(52,278	)	$	(55,396	)
Add: stock-based compensation expense	3,909			3,818			12,060			12,862
Non-GAAP operating loss	$	(2,714	)	$	(13,185	)	$	(40,218	)	$	(42,534	)

A reconciliation of free cash flow to net cash (used in) provided by operating activities, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016
	(In thousands)
Free cash flow (non-GAAP):
Net cash provided by (used in) operating activities	$	2,313		$	(20,411	)	$	3,563		$	(30,395	)
Less: purchases of property and equipment	(592		)	(5,855		)	(3,386		)	(19,959		)
Free cash flow (non-GAAP)	$	1,721		$	(26,266	)	$	177		$	(50,354	)
Net cash used in investing activities	$	(586	)	$	(3,866	)	$	(3,512	)	$	(20,162	)
Net cash (used in) provided by financing activities	$	(1,918	)	$	94		$	(7,372	)	$	3,306

It is important to note that other companies, including companies in our industry, may not use non-GAAP operating loss or free cash flow, may calculate these metrics differently, or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of these non-GAAP metrics as comparative measures.

As a result, our non-GAAP operating loss and free cash flow should be considered in addition to, not as substitutes for or in isolation from, measures prepared in accordance with GAAP.

We compensate for these limitations by providing investors and other users of our financial information, reconciliations of non-GAAP operating loss to the corresponding GAAP financial measure, operating loss, and reconciliations of free cash flow to the corresponding GAAP financial measure, cash flow (used in) provided by operating activities. We encourage investors and others to review our financial information in its entirety, not to rely on any single financial measure, and to view non-GAAP operating loss and free cash flow in conjunction with the corresponding GAAP financial measure.

Components of Financial Performance

Revenue

We derive revenue from sales of our products, maintenance, and professional services. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is reasonably assured.

Our revenue is comprised of the following:

•Product Revenue. Our product revenue is derived from sales of our Physical Appliances, Virtual Appliances, Extended Modules, Enterprise License Software, and hardware sold separately, which is recognized either up-front or ratably depending on the terms of the agreement and the product composition. Hardware Product revenue, which includes our Physical Appliances and Enterprise License Software sold with separate hardware, is recognized at the time of delivery, provided that all other revenue recognition criteria have been met. Software Product revenue, which includes Virtual Appliances, Enterprise License Software sold without hardware and Extended Modules, is recognized at the time of delivery if VSOE is established for all undelivered related items. If VSOE does not exist for one or more undelivered items, revenue from the software portion of the arrangement is deferred until the delivery of all items has begun and is then recognized ratably over the longest remaining service period, which generally is the support and maintenance term. Beginning on January 1, 2016, we established VSOE for professional services, and support and maintenance on Software Products, except Extended Modules. As a percentage of total revenue, we expect our product revenue to vary from quarter to quarter based on seasonal and cyclical factors.

•Maintenance and Professional Services Revenue. Our maintenance revenue is derived from support and maintenance contracts with terms that are generally either one or three years. We typically bill for support and maintenance contracts upfront. We recognize revenue from support and maintenance over the contractual service period. Our professional services revenue is generally recognized as the services are rendered. We intend to invest in our

professional services organization to improve the time to deliver these services. As a percentage of total revenue, we expect our maintenance and professional services revenue to vary from quarter to quarter based on seasonal and cyclical factors.

Cost of Revenue

•Cost of Product Revenue. Cost of product revenue primarily consists of costs paid to our third-party contract manufacturer for our Physical Appliances and hardware sold with our Enterprise License Software. Our cost of product revenue also includes allocated costs, shipping costs, and personnel costs associated with logistics. There is no direct cost of revenue associated with our Software Products because Software Products are delivered electronically. We expect our cost of product revenue to fluctuate from quarter to quarter based on product mix; however, over time, we expect our cost of product revenue to decline as a percentage of product revenue primarily due to a shift in product mix towards increased sales of Software Products.

•Cost of Maintenance and Professional Services Revenue. Cost of maintenance and professional services revenue consists of personnel costs for our global customer support and professional services organization and costs paid to third-party contractors that deliver some of our services. Over time, we expect our cost of maintenance and professional services revenue to decline as a percentage of our maintenance and professional services revenue as we expect to scale our customer support organization at a lower growth rate than our anticipated maintenance and professional services revenue growth rate.

Gross Margin

Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including the mix of products sold between Hardware Products and Software Products; the mix of revenue between products, maintenance, and professional services; the average sales price of our products, maintenance and professional services; and manufacturing costs. Our gross margins vary by product, with gross margin on our high-end Physical Appliances ranging from 80% to 83% and our low-end Physical Appliances ranging from 59% to 62% from the beginning of 2015 to September 30, 2017. Gross margin on hardware sold with Enterprise License Software ranged from 14% to 30% for the nine months ended September 30, 2017. Gross margin on our Software Products was 99% for the nine months ended September 30, 2017 and 2016. Our gross margins will fluctuate depending on our product, maintenance and professional services mix and the types of products we sell in a given period. Over time, as Software Products become a greater percentage of product revenue, we expect our gross margins to increase.

Operating Expenses

Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. Personnel costs are the most significant component of operating expenses and consists of salaries, benefits, bonuses, stock-based compensation, and with regard to sales and marketing expense, sales commissions.

•

Research and Development. Research and development expense consists primarily of personnel costs. Research and development expense also includes consulting expense and allocated costs including facilities and information technology related costs. We expect research and development expense to increase in the near term in absolute dollars as we continue to invest in our future products and services; however, we expect our research and development expense to decline as a percentage of total revenue in the long term as we scale the business.

•

Sales and Marketing. Sales and marketing expense consists primarily of personnel costs, including commission costs. We expense commission costs as incurred. Sales and marketing expense also includes costs for market development programs, promotional and other marketing costs, travel costs, professional services, and allocated costs including facilities and information technology related costs. We expect sales and marketing expense to continue to increase in absolute dollars as we increase the size of our sales and marketing organizations; however, we expect our sales and marketing expense to decline as a percentage of total revenue in the long term as we scale the business.

•

General and Administrative. General and administrative expense consists of personnel costs, professional services, certain non-recurring general expenses, and allocated costs including facilities and information technology related costs. General and administrative personnel include our executive, finance, human resources, and legal organizations. Professional services consist primarily of legal, auditing, accounting, and other consulting costs. We expect general and administrative expense to increase in absolute dollars due to additional costs associated with accounting, compliance, insurance, and investor relations, however, we expect our general and administrative expense to decline as a percentage of total revenue in the long term as we scale the business.

Interest Expense

Interest expense consists of interest on our outstanding indebtedness.

Other Income (Expense), Net

Other income (expense), net consists primarily of foreign currency exchange losses related to transactions denominated in currencies other than the U.S. Dollar, and interest income earned on our cash and cash equivalents.

Change in Fair Value of Warrant Liabilities

Change in fair value of warrant liabilities includes adjustments to the estimated fair value of the preferred and common stock warrants outstanding. We mark-to-market our warrant liabilities on a quarterly basis, and as such, we will have fluctuations in our consolidated financial statements.

Provision for Income Taxes

Provision for income taxes consists primarily of foreign income taxes and reserves, withholding taxes, and U.S. state income taxes. We maintain a full valuation allowance for domestic net deferred tax assets. Our foreign deferred tax assets are immaterial.

We recorded an income tax provision for the three and nine months ended September 30, 2017 due to foreign income taxes, income tax reserves and U.S. state minimum taxes.

Results of Operations

The following tables summarize our results of operations for the periods presented in dollars and as a percentage of our total revenue. The period-to-period comparison of results is not necessarily indicative of results for future periods.



	Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016
	(Dollars in thousands)
Condensed Consolidated Statements of Operations Data:
Revenue:
Product	$	39,192		$	30,799		$	83,889		$	68,861
Maintenance and professional services	25,164			17,941			71,026			48,550
Total revenue	64,356			48,740			154,915			117,411
Cost of revenue:
Product ⁽¹⁾	7,201			6,563			17,117			13,754
Maintenance and professional services ⁽¹⁾	8,688			6,945			25,662			19,304
Total cost of revenue	15,889			13,508			42,779			33,058
Total gross profit	48,467			35,232			112,136			84,353
Operating expenses:
Research and development ⁽¹⁾	10,985			8,509			32,634			22,352
Sales and marketing ⁽¹⁾	34,957			35,759			104,515			94,316
General and administrative ⁽¹⁾	9,148			7,967			27,265			23,081
Total operating expenses	55,090			52,235			164,414			139,749
Loss from operations	(6,623		)	(17,003		)	(52,278		)	(55,396		)
Interest expense	(290		)	(702		)	(953		)	(2,072		)
Other income (expense), net	160			(226		)	(66		)	(354		)
Change in fair value of warrant liabilities	—			(224		)	(342		)	379
Loss before income taxes	(6,753		)	(18,155		)	(53,639		)	(57,443		)
Income tax provision	412			157			1,221			517
Net loss and comprehensive loss	$	(7,165	)	$	(18,312	)	$	(54,860	)	$	(57,960	)

_____________________


(1)	Includes stock-based compensation expense as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016
	(In thousands)
Cost of revenue:
Product	$	19	$	6	$	60	$	16
Maintenance and professional services	286		317		930		809
Research and development	630		613		2,043		1,645
Sales and marketing	1,602		1,543		4,868		6,469
General and administrative	1,372		1,339		4,159		3,923
Total	$	3,909	$	3,818	$	12,060	$	12,862



	Three Months Ended September 30,				Nine Months Ended September 30,
	2017		2016		2017		2016
	(As a percentage of total revenue)
Condensed Consolidated Statements of Operations Data:
Revenue:
Product	61	%	63	%	54	%	59	%
Maintenance and professional services	39		37		46		41
Total revenue	100		100		100		100
Cost of revenue:
Product	12		14		11		12
Maintenance and professional services	13		14		17		16
Total cost of revenue	25		28		28		28
Total gross profit	75		72		72		72
Operating expenses:
Research and development	17		18		21		19
Sales and marketing	54		73		67		80
General and administrative	14		16		18		20
Total operating expenses	85		107		106		119
Loss from operations	(10	)	(35	)	(34	)	(47	)
Interest expense	—		(2	)	—		(2	)
Other income (expense), net	—		(1	)	—		—
Loss before income taxes	(10	)	(38	)	(34	)	(49	)
Income tax provision	1		—		1		—
Net loss and comprehensive loss	(11	)%	(38	)%	(35	)%	(49	)%

Comparison of the Three Months Ended September 30, 2017 and 2016

Revenue



	Three Months Ended September 30,
	2017		2016		Change
	Amount		Amount		Amount		%
	(Dollars in thousands)
Revenue:
Product	$	39,192	$	30,799	$	8,393	27	%
Maintenance and professional services
Support and maintenance	22,036		15,483		6,553		42	%
Professional services	3,128		2,458		670		27	%
Total maintenance and professional services	25,164		17,941		7,223		40	%
Total revenue	$	64,356	$	48,740	$	15,616	32	%

Product revenue increased $8.4 million, or 27%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016, primarily due to a $10.7 million increase in Enterprise License Software and hardware sold with Enterprise License Software, offset by a $1.3 million decrease in Extended Modules, a $0.6 million decrease in Virtual Appliances, and a $0.4 million decrease in Physical Appliances.

Maintenance and professional services revenue increased $7.2 million, or 40%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016. $3.7 million of the increase in maintenance and professional services revenue was attributed to support and maintenance contract value associated with an initial product sale, $2.8 million was attributed to support and maintenance contracts that were renewals, and $0.7 million was attributed to increased sales of professional services.

Cost of Revenue



	Three Months Ended September 30,
	2017		2016		Change
	Amount		Amount		Amount		%
	(Dollars in thousands)
Cost of revenue:
Product	$	7,201	$	6,563	$	638	10	%
Maintenance and professional services	8,688		6,945		1,743		25	%
Total cost of revenue	$	15,889	$	13,508	$	2,381	18	%

Total cost of revenue increased $2.4 million, or 18%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016.

Product cost of revenue increased $0.6 million, or 10%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016 primarily due to a higher volume of Hardware Products sold, consisting of $1.4 million of hardware sold with Enterprise License Software, offset by a decrease of $0.8 million of Physical Appliances sold.

Maintenance and professional services cost of revenue increased $1.7 million, or 25%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016 due to increases in personnel costs related to increasing headcount in our customer support and professional services organization. From September 30, 2016 to September 30, 2017, we increased our customer support and professional services organization’s headcount by 17%.

Gross Profit and Gross Margin



	Three Months Ended September 30,
	2017				2016				Change
	Gross Profit		Gross Margin		Gross Profit		Gross Margin		Gross Profit		Gross Margin
	(Dollars in thousands)
Gross profit:
Product	$	31,991	82	%	$	24,236	79	%	$	7,755	3	%
Maintenance and professional services	16,476		65	%	10,996		61	%	5,480		4	%
Total gross profit	$	48,467	75	%	$	35,232	72	%	$	13,235	3	%

Gross profit increased by $13.2 million, or 38%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016. The increase is consistent with the increases in our revenue and cost of revenue.

Gross margin increased by 3% for the three months ended September 30, 2017 compared to the three months ended September 30, 2016. The increase of 3% in product margin was driven by a shift in product revenue mix with increased sales of Software Products as compared to Hardware Products. The increase in maintenance and professional services margin was driven by the improvement in margins for professional services.

Operating Expenses



	Three Months Ended September 30,
	2017		2016		Change
	Amount		Amount		Amount			%
	(Dollars in thousands)
Operating expenses:
Research and development	$	10,985	$	8,509	$	2,476		29	%
Sales and marketing	34,957		35,759		(802		)	(2	)%
General and administrative	9,148		7,967		1,181			15	%
Total operating expenses	$	55,090	$	52,235	$	2,855		5	%

Research and development expense increased $2.5 million, or 29%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016, primarily due to an increase in personnel and travel costs of $1.9 million, due to an increase in headcount of 11%, an increase in allocated facilities costs of $0.4 million, and an increase of $0.2 million in professional fees and other operating costs.

Sales and marketing expense decreased $0.8 million, or 2%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016, primarily due to a decrease in commissions of $4.4 million due to accelerated commission expenses in the prior year related to a very large deal, offset by an increase in personnel costs of $2.4 million, due to an increase in headcount of 3%, an increase in travel and entertainment costs of $0.9 million, and an increase in allocated facilities costs of $0.3 million, all related to the increase in headcount.

General and administrative expense increased $1.2 million, or 15%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016, primarily due to an increase in personnel and travel costs of $0.7 million, largely due to an increase in headcount of 6%, an increase of $0.3 million in professional fees and an increase of $0.2 million in investor relations.

If the initial public offering had occurred on September 30, 2017, we would have recognized $22.1 million of stock-based compensation expense for all stock options and RSUs with a performance condition that had satisfied the service-based vesting condition on that date and the remaining unrecognized compensation cost of approximately $31.0 million would be recognized over the remaining service period of 1.9 years.

Interest Expense



	Three Months Ended September 30,
	2017			2016			Change
	Amount			Amount			Amount		%
	(Dollars in thousands)
Interest expense	$	(290	)	$	(702	)	$	412	(59	)%

Interest expense decreased $412,000, or 59%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016, primarily due to the lower fixed interest rate per annum associated with our amended and restated loan and security agreement entered into on December 22, 2016, compared to our previous loan and security agreement which was paid off on December 1, 2016.

Other Income (Expense), Net



	Three Months Ended September 30,
	2017		2016			Change
	Amount		Amount			Amount		%
	(Dollars in thousands)
Other income (expense), net	$	160	$	(226	)	$	386	171	%

Other income (expense), net increased $386,000, or 171%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016, primarily due to a foreign exchange gain of $43,000 in the current period compared to a loss of $263,000 in the prior period on transactions denominated in currencies other than the U.S. Dollar, and an increase in interest income from money market fund investments.

Change in Fair Value of Warrant Liabilities



	Three Months Ended September 30,
	2017		2016			Change
	Amount		Amount			Amount		%
	(Dollars in thousands)
Change in fair value of warrant liabilities	$	—	$	(224	)	$	224	(100	)%

Change in fair value of warrant liabilities decreased $224,000, or 100%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016 due to the change in estimated fair value of the preferred and common stock warrants outstanding.

Provision for Income Taxes



	Three Months Ended September 30,
	2017			2016			Change
	Amount			Amount			Amount		%
	(Dollars in thousands)
Income tax provision	$	412		$	157		$	255	162	%
Effective tax rate	(6.1		)%	(0.9		)%

We recorded an income tax provision for the three months ended September 30, 2017 due to foreign income taxes, income tax reserves and U.S. state minimum taxes. The increase in the provision for the three months ended September 30, 2017 compared to the three months ended September 30, 2016 was primarily due to an increase in pre-tax income related to international operations, and an increase in income tax reserves related to a statutory income tax and withholding tax audit in one of our foreign subsidiaries.

Comparison of the Nine Months Ended September 30, 2017 and 2016

Revenue



	Nine Months Ended September 30,
	2017		2016		Change
	Amount		Amount		Amount		%
	(Dollars in thousands)
Revenue:
Product	$	83,889	$	68,861	$	15,028	22	%
Maintenance and professional services
Support and maintenance	61,909		41,819		20,090		48	%
Professional services	9,117		6,731		2,386		35	%
Total maintenance and professional services	71,026		48,550		22,476		46	%
Total revenue	$	154,915	$	117,411	$	37,504	32	%

Product revenue increased $15.0 million, or 22%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016, due to a $16.9 million increase in Enterprise License Software and hardware sold with Enterprise License Software, and a $4.4 million increase in Physical Appliances, offset by a $3.8 million decrease in Virtual Appliance and a $2.5 million decrease in Extended Modules.

Maintenance and professional services revenue increased $22.5 million, or 46%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016. $13.2 million of the increase in maintenance and professional services revenue was attributed to support and maintenance contract value associated with an initial product sale, $6.9 million was attributed to support and maintenance contracts that were renewals, and $2.4 million was attributed to increased sales of professional services.

Cost of Revenue



	Nine Months Ended September 30,
	2017		2016		Change
	Amount		Amount		Amount		%
	(Dollars in thousands)
Cost of revenue:
Product	$	17,117	$	13,754	$	3,363	24	%
Maintenance and professional services	25,662		19,304		6,358		33	%
Total cost of revenue	$	42,779	$	33,058	$	9,721	29	%

Total cost of revenue increased $9.7 million, or 29%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016.

Product cost of revenue increased $3.4 million, or 24%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016 primarily due to a higher volume of Hardware Products sold, consisting of $2.7 million of hardware sold with Enterprise License Software, and $0.7 million of Physical Appliances.

Maintenance and professional services cost of revenue increased $6.4 million, or 33%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016 due to increases in personnel costs related to increasing headcount. From September 30, 2016 to September 30, 2017, we increased our customer support and professional services organization’s headcount by 17%.

Gross Profit and Gross Margin



	Nine Months Ended September 30,
	2017				2016				Change
	Gross Profit		Gross Margin		Gross Profit		Gross Margin		Gross Profit		Gross Margin
	(Dollars in thousands)
Gross profit:
Product	$	66,772	80	%	$	55,107	80	%	$	11,665	—	%
Maintenance and professional services	45,364		64	%	29,246		60	%	16,118		4	%
Total gross profit	$	112,136	72	%	$	84,353	72	%	$	27,783	—	%

Gross profit increased by $27.8 million, or 33% for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016. The increase in gross profit is consistent with the increases in our revenue and cost of revenue.

Gross margin remained flat for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016. Product margins remained flat but were comprised of a 2% decline in Hardware Product margins being offset by higher sales of Software Products as a percentage of total product revenue. The increase in maintenance and professional services margin was driven by the improvement in margins for professional services.

Operating Expenses



	Nine Months Ended September 30,
	2017		2016		Change
	Amount		Amount		Amount		%
	(Dollars in thousands)
Operating expenses:
Research and development	$	32,634	$	22,352	$	10,282	46	%
Sales and marketing	104,515		94,316		10,199		11	%
General and administrative	27,265		23,081		4,184		18	%
Total operating expenses	$	164,414	$	139,749	$	24,665	18	%

Research and development expense increased $10.3 million, or 46%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016, primarily due to an increase in personnel and travel costs of $7.6 million, due to an increase in headcount of 11%, an increase in allocated facilities and information technology related costs of $1.3 million, an increase in professional fees of $0.7 million, and an increase in equipment and other operating costs of $0.7 million.

Sales and marketing expense increased $10.2 million, or 11%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016, primarily due to an increase in personnel costs of $8.5 million, due to an increase in headcount of 3%, offset by a decrease in commissions of $2.9 million due to accelerated commission expenses in the prior year related to a very large deal. Additionally, there was an increase in travel and entertainment costs of $3.3 million, and an increase in allocated facilities and information technology costs of $1.3 million, all related to the increase in headcount.

General and administrative expense increased $4.2 million, or 18%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016, primarily due to an increase in personnel and travel costs of $3.3 million, due to an increase in headcount of 6%, an increase in professional fees of $1.2 million, an

increase in investor relation costs of $0.6 million and an increase in allocated facilities and other operating costs of $0.4 million, offset by a decrease of $1.3 million due to a settlement in the prior year of a disagreement with one of our partners.

Interest Expense



	Nine Months Ended September 30,
	2017			2016			Change
	Amount			Amount			Amount		%
	(Dollars in thousands)
Interest expense	$	(953	)	$	(2,072	)	$	1,119	(54	)%

Interest expense decreased $1.1 million, or 54%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016, primarily due to the lower fixed interest rate per annum associated with our amended and restated loan and security agreement entered into on December 22, 2016, compared to our previous loan and security agreement which was paid off on December 1, 2016.

Other Income (Expense), Net

Nine Months Ended September 30,

2017

2016

Change

Amount

FORESCOUT TECHNOLOGIES, INC - FORM 10-Q - December 7, 2017

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