ProofPoint-9.30.2012-10Q
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
__________________________________
FORM 10-Q
þ
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2012
OR

o
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from to
Commission File Number 001-35506
PROOFPOINT, INC.
(Exact name of Registrant as specified in its charter)
Delaware 
(State or other jurisdiction of 
incorporation or organization)
 
51-0414846 
(I.R.S. employer 
identification no.)

892 Ross Drive
Sunnyvale, California 
(Address of principal executive offices)
 
94089 
(Zip Code)

(408) 517-4710
__________________________________
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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 þ NO o

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 þ NO o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer o 
 
Accelerated filer o 
 
Non-accelerated filer þ
(Do not check if a smaller reporting company)
 
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ Shares of Proofpoint, Inc. common stock, $0.0001 par value per share, outstanding as of September 30, 2012: 31,887,245 shares.




Table of Contents


PROOFPOINT, INC.
FORM 10-Q
Quarterly Period Ended September 30, 2012
TABLE OF CONTENTS


ii

Table of Contents

PART I. FINANCIAL INFORMATION


ITEM 1. FINANCIAL STATEMENTS.

Proofpoint, Inc.
Condensed Consolidated Balance Sheets
(In thousands, except per share amounts)
(Unaudited)
 
September 30,
 
December 31,
 
2012
 
2011
Assets
 
 
 
Current assets
 
 
 
Cash and cash equivalents
$
31,528

 
$
9,767

Short-term investments
49,125

 
2,947

Accounts receivable, net
17,081

 
15,789

Inventory
898

 
729

Deferred product costs, current
1,298

 
1,803

Prepaid expenses and other current assets
3,690

 
2,556

Total current assets
103,620

 
33,591

Property and equipment, net
7,700

 
7,353

Deferred product costs, noncurrent
371

 
987

Goodwill
18,557

 
18,557

Intangible assets, net
3,325

 
6,189

Other noncurrent assets
253

 
1,275

Total assets
$
133,826

 
$
67,952

Liabilities, Convertible Preferred Stock and Stockholders’ Equity (Deficit)
 
 
 
Current liabilities
 
 
 
Accounts payable
$
4,385

 
$
3,504

Accrued liabilities
11,568

 
10,061

Notes payable and lease obligations
1,658

 
467

Deferred rent
839

 
517

Deferred revenue
54,170

 
52,836

Total current liabilities
72,620

 
67,385

Notes payable and lease obligations, noncurrent
2,767

 
4,514

Other long term liabilities, noncurrent
257

 
85

Deferred revenue, noncurrent
24,666

 
23,404

Total liabilities
100,310

 
95,388

 
 
 
 
Convertible preferred stock, $0.0001 par value; no shares authorized, issued and outstanding as of September 30, 2012 and 39,424 shares authorized, 38,942 shares issued and outstanding at December 31, 2011, net of issuance costs and liquidation preference of $110,338

 
109,911

Stockholders’ equity (deficit)
 
 
 
Preferred stock, $0.0001 par value; 5,000 shares authorized; no shares issued and outstanding at September 30, 2012; no shares authorized, issued and outstanding at December 31, 2011

 

Common stock, $0.0001 par value; 200,000 and 71,400 shares authorized at September 30, 2012 and December 31, 2011, respectively; 31,887 and 4,961 shares issued and outstanding at September 30, 2012 and December 31, 2011, respectively
3

 
1

Additional paid-in capital
210,484

 
24,773

Accumulated other comprehensive Income (loss)
10

 
(3
)
Accumulated deficit
(176,981
)
 
(162,118
)
Total stockholders’ equity (deficit)
33,516

 
(137,347
)
Total liabilities, convertible preferred stock, and stockholders’ equity (deficit)
$
133,826

 
$
67,952

See accompanying Notes to the Condensed Consolidated Financial Statements.

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Table of Contents

Proofpoint, Inc.
Condensed Consolidated Statements of Operations
(In thousands, except per share amounts)
(Unaudited)

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Revenue:
 
 
 
 
 
 
 
Subscription
$
25,991

 
$
18,793

 
$
74,010

 
$
52,533

Hardware and services
1,093

 
1,693

 
3,636

 
6,614

Total revenue
27,084

 
20,486

 
77,646

 
59,147

Cost of revenue:(1)(2)
 
 
 
 
 
 
 
Subscription
6,967

 
5,936

 
21,414

 
17,553

Hardware and services
1,163

 
1,313

 
3,466

 
4,426

Total cost of revenue
8,130

 
7,249

 
24,880

 
21,979

Gross profit
18,954

 
13,237

 
52,766

 
37,168

Operating expense:(1)(2)
 
 
 
 
 
 
 
Research and development
6,262

 
4,594

 
18,367

 
14,416

Sales and marketing
14,126

 
10,779

 
39,751

 
30,070

General and administrative
3,141

 
2,043

 
8,871

 
6,184

Total operating expense
23,529

 
17,416

 
66,989

 
50,670

Operating loss
(4,575
)
 
(4,179
)
 
(14,223
)
 
(13,502
)
Interest expense, net
(7
)
 
(70
)
 
(110
)
 
(258
)
Other income (expense), net
109

 
(31
)
 
(100
)
 
212

Loss before provision for income taxes
(4,473
)
 
(4,280
)
 
(14,433
)
 
(13,548
)
Provision for income taxes
(119
)
 
(33
)
 
(430
)
 
(169
)
Net loss
$
(4,592
)
 
$
(4,313
)
 
$
(14,863
)
 
$
(13,717
)
Net loss per share, basic and diluted
$
(0.14
)
 
$
(1.07
)
 
$
(0.70
)
 
$
(3.49
)
Weighted average shares outstanding, basic and diluted
31,844

 
4,048

 
21,258

 
3,931

(1) Includes stock‑based compensation expense as follows:
 
 
 
 
 
 
 
Cost of subscription revenue
$
205

 
$
76

 
$
443

 
$
281

Cost of hardware and services revenue
20

 
7

 
46

 
20

Research and development
502

 
307

 
1,409

 
868

Sales and marketing
830

 
511

 
2,301

 
1,418

General and administrative
390

 
220

 
1,184

 
704

(2) Includes intangible amortization expense as follows:
 
 
 
 
 
 
 
Cost of subscription revenue
$
333

 
$
949

 
$
2,452

 
$
2,809

Research and development
8

 

 
23

 

Sales and marketing
72

 
142

 
389

 
625

See accompanying Notes to the Condensed Consolidated Financial Statements.

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Proofpoint, Inc.
Condensed Consolidated Statements of Comprehensive Loss
(In thousands)
(Unaudited)

 
Three Months Ended
 
 Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
 
 
 
 
 
 
 
 
Net loss
$
(4,592
)
 
$
(4,313
)
 
$
(14,863
)
 
$
(13,717
)
Other comprehensive income, before tax and net of reclassification adjustments:
 
 
 
 
 
 
 
Unrealized gains (losses) on investments, net
22

 
(3
)
 
13

 
(6
)
Other comprehensive gain (loss), before tax
22

 
(3
)
 
13

 
(6
)
Tax benefit (provision) related to items of other comprehensive income

 

 

 

Other comprehensive gain (loss), net tax
22

 
(3
)
 
13

 
(6
)
Comprehensive loss
$
(4,570
)
 
$
(4,316
)
 
$
(14,850
)
 
$
(13,723
)


See accompanying Notes to the Condensed Consolidated Financial Statements.

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Table of Contents


Proofpoint, Inc.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)

 
Nine Months Ended
September 30,
 
2012
 
2011
Cash flows from operating activities
 
 
 
Net loss
$
(14,863
)
 
$
(13,717
)
Adjustments to reconcile net loss to net cash provided by operating activities
 
 
 
Depreciation and amortization
6,037

 
5,693

Stock‑based compensation
5,383

 
3,291

Change in fair value of warrant liability

 
(66
)
Change in fair value of contingent earn-outs

 
208

Changes in assets and liabilities, net of effect of acquisitions:
 
 
 
Accounts receivable
(1,292
)
 
359

Inventory
(169
)
 
122

Deferred products costs
1,121

 
2,360

Prepaid expenses and other current assets
(1,133
)
 
(342
)
Noncurrent assets
54

 
171

Accounts payable
1,099

 
(241
)
Accrued liabilities
2,778

 
(1,553
)
Deferred rent
321

 
228

Deferred revenue
2,596

 
3,158

Net cash provided by (used in) operating activities
$
1,932

 
$
(329
)
Cash flows from investing activities
 
 
 
Proceeds from sales and maturities of short-term investments
$
3,151

 
$
721

Purchase of short-term investments
(49,316
)
 
(5,082
)
Purchase of property and equipment, net
(3,884
)
 
(3,764
)
Acquisitions of business (net of cash acquired)

 
(160
)
Net cash used in investing activities
$
(50,049
)
 
$
(8,285
)
Cash flows from financing activities
 
 
 
Proceeds from issuance of common stock, net of repurchases
$
2,106

 
$
866

Proceeds from initial public offering, net of offering costs
68,329

 

Proceeds of equipment financing loans

 
2,926

Repayments of equipment financing loans
(557
)
 
(173
)
Net cash provided by financing activities
$
69,878

 
$
3,619

Net increase (decrease) in cash and cash equivalents
21,761

 
(4,995
)
Cash and cash equivalents
 
 
 
Beginning of period
9,767

 
12,087

End of period
$
31,528

 
$
7,092

 
 
 
 
Supplemental disclosure of cash flow information
 
 
 
Cash paid for interest
$
177

 
$
56

Cash paid for taxes
242

 
130

Supplemental disclosure of noncash investing and financing information
 
 
 
Issuance of Series B preferred stock upon net exercise of warrants

 
91

Unpaid initial public offering costs
34

 


See accompanying Notes to the Condensed Consolidated Financial Statements.

4

Table of Contents

Proofpoint, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(Dollars and share amounts in thousands, except per share amounts)
1. The Company and Summary of Significant Accounting Policies
The Company
Proofpoint, Inc. (the “Company”) was incorporated in Delaware in June 2002 and is headquartered in California.
Proofpoint is a pioneering security-as-a-service vendor that enables large and mid-sized organizations worldwide to defend, protect, archive and govern their most sensitive data. The Company’s security-as-a-service platform is comprised of a number of data protection solutions, including threat protection, regulatory compliance, archiving and governance, and secure communication.
Reverse Stock Split
On March 30, 2012, the Company's Board of Directors approved a 1-for-2 reverse stock split of the Company's common stock. The reverse stock split became effective on April 2, 2012. Upon the effectiveness of the reverse stock split, (i) every two shares of outstanding common stock was decreased to one share of common stock, (ii) the number of shares of common stock into which each outstanding option to purchase common stock is exercisable was proportionally decreased on a 1-for-2 basis, (iii) the exercise price of each outstanding option to purchase common stock was proportionately increased on a 1-for-2 basis, and (iv) the conversion ratio for each share of preferred stock outstanding was proportionately reduced on a 1-for-2 basis. All of the share numbers, share prices, and exercise prices have been retrospectively adjusted to reflect the reverse stock split.
Basis of Presentation and Consolidation
The accompanying unaudited condensed consolidated financial statements and condensed footnotes have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments considered necessary for fair statement have been included. The results of operations for the three and nine months ended September 30, 2012 are not necessarily indicative of the results to be expected for the year ended December 31, 2012 or for other interim periods or for future years.
The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated on consolidation. The condensed consolidated balance sheet as of December 31, 2011 is derived from audited financial statements as of that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in our Prospectus dated April 19, 2012, filed with the SEC pursuant to Rule 424(b)(4) under the Securities Act of 1933 (the “Securities Act”), as amended.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 expenses during the reporting period. Actual results could differ from those estimates and such difference may be material to the financial statements.

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Foreign Currency Remeasurement and Transactions
The Company’s sales to international customers are generally U.S. dollar‑denominated. As a result, there are no significant foreign currency gains or losses related to these transactions. The functional currency for the Company’s wholly-owned foreign subsidiaries is the U.S. dollar. Accordingly, the subsidiaries remeasure monetary assets and liabilities at period-end exchange rates, while nonmonetary items are remeasured at historical rates. Income and expense accounts are remeasured at the average exchange rates in effect during the year. Remeasurement adjustments are recognized in the consolidated statement of operations as transaction gains or losses within other income (expense), net, in the period of occurrence. Aggregate transaction gains (losses) included in determining net loss were $109 and $(28) for the three months, and $(108) and $93 for the nine months ended September 30, 2012 and 2011, respectively.
Cash, Cash Equivalents and Short Term Investments
The Company considers all highly liquid instruments purchased with an original maturity date of 90 days or less from the date of purchase to be cash equivalents. Cash equivalents consist of money market funds and certain types of commercial paper. Cash and cash equivalents were $31,528 and $9,767 as of September 30, 2012 and December 31, 2011, respectively. Short-term investments consist of readily marketable securities with remaining maturity of more than three months from the date of purchase and include certain types of commercial paper, corporate bonds, debt securities and certificates of deposit. Short-term investments were $49,125 and $2,947 as of September 30, 2012 and December 31, 2011, respectively, and all were classified as available-for-sale and were carried at fair value, with unrealized gains and losses reported as a component of accumulated other comprehensive income (loss). Realized gains and losses are included in “other income (expense), net.” Fair value is estimated based on available market information. The cost of securities sold is based on the specific identification method.
Revenue Recognition
The Company derives its revenue primarily from two sources: (1) subscription revenue for rights related to the use of the security-as-a-service platform and (2) hardware, training and professional services revenue provided to customers related to their use of the platform. Subscription revenue is derived from a subscription‑based enterprise licensing model with contract terms typically ranging from one to three years, and consist of (i) subscription fees from the licensing of the security-as-a-service platform, (ii) subscription fees for access to the on-demand elements of the platform and (iii) subscription fees for the right to access the Company’s customer support services.
The Company applies the provision of ASC 985-605, “Software Revenue Recognition,” and related interpretations, to all transactions involving the licensing of software, as well as related support, training, and other professional services. ASC 985-605 requires revenue earned on software arrangements involving multiple elements such as software license, support, training and other professional services to be allocated to each element based on the relative fair values of these elements. The fair value of an element must be based on vendor‑specific objective evidence (“VSOE”) of fair value. VSOE of fair value of each element is based on the price charged when the element is sold separately. Revenue is recognized when all of the following criteria are met as set forth in ASC 985-605:
Persuasive evidence of an arrangement exists,
Delivery has occurred,
The fee is fixed or determinable, and
Collectability is probable.
The Company has analyzed all of the elements included in its multiple element arrangements and has determined that it does not have sufficient VSOE of fair value to allocate revenue to its subscription and software license agreements, support, training, and professional services. The Company defers all revenue under the software arrangement until the commencement of the subscription services and any associated professional services. Once the subscription services and the associated professional services have commenced, the entire fee from the arrangement is recognized ratably over the remaining period of the arrangement. If the professional services are essential to the functionality of the subscription, then the revenue recognition

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does not commence until such services are completed.
In the consolidated statement of operations, revenue is categorized as "subscription" and "hardware and services." Although the Company is unable to separate its multiple elements under the applicable revenue recognition guidance since it does not have sufficient VSOE of fair value for revenue recognition purposes, the Company has used a systematic and rational estimate to classify revenue between "subscription" and "hardware and services." For presentation purposes only, the Company allocates revenue to hardware and services based upon management's best estimate of fair value of such deliverables using a cost plus model. The remaining consideration of the arrangement is then allocated to subscription services. Management believes that this methodology provides a reasonable basis to allocate revenue between subscription and hardware and services for presentation purposes.
The hosted on-demand service agreements do not provide customers with the right to take possession of the software supporting the hosted service. The Company recognizes revenue from its hosted on-demand services in accordance with ASC 605-20, and as such recognizes revenue when the following criteria are met:
Persuasive evidence of an arrangement exists,
Delivery of the Company’s obligations to its customers has occurred,
Collection of the fees is probable, and
The amount of fees to be paid by the customer is fixed or determinable.
In October 2009, the FASB amended the accounting guidance for multiple element arrangements (“ASU 2009-13”) to:
Provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and how the arrangement consideration should be allocated among its elements;
Require an entity to allocate revenue in an arrangement that has separate units of accounting using best estimated selling price (“BESP”) of deliverables if a vendor does not have VSOE of fair value or third-party evidence of selling price (“TPE”), and
Eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method to the separate unit of accounting.
Concurrently, the FASB amended the accounting guidance for revenue recognition (“ASU 2009-14”) to exclude hardware appliances containing software components and hardware components that function together to deliver the hardware appliance’s essential functionality from the scope of the software revenue recognition guidance of ASC 985-605.
The Company elected to adopt this new guidance in the first quarter of fiscal 2011 for new and materially modified revenue arrangements originating after January 1, 2011.
Prior to the adoption of ASU 2009-14, revenue derived from hardware appliance sales were recognized based on the software revenue recognition guidance. The Company could not establish VSOE of fair value for the undelivered elements in the arrangement, and therefore the entire fee from the arrangement was recognized ratably over the contractual term of the agreement. In addition, the Company was unable to establish VSOE of fair value of its hosted on-demand service agreements, and therefore the entire fee for the agreement was recognized ratably over the contractual term of the agreement.
As a result of the adoption of this accounting guidance, revenue derived from our subscription services and hardware appliance sales are no longer subject to industry‑specific software revenue recognition guidance. For all arrangements within the scope of these new accounting pronouncements, including the Company’s hosted on-demand services, the Company evaluates each element in a multiple element arrangement to determine whether it represents a separate unit of accounting. An element constitutes a separate unit of accounting when the delivered item has standalone value and delivery of the undelivered element is probable and within the Company’s control. Revenue derived from the licensing of the security-as-a-service platform

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continues to be accounted for in accordance with the industry specific revenue recognition guidance.
Hardware appliance revenue is recognized upon shipment. Subscription and support revenue are recognized over the contract period commencing on the start date of the contract. Professional services and training, when sold with hardware appliances or subscription and support services, are accounted for separately when those services have standalone value. In determining whether professional services and training services can be accounted for separately from subscription and support services, the Company considers the following factors: availability of the services from other vendors, the nature of the services, and the dependence of the subscription services on the customer’s decision to buy the professional services. If professional services and training do not qualify for separate accounting, the Company recognizes the professional services and training ratably over the contract term of the subscription services.
Delivery generally occurs when the hardware appliance is delivered to a common carrier freight on board shipping point by the Company or the hosted service has been activated and communicated to the customer accordingly. The Company’s fees are typically considered to be fixed or determinable at the inception of an arrangement and are negotiated at the outset of an arrangement, generally based on specific products and quantities to be delivered. In the event payment terms are provided that differ significantly from the Company's standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized as the fees become paid.
The Company assesses collectability based on a number of factors, including credit worthiness of the customer and past transaction history of the customer. Through September 30, 2012, the Company has not experienced significant credit losses.
Deferred Revenue
Deferred revenue primarily consists of billings or payments received in advance of revenue recognition from the sale of the Company’s subscription fees, training and professional services. Once the revenue recognition criteria are met, this revenue is recognized ratably over the term of the associated contract, which typically ranges from 12 to 36 months.
Fair Value of Financial Instruments
The carrying amounts of certain of the Company’s cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate their fair values due to their short maturities. Based on borrowing rates that are available to the Company for loans with similar terms and consideration of the Company’s credit risk, the carrying value of the note payable approximates its fair value.
Comprehensive Income (Loss)
Comprehensive income (loss) includes all changes in equity that are not the result of transactions with stockholders. The Company’s comprehensive income (loss) consists of its net loss and changes in unrealized gains (losses) from its available-for-sale investments. For the Company’s first reporting period beginning after December 15, 2011, the Company adopted guidance issued by FASB amending the presentation of the Statement of Comprehensive Income. The amended guidance eliminates the current option to report other comprehensive income and its components of other comprehensive income as part of the statement of changes in stockholders’ equity. In addition, it gives an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The Company has implemented this guidance effective beginning with the quarter ended March 31, 2012.
2. Acquisitions
Spam and Open Relay Blocking System (“SORBS”)
On June 30, 2011, the Company entered into an asset purchase agreement (the “SORBS Agreement”) with GFI Software Ltd., a British Virgin Islands corporation.
Under the terms of the SORBS agreement, the Company paid consideration of $200 for intellectual property and fixed

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assets with $40 being held in escrow to secure indemnification obligations, which was released from escrow in September 2012. The acquisition related costs of $28 incurred by the Company was charged to operating expenses in the year ended December 31, 2011.
Of the total cash consideration paid, $120 was allocated to goodwill as the intellectual property purchased did not meet the criteria for purchase price allocations as set forth in ASC 805, Business Combinations, and $46 was recorded as fixed assets. The following table summarizes the allocation of the purchase price and the estimated useful lives of the identifiable intangible assets acquired as of the date of the acquisition:
 
Estimated
Fair Value
 
Estimated
Useful Life
 
 
 
 
Tangible assets acquired
$
46

 
1 year
Liabilities assumed

 
 
Developed technology
34

 
2 years
Customer relationships

 
 
Vendor relationships

 
 
Goodwill
120

 
Indefinite
 
$
200

 
 

There were no acquisition related activities for the three or nine months ended September 30, 2012.
3. Goodwill and Intangible Assets
Goodwill represents the excess of the purchase price of the acquired enterprise over the fair value of identifiable assets acquired and liabilities assumed. The Company applies ASC 350, “Intangibles—Goodwill and Other,” and performs an annual goodwill impairment test during the fourth quarter of the Company’s fiscal year and more frequently if an event or circumstance indicates that an impairment may have occurred. For the purposes of impairment testing, the Company has determined that it has one reporting unit. A two-step impairment test of goodwill is required pursuant to ASC 350-20-35. In the first step, the fair value of the reporting unit is compared to its carrying value. If the fair value exceeds the carrying value, goodwill is not impaired and further testing is not required. If the carrying value exceeds the fair value, then the second step of the impairment test is required to determine the implied fair value of the reporting unit’s goodwill. The implied fair value of goodwill is calculated by deducting the fair value of all tangible and intangible net assets of the reporting unit, excluding goodwill, from the fair value of the reporting unit as determined in the first step. If the carrying value of the reporting unit’s goodwill exceeds its implied fair value, then an impairment loss must be recorded that is equal to the difference. The identification and measurement of goodwill impairment involves the estimation of the fair value of the Company. The estimate of fair value of the Company, based on the best information available as of the date of the assessment, is subjective and requires judgment, including management assumptions about expected future revenue forecasts and discount rates. No impairment to the carrying value of goodwill was identified to date by the Company during the nine months ended September 30, 2012.
Intangible assets consist of developed technology, customer relationships, vendor relationships, non-compete arrangements and trademarks and patents. The values assigned to intangibles are based on estimates and judgments regarding expectations for success and life cycle of solutions and technologies acquired.
Intangible assets are amortized on a straight-line basis over their estimated lives, which approximate the pattern in which the economic benefits of the intangible assets are consumed, typically ranging from two to four years.
Developed technology
4 years
Customer relationships
4 years
Vendor relationships
4 years


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Table of Contents

The goodwill activity and balances are presented below:
 
September 30,
 
December 31,
 
2012
 
2011
Opening balance
$
18,557

 
$
15,932

Add: Goodwill from acquisitions

 
2,625

Closing balance
$
18,557

 
$
18,557

The goodwill balance as of September 30, 2012 and December 31, 2011 was the result of the acquisitions of Fortiva, Inc., Secure Data in Motion, Inc (“Sigaba”), Everyone.net, Inc. (“EDN”), GFI Software Ltd., Spam and Open Relay Blocking System or (“SORBS”) and NextPage, Inc..
Intangible Assets
Intangible assets excluding goodwill, consisted of the following:
 
September 30, 2012
 
December 31, 2011
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
Developed technology
$
17,641

 
$
(14,830
)
 
$
2,811

 
$
17,641

 
$
(12,378
)
 
$
5,263

Customer relationships
2,408

 
(2,042
)
 
366

 
2,408

 
(1,685
)
 
723

Vendor relationships

 

 

 
290

 
(290
)
 

Non‑compete
106

 
(21)

 
85

 
106

 
(1
)
 
105

Trademark and patents
98

 
(35)

 
63

 
98

 

 
98

 
$
20,253

 
$
(16,928
)
 
$
3,325

 
$
20,543

 
$
(14,354
)
 
$
6,189

In the quarter ended March 31, 2011, the Company revised the useful life of the vendor relationship intangible asset. The Company fully depreciated this intangible asset given that it is no longer using the technology provided by this vendor. Accordingly, the entire remaining balance of $0.3 million was expensed.
Amortization expense of intangibles totaled $413 and $1,091 during the three months, and $2,864 and $3,434 during the nine months ended September 30, 2012 and 2011, respectively.
Future estimated amortization costs of intangible assets as of September 30, 2012 are presented below:
Remainder of 2012
$
412

2013
1,479

2014
725

2015
709

 
$
3,325




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Table of Contents

4. Financial Instruments and Fair Value Measurements
The cost and fair value of the Company’s available-for-sale investments as of September 30, 2012 and December 31, 2011 were as follows:
 
September 30, 2012
 
Cost Basis
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Cash and Cash Equivalents:
 
 
 
 
 
 
 
Cash
$
9,920

 
$

 
$

 
$
9,920

Money market funds
21,608

 

 

 
21,608

Commercial paper

 

 

 

Total
$
31,528

 
$

 
$

 
$
31,528

 
 
 
 
 
 
 
 
Short term investments:
 
 
 
 
 
 
 
Corporate debt securities
$
29,118

 
$
12

 
$
(2
)
 
$
29,128

Commercial paper
17,978

 

 

 
17,978

Certificates of deposit
2,019

 

 

 
2,019

Total
$
49,115

 
$
12

 
$
(2
)
 
$
49,125

 
 
 
 
 
 
 
 
 
December 31, 2011
 
Cost Basis
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Cash and Cash Equivalents:
 
 
 
 
 
 
 
Cash
$
2,917

 
$

 
$

 
$
2,917

Money market funds
6,850

 

 

 
6,850

Total
$
9,767

 
$

 
$

 
$
9,767

 
 
 
 
 
 
 
 
Short term investments:
 
 
 
 
 
 
 
Corporate debt securities
$
2,650

 
$

 
$
(3
)
 
$
2,647

Commercial paper
300

 

 

 
300

Total
$
2,950

 
$

 
$
(3
)
 
$
2,947

 
 
 
 
 
 
 
 
As of September 30, 2012 and December 31, 2011, all investments mature in less than one year. Estimated fair values for marketable securities are based on quoted market prices for the same or similar instruments.
Fair Value Measurements
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date. A hierarchy for inputs used in measuring fair value has been defined to minimize the use of unobservable inputs by requiring the use of observable market data when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on active market data. Unobservable inputs are inputs that reflect the Company’s assumptions about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances.
The fair value hierarchy prioritizes the inputs into three broad levels:
Level 1: Quoted (unadjusted) prices in active markets for identical assets or liabilities.

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The Company’s Level 1 assets generally consist of money market funds.
Level 2: Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.
The Company’s Level 2 assets and liabilities generally consist of corporate bonds and agency debt securities, commercial paper, and certificates of deposit.
Level 3: Unobservable inputs to the valuation methodology that are supported by little or no market activity and that are significant to the measurement of the fair value of the assets or liabilities. Level 3 assets and liabilities include those whose fair value measurements are determined using pricing models, discounted cash flow methodologies or similar valuation techniques, as well as significant management judgment or estimation.
The Company’s Level 3 liabilities have historically consisted of the Series B preferred stock warrants, which were exercised during the year ended December 31, 2011 and the equipment financing loans.
The following tables summarize, for each category of assets or liabilities, the respective fair value as of September 30, 2012 and December 31, 2011 and the classification by level of input within the fair value hierarchy.
 
Balance as of
September 30,
2012
 
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Unobservable
Inputs
(Level 3)
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
21,608

 
$
21,608

 
$

 
$

Commercial paper

 

 

 

Short-term investments:
 
 
 
 
 
 
 
Corporate debt securities
29,128

 

 
29,128

 

Commercial paper
17,978

 

 
17,978

 

Certificates of deposit
2,019

 

 
2,019

 

Total financial assets
$
70,733

 
$
21,608

 
$
49,125

 
$

 
Balance as of
December 31,
2011
 
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Unobservable
Inputs
(Level 3)
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
6,850

 
$
6,850

 
$

 
$

Short-term investments:
 
 
 
 
 
 
 
Corporate debt securities
2,647

 

 
2,647

 

Commercial paper
300

 

 
300

 

Total financial assets
$
9,797

 
$
6,850

 
$
2,947

 
$




12

Table of Contents


5. Commitments and Contingencies
Operating Leases
Thpropere Company leases certain of its facilities under noncancelable operating leases with various expiration dates through May 2017.
Rent expense was $393 and $388 for the three months and $1,165 and $1,084 for the nine months ended September 30, 2012 and 2011, respectively.
Capital Leases
The Company acquired capital leases as part of the EDN acquisition. The leases were secured by fixed assets primarily used in a data center. The leases have various expiration dates through October 2012. The interest rates range from 2.9% to 9.7%.
In July 2012, the Company entered into a lease agreement to lease certain office equipment with an expiration date in July 2015. The lease bears an annual interest rate of 4.5% and is secured by fixed assets used in the Company's corporate office location.
At September 30, 2012, future annual minimum lease payments under noncancelable operating and capital leases were as follows:
 
Capital
Leases
 
Operating
Leases
2012 remainder
$
7

 
$
1,369

2013
18

 
3,241

2014
18

 
1,064

2015
10

 
248

2016
 
 
253

2017
 
 
107

Total minimum lease payments
53

 
$
6,282

Less: Amount representing interest
(4
)
 
 
Present value of capital lease obligations
49

 
 
Less: Current portion
(18
)
 
 
Long-term portion of capital lease obligations
$
31

 
 
Contingencies
Under the indemnification provisions of the Company’s customer agreements, the Company agrees to indemnify and defend and hold harmless its customers against, among other things, infringement of any patent, trademark or copyright under any country’s laws or the misappropriation of any trade secret arising from the customers’ legal use of the Company’s solutions. The exposure to the Company under these indemnification provisions is generally limited to the total amount paid by the customers under the applicable customer agreement. However, certain indemnification provisions potentially expose the Company to losses in excess of the aggregate amount paid to the Company by the customer under the applicable customer agreement. To date, there have been no claims against the Company or its customers pursuant to these indemnification provisions.
Legal Contingencies

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From time to time, the Company is involved in claims and legal proceedings that arise in the ordinary course of business. Based on currently available information, management does not believe that the ultimate outcome of these unresolved matters, individually and in the aggregate, is likely to have a material adverse effect on the Company’s financial position, results of operations or cash flows. However, litigation is subject to inherent uncertainties and the Company’s view of these matters may change in the future. Were an unfavorable outcome to occur, there exists the possibility of a material adverse impact on the Company’s financial position, results of operations or cash flows for the period in which the unfavorable outcome occurs, and potentially in future periods.
The Company determined that subsequent to its acquisition of Fortiva, Inc., a Canadian company, in August 2008, it shipped a particular hardware appliance model to a limited number of international customers that, prior to shipment, required either a one-time product review or application for an encryption registration number in lieu of such product review. The Company has made voluntary submissions to the United States Commerce Department’s Bureau of Industry and Security (BIS) to report this potential violation. Based upon the results of the internal investigation completed to date, the Company does not believe that the amount of any loss incurred as a result of this matter would be material to its business, financial condition, results of operations or cash flows.
As part of a pre-IPO due diligence review, the Company discovered a potential export violation involving the provision of web-based, email communication services through its Everyone.net service, which the Company acquired in October 2009. The Company’s records indicate that there were two end-users who may have, for a portion of their respective service periods, been located in Iran, a United States designated state sponsor of terrorism. The Company’s internal investigation has progressed and the Company has found that the issues identified are specific to the acquired Everyone.net system, which has a separate customer database and billing system from that of Proofpoint’s main businesses. The Company does not have any indication that these services were utilized by the Iranian government. The accounts of both end-users were terminated in 2010 and accounted for approximately $15 in payments to us in 2009 and $6 in payments to us in 2010. Although the Company has ceased providing the service, the Company has made voluntary submissions to the U.S. Department of Treasury’s Office of Foreign Assets Control, or OFAC, to report this potential violation. Based upon the results of the internal investigation completed to date, the Company does not believe that the amount of any loss incurred as a result of this matter would be material to its business, financial condition, results of operations or cash flows.
6. Debt
Equipment Financing Loans
The Company entered into a new equipment loan agreement with Silicon Valley Bank in April 2011 for an aggregate loan principal amount of $6,000. Interest on the advances is equal to prime rate plus 0.50%. As of September 30, 2012, the interest on the outstanding advances was 4.50%. The Company had the ability to draw down on this equipment line through April 19, 2012. Each drawn amount is due 48 months after funding. Borrowings outstanding under the equipment loan at September 30, 2012 were $4,378. Equipment financed under this loan arrangement is collateralized by the respective assets underlying the loan. The terms of the loan restrict the Company’s ability to pay dividends. The loan includes a covenant that requires the Company to maintain cash and cash equivalents plus net accounts receivable of at least two times the amount of all outstanding indebtedness. As of September 30, 2012, the Company was in compliance with the financial covenant.
The Company had a previous equipment loan arrangement with Silicon Valley Bank for $2,000. The loan bore interest at an annual rate of 8.75%. The maturity date was 36 months after the funding date. Borrowings outstanding under the equipment loan at September 30, 2011 were $0, as the loan was completely repaid and terminated in June 2011. Equipment financed under this loan arrangement was collateralized by the respective assets underlying each specific draw down. This loan required the Company to maintain a tangible net worth greater than $18,000 and during the term of the loan, the Company was in compliance with the financial covenant.
Interest expense was $53 and $20 for the three months ended, and $162 and $22 for the nine months ended September 30, 2012 and 2011, respectively.
At September 30, 2012, the remaining repayment commitments related to the equipment loans are as follows:

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Table of Contents

2012 remainder
$
410

2013
1,642

2014
1,642

2015
684

2016

 
$
4,378


7. Stockholders’ Equity
Initial Public Offering
In April 2012, the Company completed its initial public offering of its common stock to the public (“IPO”) whereby 5,859 shares of common stock sold by the Company (inclusive of 729 shares of common stock from the partial exercise of the overallotment option granted to the underwriters) and 1,370 shares of common stock sold by the selling shareholders (inclusive of 171 shares of common stock from the partial exercise of the overallotment option granted to the underwriters). The public offering price of the shares sold in the offering was $13.00 per share. The Company did not receive any proceeds from the sales of shares by the selling stockholders. The total gross proceeds from the offering to the Company were $76.2 million. After deducting underwriters’ discounts and commissions and offering expenses, the aggregate net proceeds received by the Company totaled approximately $68.3 million. Immediately prior to the closing of the IPO, all shares of the Company’s outstanding redeemable convertible preferred stock automatically converted into 19,567 shares of common stock. As a result, following the IPO, the Company has two classes of authorized stock: Common stock and Preferred stock.
As of September 30, 2012, the Company is authorized to issue two classes of stock totaling 205,000 shares, of which 5,000 are designated as preferred stock and 200,000 are designated common stock, each with a par value of $0.0001 per share.
On March 30, 2012, the Company's Board of Directors approved a 1-for-2 reverse stock split of the Company's common stock. The reverse stock split became effective on April 2, 2012. All of the share numbers, share prices, and exercise prices have been retrospectively adjusted to reflect the reverse stock split.
The following table presents the shares authorized and issued and outstanding as of the dates presented:
 
As of September 30, 2012
 
As of December 31, 2011
 
Shares
 
Shares
 
Liquidation
 
Authorized
 
Outstanding
 
Authorized
 
Outstanding
 
Amount
Convertible preferred stock Series A

 

 
7,400

 
7,400

 
$
7,400

Convertible preferred stock Series B

 

 
7,109

 
7,080

 
9,062

Convertible preferred Series C

 

 
8,307

 
8,307

 
20,020

Convertible preferred Series D

 

 
665

 
665

 
2,001

Convertible preferred Series E

 

 
5,743

 
5,743

 
20,001

Convertible preferred Series F

 

 
10,200

 
9,747

 
51,854

Common Stock
200,000

 
31,887

 
71,400

 
4,961

 

Undesignated preferred stock
5,000

 

 

 

 

 
205,000

31,887

 
110,824
 
43,903
 
$
110,338

    

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Table of Contents

Number of shares of common stock reserved for future issuance was as follows:

 
As of September 30,
 
As of
December 31,
 
2012
 
2011
Options available for future grant under the stock plans
5,077

 
364

Options outstanding under stock option plans
10,205

 
10,705

Shares available for future issuance under ESPP
745

 

Conversion of convertible preferred stock

 
39,134

Common stock issuable upon exercise of warrant and settlement of outstanding restricted stock units
23

 
25

Total shares reserved
16,050

 
50,228

Stock Option Plan
On March 30, 2012, the Board of Directors and the Company’s stockholders approved the 2012 Equity Incentive Plan (the "2012 Plan"), which became effective in April 2012. The Company has two equity incentive plans: the Company’s 2002 stock option plan (the “2002 Plan”) and the 2012 Equity Incentive Plan. Upon the IPO, all shares that were reserved under the 2002 Plan but not issued, and shares issued but subsequently returned to the plan through forfeitures, cancellations and repurchases became part of the 2012 Plan and no further shares will be granted pursuant to the 2002 Plan. All outstanding stock awards under the 2002 and 2012 Plans will continue to be governed by their existing terms. Under the 2012 Plan, the Company has the ability to issue incentive stock options (“ISOs”), nonstatutory stock options (“NSOs”), restricted stock awards, stock bonus awards, stock appreciation rights ("SARs"), restricted stock units (“RSUs”), and performance shares. The 2012 Plan also allows direct issuance of common stock to employees, outside directors and consultants at prices equal to the fair market value at the date of grant of options or issuance of common stock. Additionally, the 2012 Plan provides for the grant of performance cash awards to employees, directors and consultants. The Company has the right to repurchase any unvested shares (at the option exercise price) of common stock issued directly or under option exercises. The right of repurchase generally expires over the vesting period.
Under the 2012 and 2012 Plans, the term of an option grant shall not exceed ten years from the date of its grant and options generally vest over a three to four-year period, with vesting on a monthly or annual interval. 20,316 shares of common stock are reserved for issuance to eligible participants, under the 2012 Plan. As of September 30, 2012, 5,077 shares were available for future grant. Restricted stock awards generally vest over a four-year period with 25% vesting at the end of one year and the remaining vest quarterly thereafter. The number of shares available for grant and issuance under the 2012 Plan will be increased automatically on each January 1 of 2013 through 2016 by an amount equal to 5% of the Company's shares outstanding on the immediately preceding December 31, but not to exceed 3,724 shares, unless the Board of Directors, in its discretion, determines to make a smaller increase.
Employee Stock Purchase Plan
On March 30, 2012, the Board of Directors and the Company’s stockholders approved the 2012 Employee Stock Purchase Plan (the "ESPP"), which became effective in April 2012. A total of 745 shares of the Company's common stock are initially reserved for future issuance under the ESPP. The number of shares reserved for issuance under the ESPP will increase automatically on January 1 of each of the first eight years commencing with 2013 by the number of shares equal to 1% of the Company's shares outstanding on the immediately preceding December 31, but not to exceed 1,490 shares, unless the Board of Directors, in its discretion, determines to make a smaller increase. As of September 30, 2012, there were 745 shares of the Company's common stock available for future issuance under the ESPP.

16

Table of Contents

Activity under the Plan was as follows:
 
Shares subject to
Options Outstanding
 
Number of
Shares
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual
Term
(in years)
 
Aggregate
Intrinsic
Value
Balance at December 31, 2011    
10,705
 
$
3.83

 
6.77
 
$
44,466

Options granted
1,547
 
9.79

 
 
 
 
Options exercised
(1,500)
 
1.42

 
 
 
 
Options forfeited and canceled
(547)
 
5.82

 
 
 
 
Balance at September 30, 2012
10,205
 
$
4.98

 
6.94
 
$
100,748

The total intrinsic value of options exercised was $10,725 and $1,505, for the nine months ended September 30, 2012, and for the year ended December 31, 2011 respectively. Total cash proceeds from such option exercises were $2,125 and $1,198 for the nine months ended September 30, 2012, and for the year ended December 31, 2011, respectively.
Restricted Stock Units
During the year ended December 31, 2011, the Company acquired NextPage, Inc. and assumed NextPage's 2007 Stock Plan (the "2007 Plan") and the RSUs granted to certain employees. Under the 2007 Plan, the Company assumed 23 RSUs, which remain subject to their original terms and conditions.
The fair value of each unit is based on the fair value of the Company’s common stock on the date of assumption. A summary of the status of RSUs awarded and unvested under the stock option plans as of September 30, 2012 is presented below (in thousands, except per share amounts):
 
RSUs
Outstanding
 
Number of
Shares
 
Granted Fair Value Per Unit
Awarded and unvested at December 31, 2011    
8

 
$
7.98

Awards assumed

 
7.98

Awards vested
(5
)
 
7.98

Awards forfeited
(1
)
 
7.98

Awarded and unvested at September 30, 2012    
2

 
$
7.98

As of September 30, 2012, there was $12 of unamortized stock‑based compensation expense related to unvested RSUs, which are expected to be recognized over a weighted average period of 0.45 years.


17

Table of Contents


8. Stock‑Based Compensation
The Company recognized stock-based compensation expense under the Plan in the consolidated statements of operations as follows (in thousands):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011

Cost of subscription revenue    
$
205

 
$
76

 
$
443

 
$
281

Cost of hardware and services revenue
20

 
7

 
46

 
20

Research and development
502

 
307

 
1,409

 
868

Sales and marketing
830

 
511

 
2,301

 
1,418

General and administrative
390

 
220

 
1,184

 
704

Total stock-based compensation expense
$
1,947

 
$
1,121

 
$
5,383

 
$
3,291

The fair value of options granted is estimated on the grant date using the Black‑Scholes option valuation model. This valuation model for stock‑based compensation expense requires the Company to make assumptions and judgments about the variables used in the calculation, including the expected term (weighted‑average period of time that the options granted are expected to be outstanding), the volatility of the common stock price, an assumed risk-free interest rate and the estimated forfeitures of unvested stock options. To the extent actual forfeitures differ from the estimates, the difference will be recorded as a cumulative adjustment in the period estimates are revised. No compensation cost is recorded for options that do not vest and the compensation cost from vested options, whether forfeited or not, is not reversed.
Prior to the Company's IPO, the Board of Directors, in good faith, determined the fair market values of the Company's common stock, based on the best information available to the Board and the Company's management at the time of grant. The Company performed its analysis in accordance with applicable elements of the practice aid issued by the American Institute of Certified Public Accountants entitled Valuation of Privately Held Company Equity Securities Issued as Compensation. The procedures performed to determine the fair value of the Company's common stock were based on a probability‑weighted expected return method to estimate the aggregate equity value of the Company.
The weighted average fair value of stock options granted to employees was $7.51 and $3.23 during the three months ended, and $5.39 and $3.14 during the nine months ended September 30, 2012 and 2011, respectively. The fair values were estimated on the grant dates using the Black‑Scholes option‑pricing model with the following weighted‑average assumptions:
 
Three Months ended
September 30,
 
Nine Months ended
September 30,
 
2012
 
2011
 
2012
 
2011
Expected life (in years)
6.08
 
6.08
 
5.50-6.08
 
6.08
Volatility
59%
 
60%
 
59-60%
 
59-60%
Risk-free interest rate
1.0%
 
1.5%
 
1.0-1.2%
 
1.5-2.5%
Dividend yield
—%
 
—%
 
—%
 
—%
The estimate for expected life of options granted reflects the midpoint of the vesting term and the contractual life computed utilizing the simplified method as allowed by the SEC staff. The Company does not have significant historical share option exercise experience and hence considers the expected term assumption calculated using the simplified method to be reasonable. The stock volatility assumptions represent an estimate of the historical volatilities of the common stock of a group

18

Table of Contents

of publicly‑traded peer companies that operate in a similar industry. The estimate was determined based on the average historical volatilities of these peer companies. The risk-free interest rate used was the Federal Reserve Bank’s constant maturities interest rate commensurate with the expected life of the options in effect at the time of the grant. The expected dividend yield was zero, as the Company does not anticipate paying a dividend within the relevant time frame. Expected forfeitures are estimated based on the Company’s historical experience.
The Company realized no income tax benefit from stock option exercises in each of the periods presented due to recurring losses and defined tax asset valuation allowances.
As of September 30, 2012, the Company had unamortized stock‑based compensation expense of $13,358 related to stock options, that will be recognized net of forfeitures over the average remaining vesting term of the options of 2.70 years.
The fair value of the option component of the ESPP shares was estimated at the grant date using the Black-Scholes option pricing model with the following weighted average assumptions:

 
Three Months ended September 30,
 
Nine Months ended September 30,
 
2012
 
2011
 
2012
 
2011
Expected life (in years)
n/a
 
*
 
0.53
 
*
Volatility
n/a
 
*
 
51%
 
*
Risk-free interest rate
n/a
 
*
 
0.13%
 
*
Dividend yield
n/a
 
*
 
—%
 
*
* Employee participation in the ESPP did not begin until the second quarter of 2012.
As of September 30, 2012, the Company expects to recognize $85 of the total unamortized compensation cost related to employee purchases under the ESPP over a weighted average period of 0.08 years.

9. Net Loss per Share
Basic net loss per share of common stock is calculated by dividing the net loss by the weighted‑average number of shares of common stock outstanding for the period. The weighted‑average number of shares of common stock used to calculate our basic net loss per share of common stock excludes those shares subject to repurchase related to stock options that were exercised prior to vesting as these shares are not deemed to be issued for accounting purposes until they vest. Diluted net loss per share of common stock is computed by dividing the net loss using the weighted‑average number of shares of common stock, excluding common stock subject to repurchase, and, if dilutive, potential shares of common stock outstanding during the period. Basic and diluted net loss per common share was the same for all periods presented as the impact of all potentially dilutive securities outstanding was anti-dilutive.
The following table presents the calculation of basic and diluted net loss per share:

19

Table of Contents

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Numerator:
 
 
 
 
 
 
 
Net loss
$
(4,592
)
 
$
(4,313
)
 
$
(14,863
)
 
$
(13,717
)
Denominator:
 
 
 
 
 
 
 
Weighted average number of common shares used in computing basic and diluted net loss per share
31,844

 
4,048

 
21,258

 
3,931

Net loss per common share
 
 
 
 
 
 
 
Basic and diluted net loss per share
$
(0.14
)
 
$
(1.07
)
 
$
(0.70
)
 
$
(3.49
)
The following table presents the potentially dilutive common shares outstanding that were excluded from the computation of diluted net loss per share of common stock for the periods presented because including them would have been anti-dilutive:
 
Nine Months Ended
September 30,
 
2012
 
2011
Convertible preferred stock (as converted)

 
19,567

Stock options to purchase common stock
10,205

 
10,113

Common stock subject to repurchase
5

 
2

Convertible preferred stock warrants

 

Common stock warrants

 
2

Restricted stock units
23

 

Total
10,233

 
29,684


10. Segment Reporting
Operating segments are reported in a manner consistent with the internal reporting supported and defined by the components of an enterprise about which separate financial information is available, provided and is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is its chief executive officer. The Company’s chief executive officer reviews financial information presented on a consolidated basis and as a result, the Company concluded that there is only one operating and reportable segment.
The following sets forth total revenue and long-lived assets by geographic area. Revenue by geography is based upon the billing address of the customer.
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Total revenue:
 
 
 
 
 
 
 
United States
$
21,966

 
$
16,221

 
$
63,272

 
$
46,704

Rest of World
5,118

 
4,265

 
14,374

 
12,443

Total revenue
$
27,084

 
$
20,486

 
$
77,646

 
$
59,147




20

Table of Contents

 
Nine Months Ended September 30,
 
Year Ended
December 31,
 
2012
 
2011
Long-lived assets:
 
 
 
United States
$
6,073

 
$
5,198

Rest of World
1,627

 
2,155

Total long‑lived assets
$
7,700

 
$
7,353

11. Income Taxes
The Company’s quarterly provision for income taxes is based on an estimated effective annual income tax rate. The Company’s quarterly provision for income taxes also includes the tax impact of certain unusual or infrequently occurring items, if any, including changes in judgment about valuation allowances and effects of changes in tax laws or rates, in the interim period in which they occur.
Income tax expense for the three months and nine months ended September 30, 2012 was $119 and $430 on pre-tax losses of $4,473 and $14,433, respectively. Income tax expense for the three months and nine months ended September 30, 2011 was $33 and $169 on pre-tax losses of $4,280 and $13,548, respectively. As of September 30, 2012, the income tax rate varies from the United States statutory income tax rate primarily due to valuation allowances in the United States and certain foreign jurisdictions whereby pre-tax losses in these jurisdictions do not result in the recognition of corresponding income tax benefits.
The Company's effective tax rate for the nine months ended September 30, 2012 increased to 3.0% from 1.2% for the same prior year period. The current period's effective tax rate was negatively impacted by an increase in interest and penalties as a result of the completion of a transfer pricing analysis that occurred in the three months ended June 30, 2012.
The Company reviews the likelihood that it will realize the benefit of its deferred tax assets and, therefore, the need for valuation allowances on a quarterly basis. There is no corresponding income tax benefit recognized with respect to losses incurred and no corresponding income tax expense recognized with respect to earnings generated in jurisdictions with a valuation allowance. This causes variability in the Company’s effective tax rate. The Company intends to maintain the valuation allowances until it is more likely than not that the net deferred tax assets will be realized.
As of September 30, 2012, due to recent net cumulative losses and other negative evidence, a valuation allowance of approximately $4,200 remains on certain non-U.S. deferred tax assets that are not more-likely-than-not to be realized. The Company evaluates its deferred tax asset valuation allowance position on a quarterly basis. As a result, the Company believes a reversal of a significant portion of the Company's valuation allowance on non-U.S. deferred tax assets is possible in the next 12 months.
As of September 30, 2012, the Company's gross uncertain tax benefits totaled $2,635, excluding related accrued interest and penalties of $178. As of September 30, 2012, $257 of the Company's uncertain tax benefits, including related accrued interest and penalties, would affect its effective tax rate if recognized. During the three months ended September 30, 2012, our gross uncertain tax benefits increased $142. The increase is comprised of an $111 increase for tax positions taken in the current period and a $31 decrease for tax positions taken in prior periods.
The Company is not currently under audit by the IRS or any similar taxing authority in any other material jurisdiction. The Company believes it has recorded all appropriate provisions for all jurisdictions and open years. However, the Company can give no assurance that taxing authorities will not propose adjustments that increase the tax liabilities.

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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 the (1) unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q, and (2) the audited consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the fiscal year ended December 31, 2011 included in the final prospectus for our initial public offering, or IPO, dated as of, and filed with the Securities and Exchange Commission, or the SEC, pursuant to Rule 424(b)(4) on April 19, 2012 (File No. 333-178479). This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These statements are often identified by the use of words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “estimate,” or “continue,” and similar expressions or variations. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified herein, and those discussed in the section titled “Risk Factors”, set forth in Part II, Item 1A of this Form 10-Q and in our other SEC filings, including our final prospectus dated as of April 19, 2012. We disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.
Overview
Proofpoint is a pioneering security-as-a-service vendor that enables large and mid-sized organizations worldwide to defend, protect, archive and govern their most sensitive data. Our security-as-a-service platform is comprised of an integrated suite of on-demand data protection solutions, including threat protection, regulatory compliance, archiving and governance, and secure communication.
We were founded in 2002 to provide a unified solution to help enterprises address their growing data security requirements. Our first solution was commercially released in 2003 to combat the burgeoning problem of spam and viruses and their impact on corporate email systems. As the threat environment has continued to evolve, we have dedicated significant resources to meet the ongoing challenges that this highly dynamic environment creates for our customers. In addition, we have invested significantly to expand the breadth of our data protection platform:
In 2004, we launched our Regulatory Compliance and Digital Asset Security solutions, designed to prevent the loss of critical data. These Data Loss Prevention, or DLP, solutions apply our proprietary machine learning and deep content inspection technologies to screen outbound email to prevent the theft or inadvertent loss of sensitive or confidential information.
In 2005, we launched Proofpoint Secure Messaging, our first email encryption solution.
In 2006, we combined our email encryption and DLP technologies to develop a new solution for policy‑based encryption, enabling each outgoing message to be inspected for confidential content and automatically encrypted accordingly.
In 2007, we began selling our software‑based virtual appliance, enabling our customers to deploy our solutions in a private cloud configuration. We also invested in international expansion by establishing a team in the United Kingdom as a precursor to the build out of our data center infrastructure, and launching operations in Germany and the Netherlands to support our customers outside of the United States..
In 2008, we introduced Proofpoint Enterprise Archive, a cloud‑based email archiving solution that enables businesses to securely archive both their email and instant message conversations while enabling real-time access to the entire repository for quick and easy electronic discovery, or eDiscovery.
In 2009, we launched Proofpoint Encryption, a proprietary email encryption solution that improved the level of

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integration across our data protection suite and allowed us to phase out technology licensed from a third party. We also introduced a cloud‑based email messaging service.
In 2010, we evolved our solutions to address new forms of messaging and information sharing in the enterprise such as social media and Internet‑based collaboration and file sharing applications.
In 2011, we achieved FISMA certification for our cloud‑based archiving and governance solution, enabling us to serve the rigorous security requirements of U.S. Federal agencies. We also introduced an integrated security offering in conjunction with VMware for its Zimbra Collaboration Server.
In 2012, we introduced Proofpoint Enterprise Governance, an information governance solution that provides organizations the ability to monitor and apply governance policies to unstructured information across the enterprise. We also introduced Proofpoint Targeted Attack Protection, a solution designed to stop targeted attacks by combining previously disparate email security, Web security and malware analysis technologies into a single comprehensive cloud-based defense.
Our business is based on a recurring revenue model. Our customers pay a subscription fee to license the various components of our security-as-a-service platform for a contract term that is typically one to three years. At the end of the license term, customers may renew their subscription and in each year since the launch of our first solution in 2003, we have retained over 90% of our customers. We derive this retention rate by calculating the total annually recurring subscription revenue from customers currently using our security-as-a-service platform and dividing it by the total annually recurring subscription revenue from both these current customers as well as all business lost through non-renewal. A growing number of our customers increase their annual subscription fees after their initial purchase by broadening their use of our platform or by adding more users, as evidenced by the fact that these sales consistently represent 15% or more of our billings each year since 2008. As our business has grown, our subscription revenue has increased as a percentage of our total revenue, from 87% of total revenue in 2009, to 95% for the nine months ended September 30, 2012.
We market and sell our solutions to large and mid-sized customers both directly through our field and inside sales teams and indirectly through a hybrid model where our sales organization actively assists our network of distributors and resellers. We also derive a lesser portion of our revenue from the license of our solutions to strategic partners who offer our solutions in conjunction with one or more of their own products or services.
Our sales and marketing operation consists of sales people and associated marketing resources, each of whom are assigned to a specific geographic territory. Their mission is to grow additional revenue within their respective territory in whatever manner is most efficient, either by obtaining new customers or by working with existing customers to expand their use of our solutions. Our sales teams are compensated equally for sales to new customers or sales of additional solutions to existing customers, and we do not allocate sales and marketing resources between activities related to the acquisition of new customers and activities associated with the sale of additional solutions to existing customers.
We invoice our customers for the entire contract amount at the start of the term. The majority of these invoiced amounts are treated as deferred revenue on our consolidated balance sheet and are recognized ratably over the term of the contract. We invoice our strategic partners on a monthly basis, and the associated fees vary based upon the level of usage during the month by their customers. These amounts are recognized as revenue at the time of invoice.
Our solutions are designed to be implemented, configured and operated without the need for any training or professional services. For those customers that seek to develop deeper expertise in the use of our solutions or would like assistance with complex configurations or the importing of data, we offer various training and professional services. In some cases, we provide a hardware appliance to those customers that elect to host elements of our solution behind their firewall. Increasing adoption of virtualization in the data center has led to a decline in the sales of our hardware appliances and a shift towards our software‑based virtual appliances, which are delivered as a download via the Internet. Our hardware and services offerings carry lower margins and are provided as a courtesy to our customers. The revenue derived from these offerings has declined from 8.3% and 11.2% of total revenue in the three and nine months ended September 30, 2011 to 4.0% and 4.7% of total revenue in the three and nine months ended September 30, 2012. We view this trend as favorable to our business and expect the overall proportion of total revenue derived from these offerings to continue to gradually decline.

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The substantial majority of our revenue is derived from our customers in the United States. We believe the markets outside of the United States offer an opportunity for growth and we intend to make additional investments in sales and marketing to expand in these markets. Customers from outside of the United States represented 18.9% and 18.5% for the three and nine months ended September 30, 2012, respectively, and 20.8% and 21.0% of total revenue for the three and nine months ended September 30, 2011, respectively. We had in excess of 2,400 customers around the world, including 28 of the Fortune 100. There was one partner that accounted for more than 10% of our total revenue in the three and nine months ended September 30, 2012, although the partner sold to a number of end user customers. There were no single partners or customers that accounted for more than 10% of our total revenue in the three and nine months ended September 30, 2011.
We have not been profitable to date and will need to grow revenue at a rate faster than our investments in cost of revenue and operating expenses in order to achieve profitability, as discussed in more detail below.
Key Opportunities and Challenges
The majority of costs associated with generating customer agreements are incurred up front. These upfront costs include direct incremental sales commissions, which are recognized upon the billing of the contract. The costs associated with the teams tasked with closing business with new customers and additional business with our existing customers have represented more than 90% of our total sales and marketing costs since 2008. Although we expect customers to be profitable over the duration of the customer relationship, these upfront costs typically exceed related revenue during the earlier periods of a contract. As a result, while our practice of invoicing our customers for the entire amount of the contract at the start of the term provides us with a relatively immediate contribution to cash flow, the revenue is recognized ratably over the term of the contract, and hence contributions toward operating income are limited in the period where these sales and marketing costs are incurred. Accordingly, an increase in the mix of new customers as a percentage of total customers would likely negatively impact our near‑term operating results. On the other hand, we expect that an increase in the mix of existing customers as a percentage of total customers would positively impact our operating results over time. As we accumulate customers that continue to renew their contracts, we anticipate that our mix of existing customers will increase, contributing to a decrease in our sales and marketing costs as a percentage of total revenue and a commensurate improvement in our operating income.
As part of maintaining our security-as-a-service platform, we provide ongoing updates and enhancements to the platform services both in terms of the software as well as the underlying hardware and data center infrastructure. These updates and enhancements are provided to our customers at no additional charge as part of the subscription fees paid for the use of our platform. While more traditional products eventually become obsolete and require replacement, we are constantly updating and maintaining our cloud‑based services and as such they operate with a continuous product life cycle. Much of this work is designed to both maintain and enhance the customers’ experience over time while also lowering our costs to deliver the service, as evidenced by our improvements in gross profit over the past three years. Our security-as-a-service platform is a shared infrastructure that is used by all of our more than 2,400 customers. Accordingly, the costs of the platform are spread in a relatively uniform manner across the entire customer base and no specific infrastructure elements are directly attached to any particular customer. As such, in the event that a customer chooses to not renew its subscription, the underlying resources are reallocated either to new customers or to accommodate the expanding needs of our existing customers and, as a result, we do not believe that the loss of any particular customer has a meaningful impact on our gross profit as long as we continue to grow our customer base.
To date, our customers have primarily used our solutions in conjunction with email messaging content. We have developed solutions to address the new and evolving messaging solutions such as social media and file sharing applications, but these solutions are relatively nascent. If customers increase their use of these new messaging solutions in the future, we anticipate that our growth in revenue associated with email messaging solutions may slow over time. Although revenue associated with our social media and file sharing applications has not been material to date, we believe that our ability to provide security, archiving, governance and discovery for these new solutions will be viewed as valuable by our existing customers, enabling us to derive revenue from these new forms of messaging and communication.
While the majority of our current and prospective customers run their email systems on premise, we believe that there is a trend for large and mid‑sized enterprises to migrate these systems to the cloud. While our current revenue derived from customers using cloud‑based email systems continues to grow as a percentage of our total revenue, many of these cloud‑based email solutions offer some form of threat protection and governance services, potentially mitigating the need for customers to buy these capabilities from third parties such as ourselves. We believe that we can continue to provide security, archiving, governance, and discovery solutions that are differentiated from the services offered by cloud‑based email providers, and as

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such our platform will continue to be viewed as valuable to enterprises once they have migrated their email services to the cloud, enabling us to continue to derive revenue from this new trend toward cloud‑based email deployment models.
We are currently in the midst of a significant investment cycle in which we have taken steps designed to drive future revenue growth and profitability. For example, we plan to build out our infrastructure, develop our technology, offer additional security-as-a-service solutions, and expand our sales and marketing personnel both in the United States and internationally. Accordingly, we expect that our total cost of revenue and operating expenses will continue to increase in absolute dollars, limiting our ability to achieve and maintain positive operating cash flow and profitability in the near term.
With the majority of our business, we invoice our customers for the entire contract amount at the start of the term and these amounts are recorded as deferred revenue on our balance sheet, with the dollar weighted average duration of these contracts for any given period over the past three years typically ranging from 20 to 25 months. As a result, while our practice of invoicing customers for the entire amount of the contract at the start of the term provides us with a relatively immediate contribution to cash flow, the revenue is recognized ratably over the term of the contract, and hence contributions toward operating income are realized over an extended period. As such, our efforts to improve our profitability require us to invest far less in operating expenses than the cash flow generated by our business might otherwise allow. As we strive to invest in an effort to continue to increase the size and scale of our business, we expect that the level of investment afforded by our growth in revenue should be sufficient to fund the investments needed to drive revenue growth and broaden our product line.
Considering all of these factors, we do not expect to be profitable on a GAAP basis in the near term and in order to achieve profitability we will need to grow revenue at a rate faster than our investments in operating expenses and cost of revenue.
We intend to grow our revenue through acquiring new customers by investing in our sales and marketing activities. We believe that an increase in new customers in the near term will result in a larger base of renewal customers, which, over time we expect to be more profitable for us.
Sales and marketing is our greatest expense and hence a significant contributing factor to our operating losses. Given that our costs to acquire new revenue sources, either in the form of new customers or the sale of additional solutions to existing customers, often exceed the actual revenue recognized in the initial periods, we believe that our opportunity to improve our return on investment on sales and marketing costs relies primarily on our ongoing ability to cost effectively renew our business with existing customers, thereby lowering our overall sales and marketing costs as a percentage of revenue as the mix of revenue derived from this more profitable renewal activity increases over time. Therefore, we anticipate that our initial significant investments in sales and marketing activities will over time generate a larger base of more profitable customers. Cost of subscription revenue is also a significant expense for us, and we expect to continue to build on the improvements over the past three years, such as in replacing third-party technology with our proprietary technology and improving the utilization of our fixed investments in equipment and infrastructure, in order to provide the opportunity for improved subscription gross margins over time. Although we plan to continue enhancing our solutions, we intend to lower our rate of investment in research and development as a percentage of revenue over time by deriving additional revenue from our existing platform of solutions rather than by adding entirely new categories of solutions. In addition, as personnel costs are one of the primary drivers of the increases in our operating expenses, we plan to reduce our historical rate of headcount growth over time.

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Key Metrics
We regularly review a number of metrics, including the following key metrics presented in the unaudited table below, to evaluate our business, measure our performance, identify trends in our business, prepare financial projections and make strategic decisions. Many of these key metrics, such as adjusted subscription gross profit, billings and adjusted EBITDA, are non-GAAP measures. This non-GAAP information is not necessarily comparable to non-GAAP information of other companies. Non-GAAP information should not be viewed as a substitute for, or superior to, net loss prepared in accordance with GAAP as a measure of our profitability or liquidity. Users of this financial information should consider the types of events and transactions for which adjustments have been made.
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(in thousands)
 
(in thousands)
Total revenue
$
27,084

 
$
20,486

 
$
77,646

 
$
59,147

Growth
32
%
 
24
%
 
31
%
 
27
%
Subscription revenue
$
25,991

 
$
18,793

 
$
74,010

 
$
52,533

Growth
38
%
 
26
%
 
41
%
 
27
%
Adjusted subscription gross profit
$
19,562

 
$
13,882

 
$
55,491

 
$
38,070

% of subscription revenue
75
%
 
74
%
 
75
%

72
%
Billings
$
30,014

 
$
21,575

 
$
80,242

 
$
62,305

Growth
39
%
 
8
%
 
29
%
 
14
%
Adjusted EBITDA
$
(1,090
)
 
$
(1,152
)
 
$
(2,800
)
 
$
(4,490
)
Subscription revenue
Subscription revenue represents the recurring subscription fees paid by our customers and recognized as revenue during the period for the use of our security-as-a-service platform, typically licensed for one to three years at a time. We consider subscription revenue to be a key business metric because it reflects the recurring aspect of our business model and is the primary driver of growth for our business over time. The consistent growth in subscription revenue over the past several years has resulted from our ongoing investment in sales and marketing personnel, our efforts to expand our customer base, and our efforts to broaden the use of our platform with existing customers.
Adjusted subscription gross profit
We have included adjusted subscription gross profit, a non‑GAAP financial measure, in this report because it is a key measure used by our management and board of directors to understand and evaluate our operating results, core operating performance, and trends to prepare and approve our annual budget and to develop short‑ and long-term operational plans. We have provided a reconciliation between subscription gross profit, the most directly comparable GAAP financial measure, and adjusted subscription gross profit. We believe that adjusted subscription gross profit provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management and board of directors.
Our use of adjusted subscription gross profit has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP. Because of these limitations, you should consider adjusted subscription gross profit alongside other financial performance measures, including subscription gross profit and our other GAAP results.

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The following unaudited table presents the reconciliation of subscription gross profit to adjusted subscription gross profit for the three and six months ended September 30, 2012 and 2011:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(in thousands)
 
(in thousands)
Subscription revenue
$
25,991

 
$
18,793

 
$
74,010

 
$
52,533

Cost of subscription revenue
6,967

 
5,936

 
21,414

 
17,553

Subscription gross profit
19,024

 
12,857

 
52,596

 
34,980

Add back:
 
 
 
 
 
 
 
Stock‑based compensation
205

 
76

 
443

 
281

Amortization of intangible assets
333

 
949

 
2,452

 
2,809

Adjusted subscription gross profit
$
19,562

 
$
13,882

 
$
55,491

 
$
38,070

Billings
We have included billings, a non‑GAAP financial measure, in this report because it is a key measure used by our management and board of directors to manage our business and monitor our near term cash flows. We have provided a reconciliation between total revenue, the most directly comparable GAAP financial measure, and billings. Accordingly, we believe that billings provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management and board of directors.
Our use of billings as a non-GAAP measure has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for revenue or an analysis of our results as reported under GAAP. Some of these limitations are:
Billings is not a substitute for revenue, as trends in billings are not directly correlated to trends in revenue except when measured over longer periods of time;
Billings is affected by a combination of factors including the timing of renewals, the sales of our solutions to both new and existing customers, the relative duration of contracts sold, and the relative amount of business derived from strategic partners. As each of these elements has unique characteristics in the relationship between billings and revenue, our billings activity is not closely correlated to revenue except over longer periods of time; and
Other companies, including companies in our industry, may not use billings, may calculate billings differently, or may use other financial measures to evaluate their performance ‑ all of which reduce the usefulness of billings as a comparative measure.
The following unaudited table presents the reconciliation of total revenue to billings for the three and six months ended September 30, 2012 and 2011:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(in thousands)
 
(in thousands)
Total revenue
$
27,084

 
$
20,486

 
$
77,646

 
$
59,147

Deferred revenue
 
 
 
 
 
 
 
Ending
78,836

 
72,259

 
78,836

 
72,259

Beginning
75,906

 
71,170

 
76,240

 
69,101

Net change
2,930

 
1,089

 
2,596

 
3,158

Billings
$
30,014

 
$
21,575

 
$
80,242

 
$
62,305


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Adjusted EBITDA
We have included adjusted EBITDA, a non‑GAAP financial measure, in this report because it is a key metric used by our management and board of directors to measure operating performance and trends and to prepare and approve our annual budget. We define adjusted EBITDA as net loss, adjusted to exclude: depreciation, amortization of intangibles, interest income (expense), net, provision for income taxes, stock‑based compensation, acquisition‑related expense, other income, and other expense. We believe that adjusted EBITDA is useful to investors and other users of our financial statements in evaluating our operating performance because it provides them with an additional tool to compare business performance across companies and across periods. We believe that:
Adjusted EBITDA provides investors and other users of our financial information consistency and comparability with our past financial performance, facilitates period-to-period comparisons of operations and facilitates comparisons with our peer companies, many of which use similar non-GAAP financial measures to supplement their GAAP results; and
It is useful to exclude certain non-cash charges, such as depreciation, amortization of intangible assets and stock‑based compensation and non-core operational charges, such as acquisition‑related expenses, from adjusted EBITDA because the amount of such expenses in any specific period may not be directly correlated to the underlying performance of our business operations and these expenses can vary significantly between periods as a result of new acquisitions, full amortization of previously acquired tangible and intangible assets or the timing of new stock‑based awards, as the case may be.
We use adjusted EBITDA in conjunction with traditional GAAP operating performance measures as part of our overall assessment of our performance, for planning purposes, including the preparation of our annual operating budget, to evaluate the effectiveness of our business strategies and to communicate with our board of directors concerning our financial performance.
We do not place undue reliance on adjusted EBITDA as our only measures of operating performance. Adjusted EBITDA should not be considered as a substitute for other measures of financial performance reported in accordance with GAAP. There are limitations to using non-GAAP financial measures, including that other companies may calculate these measures differently than we do, that they do not reflect our capital expenditures or future requirements for capital expenditures and that they do not reflect changes in, or cash requirements for, our working capital.
The following unaudited table presents the reconciliation of net loss to adjusted EBITDA for the three and six months ended September 30, 2012 and 2011:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(in thousands)
 
(in thousands)
Net loss
$
(4,592
)
 
$
(4,313
)
 
$
(14,863
)
 
$
(13,717
)
Depreciation
1,125

 
815

 
3,173

 
2,259

Amortization of intangible assets
413

 
1,091

 
2,864

 
3,434

Interest expense, net
7

 
70

 
110

 
258

Provision for income taxes
119

 
33

 
430

 
169

EBITDA
$
(2,928
)
 
$
(2,304
)
 
$
(8,286
)
 
$
(7,597
)
Stock‑based compensation expense
1,947

 
1,121

 
5,383

 
3,291

Acquisition‑related expense

 

 
3

 
28

Other income
(1
)
 
(2
)
 
(12
)
 
(140
)
Other expense
(108
)
 
33

 
112

 
(72
)
Adjusted EBITDA
$
(1,090
)
 
$
(1,152
)
 
$
(2,800
)
 
$
(4,490
)


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Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations is based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates, assumptions and judgments that can have significant impact on the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. We base our estimates, assumptions and judgments on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. On a regular basis we evaluate our estimates, assumptions and judgments and make changes accordingly.
We believe that the estimates, assumptions and judgments involved in revenue recognition, deferred revenue, stock-based compensation and accounting for income taxes have the greatest potential impact on our Consolidated Financial Statements, and consider these to be our critical accounting policies. Historically, our estimates, assumptions and judgments relative to our critical accounting policies have not differed materially from actual results. The critical accounting estimates associated with these policies are described in our Prospectus dated April 19, 2012 (the "Prospectus"), filed with the SEC pursuant to Rule 424(b)(4) under the Securities Act of 1933 (the “Securities Act”), as amended, under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” There have been no material changes to our significant accounting policies as compared to the significant accounting policies described in our Prospectus for the year ended December 31, 2011.
Components of Our Results of Operations
Revenue
We derive our revenue primarily through the license of various solutions and services on our security-as-a-service platform on a subscription basis, supplemented by the sales of training, professional services and hardware depending upon our customers’ requirements.
Subscription. We license our platform and its associated solutions and services on a subscription basis. The fees are charged on a per user, per year basis. Subscriptions are typically one to three years in duration. We invoice our customers upon signing for the entire term of the contract. The invoiced amounts billed in advance are treated as deferred revenue on the balance sheet and are recognized ratably, in accordance with the appropriate revenue recognition guidelines, over the term of the contract (as more fully described in the Prospectus under "-Management's Discussion and Analysis of Financial Condition and Results of Operations"). We also derive a portion of our subscription revenue from the license of our solutions to strategic partners. We bill these strategic partners monthly. As our business has grown, our subscription revenue has increased as a percentage of our total revenue, from 92% and 89% of total revenue in the three and nine months ended September 30, 2011, respectively, compared to 96% and 95% of total revenue in the three and nine months ended September 30, 2012, respectively.
Hardware and services. We provide hardware appliances as a convenience to our customers and as such it represents a small part of our business. Our solutions are designed to be implemented, configured and operated without the need for any training or professional services. For those customers that seek to develop deeper expertise in the use of our solutions or would like assistance with complex configurations or the importing of data, we offer various training and professional services. We typically invoice the customer for hardware at the time of shipment. Effective January 1, 2011, we adopted the revenue recognition guidance of Accounting Standards Update (ASU) 2009-13 and ASU 2009-14, which mandate that our revenue derived from the sale of hardware be recognized at the time of shipment. Prior to the adoption of this new accounting guidance, hardware revenue was recognized ratably over the duration of the contract. We typically invoice customers for services at the time the order is placed and recognize this revenue ratably over the term of the contract. On occasion, customers may retain us for special projects such as archiving import and export services; these types of services are recognized upon completion of the project. The revenue derived from these hardware and services offerings has declined from 8% and 11% of total revenue in the three and nine months ended September 30, 2011, respectively, to 4% and 5% of total revenue of the total revenue in the three and nine months ended September 30, 2012, respectively. We view this trend as favorable to our business and expect the overall proportion of revenue derived from these offerings to generally remain below 10% of our total revenue.

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Total Cost of Revenue
Our cost of revenues consist of cost of subscription revenue and cost of hardware and services revenue. Personnel costs, which consist of salaries, benefits, bonuses, and stock‑based compensation, data center costs and hardware costs are the most significant components of our cost of revenues. As a result of headcount growth, cost of revenues have increased significantly over these periods. We expect personnel costs to continue to increase in absolute dollars as we hire new employees to continue to grow our business.
Cost of Subscription Revenue. Cost of subscription revenue primarily includes personnel costs, consisting of salaries, benefits, bonuses, and stock‑based compensation, for employees who provide support services to our customers and operate our data centers. Employee compensation expenses increased within our operations and customer support organization from September 30, 2011 to September 30, 2012, due to increased headcount. Other costs include fees paid to contractors who supplement our support and data center personnel; expenses related to the use of third‑party data centers in both the United States and internationally; depreciation of data center equipment; amortization of licensing fees and royalties paid for the use of third‑party technology; amortization of capitalized research and development costs; and the amortization of intangible assets related to prior acquisitions. Growth in subscription revenue generally consumes production resources, requiring us to gradually increase our cost of subscription revenue in absolute dollars as we expand our investment in data center equipment, the third party data center space required to house this equipment, and the personnel needed to manage this higher level of activity. However, our cost of subscription revenue has declined in recent periods as a percentage of its associated revenue as we have replaced third‑party licensed technology with our proprietary technology, and we expect the benefit of these initiatives to continue in future periods.
Cost of Hardware and Services Revenue. Cost of hardware and services revenue includes personnel costs for employees who provide training and professional services to our customers as well as the cost of server hardware shipped to our customers that we procure from third parties and configure with our software solutions. We experienced growth in our manufacturing, training and professional services organization resulting in increased headcount from September 30, 2011 to September 30, 2012. Effective January 1, 2011, in conjunction with the adoption of the new revenue recognition guidance, the cost of hardware is expensed at the time of shipment. Prior to the adoption of this new guidance, these hardware costs were recognized ratably over the duration of the contract with which they were sold. Our cost of hardware and services as a percentage of its associated revenue has been relatively consistent from period to period in the past. With the adoption of our new accounting guidance we expect that cost of hardware and services revenue may gradually increase as a percentage of hardware and services revenue in future periods, as the remaining deferred costs are amortized over remaining contract terms.
Operating Expenses
Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. Personnel costs, which consist of salaries, benefits, bonuses, and stock‑based compensation, are the most significant component of our operating expenses. As a result of headcount growth, operating expenses have increased significantly over these periods. We expect personnel costs to continue to increase in absolute dollars as we hire new employees to continue to grow our business.
Research and Development. Research and development expenses include personnel costs, consulting services and depreciation. As a result of our ongoing investment in solutions developed internally as well as those added through acquisitions, our research and development headcount has increased from September 30, 2011 to September 30, 2012. We believe that these investments have played an important role in broadening the capabilities of our platform over the course of our operating history, enhancing the relevance of our solutions in the market in general and helping us to retain our customers over time. We expect to continue to devote substantial resources to research and development in an effort to continuously improve our existing solutions as well as to develop new offerings. We believe that these investments are necessary to maintain and improve our competitive position. Our research efforts include both software developed for our internal use on behalf of our customers as well as software elements to be used by our customers in their own facilities. To date, for software developed for internal use on behalf of our customers, we have capitalized costs of approximately $0.4 million, all of which was incurred during 2011, and will be amortized as cost of subscription revenue over a two‑year period. Based on our current plans, we expect to capitalize a similar portion of our development costs in the future. For the software developed for use on our customers’ premises, the costs associated with the development work between technological feasibility and the general availability has not been material and as such we have not capitalized any of these development costs to date.

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Sales and Marketing. Sales and marketing expenses include personnel costs, sales commissions, and other costs including travel and entertainment, marketing and promotional events, public relations and marketing activities. All of these costs are expensed as incurred, including sales commissions. These costs also include amortization of intangible assets as a result of our past acquisitions. Reflecting our continued investment in growing our sales and marketing operations, both domestically and internationally, headcount increases were reflected in higher compensation expense from September 30, 2011 compared to September 30, 2012. Our sales personnel are typically not immediately productive, and therefore the increase in sales and marketing expenses we incur when we add new sales representatives is not immediately offset by increased revenue and may not result in increased revenue over the long-term if these new sales people fail to become productive. The timing of our hiring of new sales personnel and the rate at which they generate incremental revenue will affect our future financial performance. We expect that sales and marketing expenses will continue to increase in absolute dollars and be among the most significant components of our operating expenses.
General and Administrative. General and administrative expenses include personnel costs, consulting services, audit fees, tax services, legal expenses and other general corporate items. As a result of our operational growth transitioning from a non-public to public company, our administrative headcount increased from September 30, 2011 to September 30, 2012. We expect our general and administrative expenses to increase in future periods as we continue to expand our operations, hire additional personnel and continue to transition from being a private company to a public company.
Total Other Income (Expense), Net
Total other income (expense), net, consists of interest income (expense), net and other income (expense), net. Interest income (expense), net, consists primarily of interest income earned on our cash, cash equivalents and short term investments offset by the interest expense for our capital lease payments and borrowings under our equipment loans. Other income (expense), net, consists primarily of the net effect of foreign currency transaction gain or loss.
Provision for Income Taxes
The provision for income taxes is related to certain state and foreign income taxes. As we have incurred operating losses in all periods to date and recorded a full valuation allowance against our deferred tax assets, we have not historically recorded a provision for federal income taxes. Realization of any of our deferred tax assets depends upon future earnings, the timing and amount of which are uncertain. Utilization of our net operating losses may be subject to substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. An analysis was conducted to determine whether an ownership change had occurred since inception. The analysis indicated that although an ownership change occurred in a prior year, the net operating losses and research and development credits would not expire before utilization. In the event we have subsequent changes in ownership, net operating losses and research and development credit carryovers could be limited and may expire unutilized.


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Results of Operations
The following table is a summary of our consolidated statements of operations and results of operations as a percentage of our total revenue for those periods.
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
 
Amount
 
% of revenue
 
Amount
 
% of revenue
 
Amount
 
% of revenue
 
Amount
 
% of revenue
 
($ in thousands)
 
($ in thousands)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subscription
$
25,991

 
96
 %
 
$
18,793

 
92
 %
 
$
74,010

 
95
 %
 
$
52,533

 
89
 %
Hardware and services
1,093

 
4

 
1,693

 
8

 
3,636

 
5

 
6,614

 
11

Total revenue
27,084

 
100

 
20,486

 
100

 
77,646

 
100

 
59,147

 
100

Cost of revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subscription
6,967

 
26

 
5,936

 
29

 
21,414

 
28

 
17,553

 
30

Hardware and services
1,163

 
4

 
1,313

 
7

 
3,466

 
4

 
4,426

 
7

Total cost of revenue
8,130

 
30

 
7,249

 
36

 
24,880

 
32

 
21,979

 
37

Gross profit
18,954

 
70

 
13,237

 
64

 
52,766

 
68

 
37,168

 
63

Operating expense:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
6,262

 
23

 
4,594

 
22

 
18,367

 
24

 
14,416

 
24

Sales and marketing
14,126

 
52

 
10,779

 
53

 
39,751

 
51

 
30,070

 
51

General and administrative
3,141

 
12

 
2,043

 
10

 
8,871

 
11

 
6,184

 
10

Total operating expense
23,529

 
87

 
17,416

 
85

 
66,989

 
86

 
50,670

 
86

Operating loss
(4,575
)
 
(17
)
 
(4,179
)
 
(21
)
 
(14,223
)
 
(18
)
 
(13,502
)
 
(23
)
Interest expense, net
(7
)
 

 
(70
)
 

 
(110
)
 

 
(258
)
 

Other income (expense), net
109

 

 
(31
)
 

 
(100
)
 

 
212

 

Loss before provision for income taxes
(4,473
)
 
(17
)
 
(4,280
)
 
(21
)
 
(14,433
)
 
(18
)
 
(13,548
)
 
(23
)
Provision for income taxes
(119
)
 

 
(33
)
 

 
(430
)
 
(1
)
 
(169
)
 

Net loss
$
(4,592
)
 
(17
)%
 
$
(4,313
)
 
(21
)%
 
$
(14,863
)
 
(19
)%
 
$
(13,717
)
 
(23
)%


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Comparison of the Three and Nine Months Ended September 30, 2012 and 2011
Revenue