ProofPoint-09.30.2013-10Q
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, 2013
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 October 31, 2013: 35,906,978 shares.




Table of Contents


PROOFPOINT, INC.
FORM 10-Q

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,
 
2013
 
2012
Assets
 
 
 
Current assets
 
 
 
Cash and cash equivalents
$
51,828

 
$
39,254

Short-term investments
19,760

 
47,263

Accounts receivable, net of allowance for doubtful accounts of $249 and $187 at September 30, 2013 and December 31, 2012, respectively
21,881

 
18,115

Inventory
429

 
567

Deferred product costs, current
928

 
1,184

Prepaid expenses and other current assets
3,838

 
3,491

Total current assets
98,664

 
109,874

Property and equipment, net
10,545

 
8,560

Deferred product costs, noncurrent
272

 
326

Goodwill
39,206

 
18,557

Intangible assets, net
13,348

 
2,913

Other noncurrent assets
3,848

 
211

Total assets
$
165,883

 
$
140,441

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities
 
 
 
Accounts payable
$
4,468

 
$
2,496

Accrued liabilities
15,960

 
12,078

Notes payable and lease obligations, current
1,667

 
1,658

Deferred rent
445

 
462

Deferred revenue, current
75,053

 
62,642

Total current liabilities
97,593

 
79,336

Notes payable and lease obligations, noncurrent
1,110

 
2,354

Other long term liabilities, noncurrent
3,062

 
726

Deferred revenue, noncurrent
26,275

 
24,217

Total liabilities
128,040

 
106,633

 
 
 
 
Stockholders’ Equity
 
 
 
Common stock, $0.0001 par value; 200,000 shares authorized at September 30, 2013 and December 31, 2012, respectively; 35,786 and 33,044 shares issued and outstanding at September 30, 2013 and December 31, 2012, respectively
4

 
3

Additional paid-in capital
235,965

 
216,280

Accumulated other comprehensive (loss) income
(1
)
 
3

Accumulated deficit
(198,125
)
 
(182,478
)
Total stockholders’ equity
37,843

 
33,808

Total liabilities and stockholders’ equity
$
165,883

 
$
140,441

See accompanying Notes to the Condensed Consolidated Financial Statements.

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

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Revenue:
 
 
 
 
 
 
 
Subscription
$
33,464

 
$
25,991

 
$
92,732

 
$
74,010

Hardware and services
1,039

 
1,093

 
4,362

 
3,636

Total revenue
34,503

 
27,084

 
97,094

 
77,646

Cost of revenue:(1)(2)
 
 
 
 
 
 
 
Subscription
8,937

 
6,967

 
25,042

 
21,414

Hardware and services
1,409

 
1,163

 
3,851

 
3,466

Total cost of revenue
10,346

 
8,130

 
28,893

 
24,880

Gross profit
24,157

 
18,954

 
68,201

 
52,766

Operating expense:(1)(2)
 
 
 
 
 
 
 
Research and development
8,307

 
6,262

 
23,460

 
18,367

Sales and marketing
17,415

 
14,126

 
49,782

 
39,751

General and administrative
5,758

 
3,141

 
13,437

 
8,871

Total operating expense
31,480

 
23,529

 
86,679

 
66,989

Operating loss
(7,323
)
 
(4,575
)
 
(18,478
)
 
(14,223
)
Interest expense, net
(11
)
 
(7
)
 
(4
)
 
(110
)
Other income (expense), net
352

 
109

 
(163
)
 
(100
)
Loss before (provision for) benefit from income taxes
(6,982
)
 
(4,473
)
 
(18,645
)
 
(14,433
)
(Provision for) benefit from income taxes
(207
)
 
(119
)
 
2,998

 
(430
)
Net loss
$
(7,189
)
 
$
(4,592
)
 
$
(15,647
)
 
$
(14,863
)
Net loss per share, basic and diluted
$
(0.20
)
 
$
(0.14
)
 
$
(0.45
)
 
$
(0.70
)
Weighted average shares outstanding, basic and diluted
35,436

 
31,844

 
34,502

 
21,258

(1) Includes stock‑based compensation expense as follows:
 
 
 
 
 
 
 
Cost of subscription revenue
$
203

 
$
205

 
$
631

 
$
443

Cost of hardware and services revenue
45

 
20

 
120

 
46

Research and development
502

 
502

 
1,566

 
1,409

Sales and marketing
881

 
830

 
2,502

 
2,301

General and administrative
748

 
390

 
1,783

 
1,184

(2) Includes intangible amortization expense as follows:
 
 
 
 
 
 
 
Cost of subscription revenue
$
568

 
$
333

 
$
1,307

 
$
2,452

Research and development
8

 
8

 
24

 
23

Sales and marketing
321

 
72

 
619

 
389

General and administrative
12

 

 
23

 

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
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Net loss
$
(7,189
)
 
$
(4,592
)
 
$
(15,647
)
 
$
(14,863
)
Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Unrealized gains (losses) on short-term investments, net
9

 
22

 
(4
)
 
13

Comprehensive loss
$
(7,180
)
 
$
(4,570
)
 
$
(15,651
)
 
$
(14,850
)


See accompanying Notes to the Condensed Consolidated Financial Statements.

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

 
Nine Months Ended
September 30,
 
2013
 
2012
Cash flows from operating activities
 
 
 
Net loss
$
(15,647
)
 
$
(14,863
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization
6,123

 
6,037

Accretion of investments
490

 

Provision for allowance for doubtful accounts
26

 

Stock‑based compensation
6,602

 
5,383

Change in fair value of contingent earn-out liability
6

 

Changes in assets and liabilities, net of effect of acquisition:
 
 
 
Accounts receivable
(2,902
)
 
(1,292
)
Inventory
138

 
(169
)
Deferred products costs
310

 
1,121

Prepaid expenses and other current assets
(114
)
 
(1,133
)
Noncurrent assets
(3,580
)
 
54

Accounts payable
897

 
1,099

Accrued liabilities
733

 
2,778

Deferred rent
(257
)
 
321

Deferred revenue
14,469

 
2,596

Net cash provided by operating activities
7,294

 
1,932

Cash flows from investing activities
 
 
 
Proceeds from sales and maturities of short-term investments
47,386

 
3,151

Purchase of short-term investments
(20,376
)
 
(49,316
)
Purchase of property and equipment
(4,502
)
 
(3,884
)
Acquisitions of businesses, net of cash acquired
(28,509
)
 

Net cash used in investing activities
(6,001
)
 
(50,049
)
Cash flows from financing activities
 
 
 
Proceeds from issuance of common stock, net of repurchases
12,954

 
2,106

Proceeds from initial public offering, net of offering costs

 
68,329

Repayments of equipment financing loans
(1,673
)
 
(557
)
Net cash provided by financing activities
11,281

 
69,878

Net increase in cash and cash equivalents
12,574

 
21,761

Cash and cash equivalents
 
 
 
Beginning of period
39,254

 
9,767

End of period
$
51,828

 
$
31,528

 
 
 
 
Supplemental disclosure of noncash investing and financing information
 
 
 
Unpaid initial public offering costs
$

 
$
34

Unpaid purchase of property and equipment
$
1,838

 
$
439


See accompanying Notes to the Condensed Consolidated Financial Statements.

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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 ("SaaS") vendor that enables large and mid-sized organizations worldwide to defend, protect, archive and govern their most sensitive data. The Company’s SaaS platform is comprised of a number of data protection solutions, including threat protection, regulatory compliance, archiving and governance, and secure communication.
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 (consisting only of normal recurring adjustments) for a fair statement of results for the interim periods presented have been included. The results of operations for the three and nine months ended September 30, 2013 and 2012 are not necessarily indicative of the results to be expected for the year ended December 31, 2013 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 accompanying Condensed Consolidated Balance Sheet as of December 31, 2012 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 accompanying Condensed Consolidated Financial Statements should be read in conjunction with the consolidated financial statements and related notes included in the Company's 2012 Annual Report on Form 10-K.
There have been no material changes to the Company's significant accounting policies described in the Company's Annual Report on Form 10-K for the year ended December 31, 2012 except as otherwise described below.
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.
Business Combinations
The accompanying Condensed Consolidated Financial Statements include the operations of each acquired businesses after the completion of the acquisitions. The Company accounts for acquired businesses using the acquisition method of accounting which requires, among other things, that assets acquired and liabilities assumed be recognized at their estimated fair values as of the acquisition date, while transaction costs are expensed as incurred. The measurement of fair value of assets and

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liabilities assumed requires significant judgment. Any excess of the purchase price over the fair value of the net assets acquired is recorded as goodwill.
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 Accounting Standards Codification ("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 Company conducts an assessment of qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount. If the Company determines that it is more likely than not that the fair value of its reporting unit is less than its carrying amount, it then conducts the second step, a two-part test for impairment of goodwill. The Company first compares the fair value of its reporting unit to its carrying value. If the fair value exceeds the carrying value of the net assets, goodwill is not considered impaired and no further analysis is required. If the carrying value of the net assets exceeds the fair values of the reporting unit, then the second part of the impairment test must be performed in order to determine the implied fair value of the 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 goodwill exceeds the implied fair value, then an impairment loss equal to the difference would be recorded. 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, 2013.
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 one to seven years.
Revenue Recognition
The Company derives its revenue primarily from two sources: (1) subscription revenue for rights related to the use of the SaaS 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 SaaS 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

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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 does not commence until such services are completed.
In the accompanying Condensed 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

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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 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 SaaS platform 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, 2013, the Company experienced no 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 and is a Level 2 measurement within the fair value hierarchy. The Company has an Acquisition-related contingent earn-out liability that requires Level 3 classification because there are no active markets or observable inputs.

Comprehensive Loss

Comprehensive loss includes all changes in equity that are not the result of transactions with stockholders. The Company’s comprehensive loss consists of its net loss and changes in unrealized gains (losses) from its available-for-sale investments. Total comprehensive loss has been presented in the accompanying Condensed Consolidated Statements of Comprehensive Loss.
During the nine months ended September 30, 2013, the Company adopted Accounting Standards Update ("ASU") 2013-02, "Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income", which requires filers to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net loss. The Company had no significant reclassifications out of accumulated other comprehensive loss into net loss for the three and nine months ended September 30, 2013 and 2012.

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Recent Accounting Pronouncements
In July 2013, the FASB issued ASU 2013-11, "Income Taxes", a new accounting standard update on the financial statement presentation of unrecognized tax benefits. The new guidance provides that a liability related to an unrecognized tax benefit would be presented as a reduction of a deferred tax asset for a net operating loss carryforward, a similar tax loss or a tax credit carryforward if such settlement is required or expected in the event the uncertain tax position is disallowed. The new guidance becomes effective for the Company on January 1, 2014 and it should be applied prospectively to unrecognized tax benefits that exist at the effective date with retrospective application permitted. The Company is currently assessing the impact of this new guidance.
2. Acquisitions

In 2013, the Company entered into agreements to acquire several companies (collectively, the "Acquisitions"). Each acquisition was accounted for under the acquisition method of accounting in which the tangible and identifiable intangible assets and liabilities of each acquired company was recorded at their respective fair values as of each acquisition date, including an amount for goodwill representing the difference between the respective acquisition consideration and fair values of identifiable net assets. The Company expects the combined entities to achieve savings in corporate overhead costs and opportunities for growth through expanded geographic and customer segment diversity with the ability to leverage additional products and capabilities. These factors, among others, contributed to a purchase price in excess of the estimated fair value of each acquired company's net identifiable assets acquired and, as a result, goodwill was recorded in connection with each acquisition. Goodwill is not deductible for tax purposes.

Armorize Technologies, Inc.

On September 5, 2013 (the "Armorize Acquisition Date"), pursuant to the terms of an Agreement and Plan of Merger, a wholly-owned subsidiary of the Company merged with and into Armorize Technologies, Inc. ("Armorize"), with Armorize surviving as a wholly-owned subsidiary of the Company. Based in Taiwan, Armorize develops and markets leading cloud-based SaaS anti-malware products and will add real-time dynamic detection of next generation threats and malware to the Company's existing capabilities.

At September 30, 2013, the Company completed the valuation of the estimated fair values of the acquired tangible and identifiable intangible assets and liabilities assumed at the Armorize Acquisition Date, and the results of operations and the fair values of the acquired assets and liabilities assumed have been included in the accompanying Condensed Consolidated Financial Statements since the Armorize Acquisition Date. The Company recorded $183 in revenue from Armorize for the nine months ended September 30, 2013.

At the Armorize Acquisition Date, the Company paid $24,215 in cash consideration, net of cash acquired of $1,746. Of the cash consideration paid, $3,750 was held in escrow to secure indemnification obligations, which has not been released as of the filing date of this Quarterly Report on Form 10-Q. The Company incurred $775 in acquisition-related costs which were recorded in operating expenses for the three and nine months ended September 30, 2013.

Fair value of acquired assets and liabilities assumed

The following table summarizes the fair values of tangible assets acquired, liabilities assumed, intangible assets and goodwill:



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Estimated
Fair Value in USD
Estimated
Useful Life (in years)
Tangible assets acquired
$
2,754

N/A
Liabilities assumed
(1,256
)
N/A
Customer relationships
1,300

2
Non-compete agreements
500

3
Core/developed technology
3,850

5
Goodwill
18,813

Indefinite
 
$
25,961

 


Abaca Technology Corporation

On July 19, 2013 (the "Abaca Technology Acquisition Date"), pursuant to the terms of an Agreement and Plan of Merger, a wholly-owned subsidiary of the Company merged with and into Abaca Technology Corporation ("Abaca Technology"), with Abaca Technology surviving as a wholly-owned subsidiary of the Company. Abaca Technology specializes in email filtering and protection algorithms and their cloud-based, in-memory threat scoring technologies are expected to complement the Company's continued investment in anti-spam and threat detection capabilities.

At September 30, 2013, the Company completed the valuation of the estimated fair values of the acquired tangible and identifiable intangible assets and liabilities at the Abaca Technology Acquisition Date, and the results of operations and the fair values of the acquired assets and liabilities assumed have been included in the accompanying Condensed Consolidated Financial Statements since the Abaca Technology Acquisition Date. The Company recorded $121 in revenue from Abaca Technology for the nine months ended September 30, 2013.

At the Abaca Technology Acquisition Date, the Company paid $23 in cash consideration, net of cash acquired of $3. The purchase consideration included an additional amount of $1,520 which was held back to secure contingent liabilities related to indemnification obligations. The initial fair values of the contingent liabilities of $1,397 were recorded in Other long term liabilities in the accompanying Condensed Consolidated Balance Sheets. The indemnification obligations have not been released as of the filing date of this Quarterly Report on Form 10-Q. The Company incurred $254 in acquisition-related costs which were recorded in operating expenses for the three and nine months ended September 30, 2013.

Fair value of acquired assets and liabilities assumed

The following table summarizes the fair values of tangible assets acquired, liabilities assumed, intangible assets and goodwill:

 
Estimated
Fair Value in USD
Estimated
Useful Life (in years)
Tangible assets acquired
$
311

N/A
Liabilities assumed
(975
)
N/A
Customer relationships
40

3
Core/developed technology
1,770

5
Goodwill
277

Indefinite
 
$
1,423

 


eDynamics, LLC

On July 10, 2013 (the "eDynamics Acquisition Date"), pursuant to the terms of an Asset Purchase Agreement. the Company purchased substantially all of the business intellectual property and assumed certain liabilities of eDynamics, LLC ("eDynamics"). eDynamics is a social media archiving company and is expected to be an integral part of the Company's broader effort in rolling out a comprehensive social media archiving platform for customers.


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At September 30, 2013, the Company completed the valuation of the estimated fair values of the acquired tangible and identifiable intangible assets and liabilities assumed at the eDynamics Acquisition Date, and the results of operations and the fair values of the acquired assets and liabilities assumed have been included in the accompanying Condensed Consolidated Financial Statements since the eDynamics Acquisition Date. Revenue from eDynamics was immaterial for the nine months ended September 30, 2013.

At the eDynamics Acquisition Date, the Company paid $500 in cash consideration. The Company also agreed to pay earn-out consideration ("Acquisition-related contingent earn-out liability") of up to $600 through April 2014, such liability being contingent upon the achievement of specified product development milestones. The initial fair value of the contingent earn-out liability of $586 was recorded as part of the purchase consideration. The purchase consideration also included an additional amount of $100, which was held back to secure any claims that may arise in the 12-month period after the eDynamics Acquisition Date. The initial fair value of such amount withheld of $72 as well as the contingent earn-out liability were recorded in Accrued liabilities on the accompanying Condensed Consolidated Balance Sheets. The Company incurred $7 in acquisition-related costs which were recorded in operating expenses for the three and nine months ended September 30, 2013.

Fair value of acquired assets and liabilities assumed

The following table summarizes the fair values of tangible assets acquired, liabilities assumed, intangible assets and goodwill:

 
Estimated
Fair Value in USD
Estimated
Useful Life (in years)
Customer relationships
$
243

3.5
Non-compete agreements
75

2
Core/developed technology
733

3.5
Goodwill
107

Indefinite
 
$
1,158

 


Mail Distiller Limited

On April 5, 2013 (the "Mail Distiller Acquisition Date"), pursuant to the terms of a share transfer agreement, the Company purchased all of the outstanding share capital of Mail Distiller Limited, a Northern Ireland Company ("Mail Distiller"). Mail Distiller is a European-based provider of the SaaS email security solutions. Mail Distiller allowed the Company to create the Proofpoint Essentials product line, a suite of SaaS security and compliance solutions specifically designed for distribution across managed service providers and dedicated security resellers.

At June 30, 2013, the Company completed the valuation of the estimated fair values of the acquired tangible and identifiable intangible assets and liabilities assumed at the Mail Distiller Acquisition Date, and the results of operations and the fair values of the acquired assets and liabilities assumed have been included in the accompanying Condensed Consolidated Financial Statements since the Mail Distiller Acquisition Date. The Company recognized $38 in revenue from Mail Distiller for the nine months ended September 30, 2013.

At the Mail Distiller Acquisition Date, the Company paid $3,771 in cash consideration, net of cash acquired of $60. The purchase consideration included an additional amount of $669 held back to secure indemnification obligations, which was recorded in Accrued liabilities on the accompanying Condensed Consolidated Balance Sheets. The indemnification obligations have not been released as of the filing date of this Quarterly Report on Form 10-Q. The Company incurred $129 and $256 in acquisition-related costs which were recorded in operating expenses for the three and nine months ended September 30, 2013.

Fair value of acquired assets and liabilities assumed

The following table summarizes the fair values of tangible assets acquired, liabilities assumed, intangible assets and goodwill:


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Estimated
Fair Value in USD
Estimated
Useful Life (in years)
Tangible assets acquired
$
204

N/A
Liabilities assumed
(1,052
)
N/A
Trade name
7

1
Customer relationships
1,291

2
Non-compete agreements
123

2
Core/developed technology
2,475

7
Goodwill
1,452

Indefinite
 
$
4,500

 

Pro Forma Financial Information

The following unaudited pro forma financial information presents the combined results of operations for the three and nine months ended September 30, 2013 and 2012 as if all the Acquisitions entered into during 2013 had been completed on January 1, 2012, with adjustments to give effect to pro forma events that are directly attributable to the Acquisitions such as amortization expense from acquired intangible assets and acquisition-related transaction costs. The unaudited pro forma results do not reflect any operating efficiencies or potential cost savings which may result from the consolidation of the operations of the Company and Acquisitions. Accordingly, these unaudited pro formas results are presented for informational purposes only and are not necessarily indicative of what the actual results of operations of the combined company would have been if the Acquisitions had occurred at the beginning of the period presented, nor are they indicative of future results of operations:

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2013
 
2012
 
2013
 
2012
Total revenue
$
35,089

 
$
28,560

 
$
100,169

 
$
81,429

Net loss
(7,183
)
 
(5,985
)
 
(18,947
)
 
(21,565
)
Basic and diluted loss per share
$
(0.20
)
 
$
(0.19
)
 
$
(0.55
)
 
$
(1.01
)

The unaudited pro forma financial information includes non-recurring acquisition-related transaction cost of $1,292 for the nine months ended September 30, 2012.

3. Goodwill and Intangible Assets
The goodwill activity and balances are presented below:
Balance at December 31, 2012
$
18,557

Add: Goodwill from acquisitions
20,649

Balance at September 30, 2013
$
39,206

The goodwill balance as of September 30, 2013 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 (“SORBS”), NextPage, Inc. and the Acquisitions during the nine months ended September 30, 2013.
Intangible Assets
Intangible assets excluding goodwill, consisted of the following:

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September 30, 2013
 
December 31, 2012
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
Developed technology
$
26,469

 
$
(16,469
)
 
$
10,000

 
$
17,641

 
$
(15,163
)
 
$
2,478

Customer relationships
5,282

 
(2,684
)
 
2,598

 
2,408

 
(2,109
)
 
299

Non-compete agreements
804

 
(97)

 
707

 
106

 
(27
)
 
79

Trademark and patents
105

 
(62)

 
43

 
98

 
(41
)
 
57

 
$
32,660

 
$
(19,312
)
 
$
13,348

 
$
20,253

 
$
(17,340
)
 
$
2,913


Amortization expense of intangibles totaled $909 and $413, respectively, for the three months ended September 30, 2013 and 2012 and $1,973 and $2,864, respectively, for the nine months ended September 30, 2013 and 2012.
Future estimated amortization expense of intangible assets as of September 30, 2013 is presented below:
2013, remainder
$
1,093

2014
4,071

2015
3,297

2016
1,877

2017
1,482

Thereafter
1,528

 
$
13,348


4. Fair Value Measurements and Financial Instruments
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.
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

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determined using pricing models, discounted cash flow methodologies or similar valuation techniques, as well as significant management judgment or estimation.
In connection with the acquisition of eDynamics during the three months ended September 30, 2013, a liability was recognized on the eDynamics Acquisition Date for the estimate of the fair value of the Company's contingent earn-out payments related to eDynamics. The Company determined the fair value of the Acquisition-related contingent earn-out liability based on the probability-based attainment of product development milestones. Any changes to the variables and assumptions could significantly impact the estimated fair values recorded for the liability, resulting in significant charges to the accompanying Condensed Consolidated Statements of Operations. The fair value measurements are based on significant inputs not observable in the market and thus represent Level 3 measurements, which reflect the Company's own assumptions concerning achievement of the product development milestones of eDynamics, in measuring the fair value of the Acquisition-related contingent earn-out liability.
The following tables summarize, for each category of assets or liabilities, the respective fair value as of September 30, 2013 and December 31, 2012 and the classification by level of input within the fair value hierarchy.
 
Balance as of
September 30,
2013
 
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
Assets
 
 
 
 
 
 
 
Cash equivalents
 
 
 
 
 
 
 
Money market funds
$
6,828

 
$
6,828

 
$

 
$

Short-term investments:
 
 
 
 
 
 
 
Corporate debt securities
15,760

 

 
15,760

 

Commercial paper
2,000

 

 
2,000

 

Certificates of deposit
2,000

 

 
2,000

 

Total financial assets
$
26,588

 
$
6,828

 
$
19,760

 
$

 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
Acquisition-related contingent earn-out liability
$
592

 
$

 
$

 
$
592

 
Balance as of
December 31,
2012
 
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
Assets
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
Money market funds
$
26,485

 
$
26,485

 
$

Commercial paper
1,020

 
1,020

 

Short-term investments:
 
 
 
 
 
Corporate debt securities
29,267

 

 
29,267

Commercial paper
15,988

 

 
15,988

Certificates of deposit
2,008

 

 
2,008

Total financial assets
$
74,768

 
$
27,505

 
$
47,263



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The following table represents a reconciliation of the Acquisition-related contingent earn-out liability measured at fair value on a recurring basis, using significant unobservable inputs (Level 3) for the nine months ended September 30, 2013:
 
 
Fair Value Measurements Using Significant Unobservable Inputs
(Level 3)
Balance at December 31, 2012
 
$

Additions during the period
 
586

Adjustments to fair value during the period recorded in General and Administrative expenses
 
6

Balance at September 30, 2013
 
$
592

Financial Instruments
The cost and fair value of the Company’s available-for-sale investments as of September 30, 2013 and December 31, 2012 were as follows:
 
September 30, 2013
 
Cost Basis
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash
$
45,000

 
$

 
$

 
$
45,000

Money market funds
6,828

 

 

 
6,828

Total
$
51,828

 
$

 
$

 
$
51,828

 
 
 
 
 
 
 
 
Short term investments:
 
 
 
 
 
 
 
Corporate debt securities
$
15,761

 
$
2

 
$
(3
)
 
$
15,760

Commercial paper
2,000

 

 

 
2,000

Certificates of deposit
2,000

 

 

 
2,000

Total
$
19,761

 
$
2

 
$
(3
)
 
$
19,760

 
December 31, 2012
 
Cost Basis
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash
$
11,749

 
$

 
$

 
$
11,749

Money market funds
26,485

 

 

 
26,485

Commercial paper
1,020

 

 

 
1,020

Total
$
39,254

 
$

 
$

 
$
39,254

 
 
 
 
 
 
 
 
Short term investments:
 
 
 
 
 
 
 
Corporate debt securities
$
29,266

 
$
4

 
$
(3
)
 
$
29,267

Commercial paper
15,987

 
1

 

 
15,988

Certificates of deposit
2,007

 
1

 

 
2,008

Total
$
47,260

 
$
6

 
$
(3
)
 
$
47,263

 
 
 
 
 
 
 
 

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Table of Contents

As of September 30, 2013 and December 31, 2012, 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.
5. Commitments and Contingencies
Operating Leases
The Company has noncancellable operating leases with various expiration dates through May 2017.
Rent expense was $442 and $393, respectively, for the three months ended September 30, 2013 and 2012 and $1,245 and $1,165, respectively, for the nine months ended September 30, 2013 and 2012.
Capital Leases
In July 2012, the Company entered into two lease agreements to lease certain office equipment with expiration dates in July and October 2015. These leases bear an annual interest rate of 4.5% and are secured by fixed assets used in the Company's office locations.
At September 30, 2013, future annual minimum lease payments under noncancellable operating and capital leases were as follows:
 
Capital
Leases
 
Operating
Leases
2013, remainder
$
5

 
$
1,544

2014
18

 
3,948

2015
11

 
767

2016

 
306

2017

 
130

Total minimum lease payments
34

 
$
6,695

Less: Amount representing interest
(1
)
 
 
Present value of capital lease obligations
33

 
 
Less: Current portion
(17
)
 
 
Long-term portion of capital lease obligations
$
16

 
 

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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 material claims against the Company pursuant to these indemnification provisions.
Legal Contingencies
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.
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 0.5%. As of September 30, 2013, the interest rate on the outstanding advances was 4.5%. 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, 2013 were $2,736. 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, 2013, the Company was in compliance with the financial covenant.
Interest expense was $33 and $53, respectively, for the three months ended September 30, 2013 and 2012, and $113 and $162, respectively, for the nine months ended September 30, 2013 and 2012.
At September 30, 2013, the remaining repayment commitments related to the equipment loans are as follows:
2013, remainder
$
410

2014
1,642

2015
684

 
$
2,736

Third-Party Financing
As part of the acquisitions of Mail Distiller and Abaca Technology, the Company assumed third-party financing held by each respective company. The third-party financing held by Abaca Technology was paid off in full during the three months ended September 30, 2013. As of September 30, 2013, Mail Distiller had an the outstanding balance of $8.
7. Stockholders’ Equity
Initial Public Offering

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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 $76,200. After deducting underwriters’ discounts and commissions and offering expenses, the aggregate net proceeds received by the Company totaled approximately $68,300. 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, 2013, 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. The Company had 35,786 and 33,044 shares, respectively, issued and outstanding at September 30, 2013 and December 31, 2012.
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.
Number of shares of common stock reserved for future issuance was as follows:

 
As of
September 30,
 
As of
December 31,
 
2013
 
2012
Options available for future grant under the stock plans
5,741

 
4,611

Options outstanding under stock option plans
7,379

 
9,636

Shares available for future issuance under ESPP
860

 
646

Common stock issuable upon settlement of outstanding restricted stock units
153

 
1

Total shares reserved
14,133

 
14,894

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 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 (collectively, the "Plan") 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 2002 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 were initially reserved for issuance to eligible participants, under the 2012 Plan. As of September 30, 2013, 5,741 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 monthly 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

18

Table of Contents

discretion, determines to make a smaller increase. On January 1, 2013, the number of shares of the Company's common stock available for grant and issuance under the 2012 Plan increased by 1,652 shares.
Stock option activity under the Plan was as follows:
 
Shares subject to
Options Outstanding
 
Number of
Shares
 
Weighted
Average
Exercise
Price per share
 
Weighted
Average
Remaining
Contractual
Term
(in years)
 
Aggregate
Intrinsic
Value
Balance at December 31, 2012    
9,636

 
$
5.63

 
7.33
 
$
64,719

Options granted
1,380

 
15.40

 
 
 
 
Options exercised
(2,626
)
 
4.49

 
 
 
 
Options forfeited and canceled
(1,011
)
 
8.35

 
 
 
 
Balance at September 30, 2013
7,379

 
$
7.49

 
7.15
 
$
181,727

The total intrinsic value of options exercised was $39,434 and $10,725, respectively, for the nine months ended September 30, 2013 and 2012. Total cash proceeds from such option exercises were $11,786 and $2,125, respectively, for the nine months ended September 30, 2013 and 2012.
Restricted Stock Units
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, 2013 is presented below:
 
RSUs
Outstanding
 
Number of
Shares
 
Granted Fair Value Per Unit
Awarded and unvested at December 31, 2012    
1

 
$
7.98

Awards granted
166

 
26.09

Awards released
(1
)
 
7.98

Awards forfeited
(13
)
 
21.44

Awarded and unvested at September 30, 2013    
153

 
$
26.49

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 were 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, 2013, there were 860 shares of the Company's common stock available for future issuance under the ESPP. On January 1, 2013, the number of shares of the Company's common stock reserved and available for issuance under the ESPP increased by 330 shares.
8. Stock‑Based Compensation

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The Company recognized stock-based compensation expense under the Plan in the accompanying Condensed Consolidated Statements of Operations as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Cost of subscription revenue
$
203

 
$
205

 
$
631

 
$
443

Cost of hardware and services revenue
45

 
20

 
120

 
46

Research and development
502

 
502

 
1,566

 
1,409

Sales and marketing
881

 
830

 
2,502

 
2,301

General and administrative
748

 
390

 
1,783

 
1,184

Total stock-based compensation expense
$
2,379

 
$
1,947

 
$
6,602

 
$
5,383

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 $16.60 and $7.51, respectively, during the three months ended September 30, 2013 and 2012 and $8.31 and $5.39, respectively, for the nine months ended September 30, 2013 and 2012. 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,
 
2013
 
2012
 
2013
 
2012
Expected life (in years)
6.08
 
6.08
 
5.31-6.08
 
5.50-6.08
Volatility
61%
 
59%
 
57-61%
 
59-60%
Risk-free interest rate
1.8%
 
1.0%
 
0.9-1.8%
 
1.0-1.2%
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 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

20

Table of Contents

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 deferred tax asset valuation allowances.
As of September 30, 2013, the Company had unamortized stock‑based compensation expense of $15,441 related to stock options, that will be recognized net of forfeitures over the average remaining vesting term of the options of 2.46 years. The Company had $3,058 of unamortized stock‑based compensation expense related to unvested RSUs, which are expected to be recognized over a weighted average period of 3.73 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,
 
2013
 
2012
 
2013
 
2012
Expected life (in years)
n/a
 
n/a
 
0.50
 
0.53
Volatility
n/a
 
n/a
 
40%
 
51%
Risk-free interest rate
n/a
 
n/a
 
0.1%
 
0.1%
Dividend yield
n/a
 
n/a
 
—%
 
—%
No ESPP shares were issued during the three months ended September 30, 2013. As of September 30, 2013, the Company had $82 of unamortized compensation costs related to the current ESPP offering period, which are expected to be recognized 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 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 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,
 
2013
 
2012
Stock options to purchase common stock
7,379

 
10,205

Common stock subject to repurchase
2

 
5

Restricted stock units
153

 
23

Total
7,534

 
10,233

10. Segment Reporting

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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,
 
2013
 
2012
 
2013
 
2012
Total revenue:
 
 
 
 
 
 
 
United States
$
28,241

 
$
21,966

 
$
80,038

 
$
63,272

Rest of World
6,262

 
5,118

 
17,056

 
14,374

Total revenue
$
34,503

 
$
27,084

 
$
97,094

 
$
77,646



 
As of
September 30,
 
As of
December 31,
 
2013
 
2012
Long-lived assets:
 
 
 
United States
$
8,728

 
$
6,857

Rest of World
1,817

 
1,703

Total long‑lived assets
$
10,545

 
$
8,560

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.

The Company recognized an income tax expense of $207 during the three months ended September 30, 2013 and an income tax benefit of $2,998 during the nine months ended September 30, 2013. These were based on pre-tax losses of $6,982 and $18,645, respectively. Income tax expense for the three and nine months ended September 30, 2012 was $119 and $430 on pre-tax losses of $4,473 and $14,433, respectively. The income tax rate for the three and nine months ended September 30, 2013 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 and gains in these jurisdictions do not result in the recognition of corresponding income tax benefits and expenses. The income tax rate for the nine months ended September 30, 2013 also varies from the United States statutory rate due to the recognition of a $3,364 deferred income tax benefit related to the release of a valuation allowance in Canada which occurred during the period.

The Company's effective tax rate for the nine months ended September 30, 2013 increased to 16.1% from (3.0)% for the same prior year period. The current period's effective tax rate was impacted by the recognition of a $3,364 deferred income tax benefit related to the release of a valuation allowance in Canada.

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.


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In Canada, the Company has historically had cumulative losses in recent years. However, that position changed to a three year cumulative income position during the second quarter of 2013. This position, along with management's analysis of all other available evidence, resulted in the conclusion that the net deferred tax asset in this jurisdiction are more likely than not to be utilized. As such, the valuation allowance previously recorded against the net deferred tax assets has been reversed during the second quarter of 2013.

As of September 30, 2013, the Company's gross uncertain tax benefits totaled $3,373, excluding related accrued interest and penalties of $214. As of September 30, 2013, $1,238 of the Company's uncertain tax benefits, including related accrued interest and penalties, would affect the effective tax rate if recognized. During the three months ended September 30, 2013, the Company's gross uncertain tax benefits increased $301. The increase is comprised of a $137 increase for tax positions taken in the current period and a $164 increase for tax positions taken in prior period. Of the $164 increase for tax positions taken in a prior period, $154 relate to tax positions for entities which were acquired during the current quarter.

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 would increase its tax liabilities.

12. Subsequent Events

On October 1, 2013, the Company completed the acquisition of privately-held Sendmail, Inc. ("Sendmail") for $23,000. The results of Sendmail's operations will be included in the accompanying Consolidated Financial Statements following the acquisition date. The Company is currently evaluating the purchase price allocation following the consummation of the transaction. It is not possible to disclose the preliminary purchase price allocation or pro forma combined financial information given the short period of time between acquisition date and the filing of this report.

In October 2013, the Company entered into an operating lease agreement to rent office space in Taiwan. The lease has a 36-month term and will expire on September 30, 2016.
 

    

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, 2012 included in our Annual Report on Form 10-K for fiscal year 2012, or 2012 Annual Report on Form 10-K. 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 2012 Annual Report on Form 10-K. 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 ("SaaS") vendor that enables large and mid-sized organizations worldwide to defend, protect, archive and govern their most sensitive data. Our SaaS platform is comprised of an integrated suite of on-demand data protection solutions, including threat protection, regulatory compliance, archiving and governance, and secure communication.

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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 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 along with Proofpoint Secure Share. Proofpoint Targeted Attack Protection is a solution that uses big data analysis techniques to identify and apply additional security controls to suspicious messages. Proofpoint Secure Share allows enterprises to securely exchange large files with ease in a cloud-based environment.
In 2013, we launched Proofpoint Essentials, a suite of SaaS security and compliance capabilities designed to meet the needs of managed service providers and dedicated security resellers, enabling these partners to offer their customers this full suite of cloud-based solutions. We also introduced Proofpoint’s Social Platform for Archiving, which provides our customers a quick path to regulatory compliance regarding their social media usage, enabling them to leverage a wide range of social media platforms such as Yammer, Chatter, and Facebook while adhering to strict compliance standards.

Our business is based on a recurring revenue model. Our customers pay a subscription fee to license the various components of our SaaS 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

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Table of Contents

customers currently using our SaaS platform and dividing it by the total annually recurring subscription revenue from both these current customers as well as all business lost through nonrenewal. 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, and these sales have consistently represented 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 89% of total revenue in 2010, to 96% during the nine months of 2013.
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 is treated as deferred revenue on our consolidated balance sheets and is 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. We expect the overall proportion of revenue derived from the hardware and services offerings to generally remain below 10% of our total revenue.
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. Revenue from customers outside of the United States grew 22% and 19% for the three and nine months ended September 30, 2013 as compared to the prior year periods. As of September 30, 2013, we had more than 2,700 customers around the world, including 30 of the Fortune 100. In terms of customer concentration, there was one partner that accounted for 14% of our total revenue in the three months ended September 30, 2013, although the partner sold to a number of end user customers, none of which accounted for more than 10% of our total revenue. Other than the aforementioned partner above, there were no other single partners or customers that accounted for more than 10% of our total revenue in the three months ended September 30, 2012.
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.
Additionally, during 2013, we have completed a number of acquisitions to complement our solutions offerings. These acquisitions are described in Note 2 to our Condensed Consolidated Financial Statements included in this report. We expect Sendmail to contribute approximately $5 million in total revenue in 2014, with approximately equal amounts from the legacy renewals associated with maintenance contracts and the remainder from new sales of Proofpoint solutions to these existing customers. With respect to adjusted EBITDA for the fourth quarter and for 2014, we currently expect that the Amorize and Sendmail acquisitions will negatively reduce adjusted EBITDA by approximately $2.5 million and $5.0 million, respectively.

Key Opportunities and Challenges

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Table of Contents

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 SaaS 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 SaaS platform is a shared infrastructure that is used by all of our more than 2,700 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 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 SaaS 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 16 to 22 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

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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.
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,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
Total revenue
$
34,503

 
$
27,084

 
$
97,094

 
$
77,646

Growth
27
%
 
32
%
 
25
%
 
31
%
Subscription revenue
$
33,464

 
$
25,991

 
$
92,732

 
$
74,010

Growth
29
%
 
38
%
 
25
%
 
41
%
Adjusted subscription gross profit
$
25,298

 
$
19,562

 
$
69,628

 
$
55,491

% of subscription revenue
76
%
 
75
%
 
75
%
 
75
%
Billings
$
41,357

 
$
30,014

 
$
111,563

 
$
80,242

Growth
38
%
 
39
%
 
39
%
 
29
%
Adjusted EBITDA
$
(935
)
 
$
(1,090
)
 
$
(3,965
)
 
$
(2,800
)
Subscription revenue

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Subscription revenue represents the recurring subscription fees paid by our customers and recognized as revenue during the period for the use of our SaaS 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.
The following unaudited table presents the reconciliation of subscription gross profit to adjusted subscription gross profit for the three and nine months ended September 30, 2013 and 2012:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
Subscription revenue
$
33,464

 
$
25,991

 
$
92,732

 
$
74,010

Cost of subscription revenue
8,937

 
6,967

 
25,042

 
21,414

Subscription gross profit
24,527

 
19,024

 
67,690

 
52,596

 
 
 
 
 
 
 
 
Stock‑based compensation
203

 
205

 
631

 
443

Amortization of intangible assets
568

 
333

 
1,307

 
2,452

Adjusted subscription gross profit
$
25,298

 
$
19,562

 
$
69,628

 
$
55,491

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

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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 nine months ended September 30, 2013 and 2012:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
Total revenue
$
34,503

 
$
27,084

 
$
97,094

 
$
77,646

Deferred revenue
 
 
 
 
 
 
 
Ending
101,328

 
78,836

 
101,328

 
78,836

Beginning
94,474

 
75,906

 
86,859

 
76,240

Net change
6,854

 
2,930

 
14,469

 
2,596

Billings
$
41,357

 
$
30,014

 
$
111,563

 
$
80,242

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) benefit from 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.

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The following unaudited table presents the reconciliation of net loss to adjusted EBITDA for the three and nine months ended September 30, 2013 and 2012:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
Net loss
$
(7,189
)
 
$
(4,592
)
 
$
(15,647
)
 
$
(14,863
)
Depreciation
1,513

 
1,125

 
4,150

 
3,173

Amortization of intangible assets
909

 
413

 
1,973

 
2,864

Interest expense (income), net
11

 
7

 
4

 
110

Provision (benefit) for income taxes
207

 
119

 
(2,998
)
 
430

EBITDA
(4,549
)
 
(2,928
)
 
(12,518
)
 
(8,286
)
Stock‑based compensation expense
2,379

 
1,947

 
6,602

 
5,383

Acquisition‑related expense
1,587

 

 
1,788

 
3

Other income
(24
)
 
(1
)
 
(28
)
 
(12
)
Other expense
(328
)
 
(108
)
 
191

 
112

Adjusted EBITDA
$
(935
)
 
$
(1,090
)
 
$
(3,965
)
 
$
(2,800
)

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 business combinations, 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 2012 Annual Report on Form 10-K, 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 2012 Annual Report on Form 10-K for the year ended December 31, 2012.
Components of Our Results of Operations
Business Combinations
In each of our acquisitions, we used the acquisition method of accounting which requires us to allocate the fair value of the total consideration transferred to tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair values on the date of the acquisition, with the difference between the net assets acquired and the total consideration transferred recorded as goodwill. The fair values assigned, defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing market participants, are based on significant estimates and assumptions determined by management. These estimates and assumptions are inherently uncertain and subject to refinement, as a result, during the adjustment period, which may be up to one year from the acquisition date, we may record adjustments to the assets acquired or liabilities assumed with any corresponding offset to goodwill. Upon conclusion of the measurement period or final determination of the values of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to our Condensed Consolidated Statements of Operations.

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We used either the discounted cash flow method or the replacement cost method to assign fair values to acquired identifiable intangible assets. This method requires significant management judgment to forecast future operating results and establish residual growth rates and discount factors. These models are based on reasonable estimates and assumptions given available facts and circumstances, including industry estimates and averages, as of the acquisition dates and are consistent with the plans and estimates that we use to manage our business. If the subsequent actual results and updated projections of the underlying business activity change compared with the estimates and assumptions used to develop these values, we could experience impairment charges. In addition, we have estimated the economic lives of certain acquired assets and these lives are used to calculate depreciation and amortization expense. If our estimates of the economic lives change, depreciation or amortization expenses could be accelerated or slowed.
Revenue
We derive our revenue primarily through the license of various solutions and services on our SaaS 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 our 2012 Annual Report on Form 10-K 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. We expect our subscription revenue will continue to grow and remain above 90% of our total revenue.
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. 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. We expect the overall proportion of revenue derived from hardware and service offerings to generally remain below 10% of our total revenue.
Total Cost of Revenue
Our cost of revenues consists 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. 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. 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.

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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. 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. 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. 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, however, over the longer term, we intend to monitor these costs so as to decrease this spending as a percentage of total revenue. 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 is being amortized as cost of subscription revenue over a two‑year period. 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.
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 consistently with our revenue growth. 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 consist of personnel costs, consulting services, audit fees, tax services, legal expenses and other general corporate items. As a result of our operational growth as a recently public company, we expect our general and administrative expenses to increase in absolute dollars in future periods as we continue to expand our operations and hire additional personnel.
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 gains or losses.
(Provision for) Benefit from Income Taxes
The (provision for) benefit from 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

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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 and research and development credits may be subject to substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. Analyses have been conducted to determine whether an ownership change has occurred since inception. The analyses have indicated that although an ownership change occurred in a prior year, the net operating losses would not expire before utilization as a result of the ownership change. 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 as a result of the subsequent ownership change.

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,
 
2013
 
2012
 
2013
 
2012
 
Amount
 
% of revenue
 
Amount
 
% of revenue
 
Amount
 
% of revenue
 
Amount
 
% of revenue
 
($ in thousands)
 
($ in thousands)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subscription
$
33,464

 
97
 %
 
$
25,991

 
96
 %
 
$
92,732


96
 %
 
$
74,010

 
95
 %
Hardware and services
1,039

 
3

 
1,093

 
4

 
4,362


4

 
3,636

 
5

Total revenue
34,503

 
100

 
27,084

 
100

 
97,094


100

 
77,646

 
100

Cost of revenue:
 
 
 
 
 
 
 
 





 
 
 
 
Subscription
8,937

 
26

 
6,967

 
26

 
25,042


26

 
21,414

 
28

Hardware and services
1,409

 
4

 
1,163

 
4

 
3,851


4

 
3,466

 
4

Total cost of revenue
10,346

 
30

 
8,130

 
30

 
28,893


30

 
24,880

 
32

Gross profit
24,157

 
70

 
18,954

 
70

 
68,201


70

 
52,766

 
68

Operating expense:
 
 
 
 
 
 
 
 





 
 
 
 
Research and development
8,307

 
24

 
6,262

 
23

 
23,460


24

 
18,367

 
24

Sales and marketing
17,415

 
50

 
14,126

 
52

 
49,782


51

 
39,751

 
51

General and administrative
5,758

 
17

 
3,141

 
12

 
13,437


14

 
8,871

 
11

Total operating expense
31,480

 
91

 
23,529

 
87

 
86,679


89

 
66,989

 
86

Operating loss
(7,323
)
 
(21
)
 
(4,575
)
 
(17
)
 
(18,478
)

(19
)
 
(14,223
)
 
(18
)
Interest expense, net
(11
)
 

 
(7
)
 

 
(4
)


 
(110
)
 

Other income (expense), net
352

 
1

 
109

 

 
(163
)


 
(100
)
 

Loss before (provision for) benefit from income taxes
(6,982
)
 
(20
)
 
(4,473
)
 
(17
)
 
(18,645
)

(19
)
 
(14,433
)
 
(18
)
(Provision for) benefit from income taxes
(207
)
 
(1
)
 
(119
)
 

 
2,998


3

 
(430
)
 
(1
)
Net loss
$
(7,189
)
 
(21
)%
 
$
(4,592
)
 
(17
)%
 
$
(15,647
)

(16
)%
 
$
(14,863
)
 
(19
)%

Comparison of the three and nine months ended September 30, 2013 and 2012:
Revenue

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Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
% Change
 
2013
 
2012
 
% Change
 
(in thousands)
 
 
 
(in thousands)
 
 
Revenue
 
 
 
 
 
 
 
 
 
 
 
Subscription
$
33,464

 
$
25,991

 
29
 %
 
$
92,732

 
$
74,010

 
25
%
Hardware and services
1,039

 
1,093

 
(5
)
 
4,362

 
3,636

 
20

Total revenue
$
34,503

 
$
27,084

 
27
 %
 
$
97,094