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Part II. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis should be read together with our consolidated financial statements and the notes to those statements included elsewhere in this annual report on Form 10-K. This discussion contains forward-looking statements based on our current expectations, assumptions, estimates and projections about Fusion-io and our industry. These forward-looking statements involve risks and uncertainties. Our actual results could differ materially from those indicated in these forward-looking statements as a result of certain factors, as more fully described in "Risk Factors" in Item 1A of this Form 10-K, in this Item 7, and elsewhere in this Form 10-K. We undertake no obligation to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future. Overview We have pioneered a next generation storage memory platform for data decentralization. Our data decentralization platform includes our ioMemory hardware, VSL virtualization software, and leverages our recently released directCache automated data-tiering software and ioSphere platform management software. We were incorporated in December 2005, and we initially focused on the engineering and development of our platform. We have experienced significant growth with revenue of $10.2 million, $36.2 million and $197.2 million in fiscal years 2009, 2010 and 2011, respectively. Our headcount increased from 172 employees as of June 30, 2009, to 262 employees as of June 30, 2010 and to 441 employees as of June 30, 2011. We sell our products through our global direct sales force, OEMs, including Dell, HP and IBM, and other channel partners. Some of our OEMs and channel partners integrate our platform into their own proprietary product offerings. Our primary sales office is located in San Jose, California, and we also have a sales presence in the United Kingdom, Germany, Japan, Hong Kong, Singapore, Korea, Australia, Canada, France, China, Italy, Denmark and the Netherlands. Large purchases by a limited number of customers have accounted for a substantial majority of our revenue, and the composition of the group of our largest customers changes from period to period. Some of our customers make concentrated purchases to complete or upgrade specific large-scale data storage installations. These concentrated purchases are short-term in nature and are typically made on a purchase order basis rather than pursuant to long-term contracts. During fiscal 2009, 2010 and 2011, sales to the 10 largest customers in each period, including the applicable OEMs, accounted for approximately 47%, 75% and 92% of revenue, respectively. Our OEM customers IBM and HP, direct customer Facebook and Apple, through a reseller, each accounted for 13%, 10%, 10% and less than 10% of our revenue, respectively, in fiscal 2010, and less than 10%, 14%, 36% and 24% of our revenue, respectively, in fiscal 2011. We expect that sales to a limited number of customers will continue to contribute materially to our revenue for the foreseeable future. We anticipate that sales through OEMs will continue to constitute a substantial portion of our future revenue. In some cases, our products must be designed into the OEM's products. If that fails to occur for a given product line of an OEM, we would likely be unable to sell our products to that OEM during the life cycle of that product, which would adversely affect our revenue. We expect that as we expand our global presence and business overseas that we will increasingly depend on our OEM relationships in such markets. We believe that extending our platform differentiation through software innovation will be critical to achieving broader market acceptance and maintaining or increasing our gross margins. In this regard, we have recently developed our directCache data-tiering software and ioSphere platform management software for incorporation into our solutions and intend to continue to add software functionality to differentiate our products. We also recently acquired IO Turbine, Inc., which provides us virtualization software solutions that will enable us to accelerate our platform into the virtualized server and desktop markets. Our directCache software and ioSphere software were recently released for general availability. We are devoting the majority of our research and development resources to software development, and if we are unable to successfully develop or acquire, and then market and sell additional software functionality, our ability to increase our revenue and gross margins will be adversely affected. -38- -------------------------------------------------------------------------------- Table of Contents We outsource the manufacturing of our hardware products to our two primary contract manufacturers. We procure a majority of the components used in our products directly from third-party vendors and have them delivered to our contract manufacturers for manufacturing and assembly. Once our products are assembled, we perform quality assurance testing, labeling, final configuration, including a final firmware installation, and shipment to our customers. As a consequence of the rapidly evolving nature of our business and our limited operating history, we believe that period-to-period comparisons of revenue and other operating results, including gross margin and operating expenses as a percentage of our revenue, are not necessarily meaningful and should not be relied upon as indications of future performance. Although we have experienced significant percentage growth in our revenue, we do not believe that our historical growth rates are likely to be sustainable or indicative of future growth. Recent Developments In June 2011, we completed an initial public offering, or IPO, of our common stock, in which we sold and issued 12,600,607 shares, including 1,845,000 shares sold pursuant to the full exercise by the underwriters of their over-allotment option, at an issuance price of $19.00 per share, less underwriting discounts and commissions. As a result of the offering, we received proceeds of approximately $218.9 million, net of approximately $3.8 million in offering costs. On August 11, 2011, we acquired 100% of the stock of IO Turbine, Inc., or IO Turbine, a provider of caching solutions for virtual environments, based in San Jose, California. The acquisition of IO Turbine is a key part of our strategy to enable enterprise customers to increase the utilization, performance and efficiency of their datacenter resources and extract greater value from their information assets. The preliminary fair value of the aggregate purchase price was approximately $65.6 million, which consisted of (1) cash, (2) shares of our common stock valued at $28.40 per share, the closing sale price of our common stock on the closing date of the acquisition, and (3) the fair value of assumed stock options and restricted stock awards attributable to pre-acquisition service. In addition, subsequent to the acquisition we will recognize up to approximately $26.4 million of stock-based compensation expense related to the fair value of assumed restricted stock awards and stock options, of which approximately $3.8 million will be expensed immediately in connection with the acceleration of vesting of certain restricted stock awards and the remainder recognized over the underlying future service period of the assumed stock awards and stock options. Approximately $3.6 million of cash and 278,974 shares were deposited in escrow and held as partial security for indemnification obligations of the IO Turbine stockholders pursuant to the merger agreement. Components of Consolidated Statements of Operations Revenue We derive revenue primarily from the sale of our storage memory products and support services. We sell our storage memory platform through our global direct sales force, OEMs and other channel partners. We provide our support services pursuant to support contracts, which involve hardware support, software support and software upgrades on a when-and-if available basis, and typically have a one-year term. Revenue from support services represented less than $1.0 million for fiscal 2009 and 2010 and approximately $4.5 million for fiscal 2011. In fiscal 2011, our software revenue was not significant to our consolidated statement of operations. Cost of Revenue Cost of revenue consists primarily of material costs including amounts paid to our suppliers and contract manufacturers for hardware components and assembly of those components into our products. The largest portion of our cost of revenue consists of the cost of non-volatile memory components. Given the commodity nature of memory components, neither we nor our contract manufacturers enter into long-term supply contracts -39--------------------------------------------------------------------------------- Table of Contents for our product components, which can cause our cost of revenue to fluctuate. Cost of revenue is recorded when the related product revenue is recognized. Cost of revenue also includes personnel expenses related to customer support, warranty costs, costs of shipping, and carrying value adjustments recorded for excess and obsolete inventory. Operating Expenses The largest component of our operating expenses is personnel costs, consisting of salaries, benefits and incentive compensation for our employees, which includes stock-based compensation. Our headcount increased from 172 employees as of June 30, 2009, to 262 employees as of June 30, 2010 and to 441 employees as of June 30, 2011. As a result, operating expenses have increased significantly over these periods. Sales and Marketing Sales and marketing expenses consist primarily of personnel costs, incentive compensation, marketing programs, travel-related costs, consulting expenses associated with sales and marketing activities, and facilities-related costs. We plan to continue to invest heavily in sales by increasing our sales headcount. Our sales personnel are typically not immediately productive and therefore the increase in sales and marketing expense 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. The timing of our hiring of new sales personnel and the rate at which they generate incremental revenue could therefore affect our future period-to-period financial performance. We expect that sales and marketing expenses will continue to increase in absolute dollars as we expect to continue hiring. Research and Development Research and development expenses consist primarily of personnel costs, prototype expenses, consulting services and depreciation associated with research and development equipment. We expense research and development costs as incurred. We expect to continue to devote substantial resources to the development of our products including the development of new software products. We believe that these investments are necessary to maintain and improve our competitive position. We expect that our research and development expenses will continue to increase in absolute dollars as we continue to invest in additional engineering personnel and infrastructure required to support the development of new products and to enhance existing products. General and Administrative General and administrative expenses consist primarily of personnel costs, legal expenses, consulting and professional services, audit costs, and facility-related expenses for our executive, finance, human resources, information technology and legal organizations. While we expect personnel costs to be the primary component of general and administrative expenses, we also expect to incur significant additional legal and accounting costs related to compliance with rules and regulations implemented by the SEC, as well as additional insurance, investor relations and other costs associated with being a public company. Other income (expense), net Other income (expense), net consists of changes in the fair value of a preferred stock warrant, changes in the fair value of a derivative related to a repurchase of our common stock, interest expense, interest income, realized gains and losses from investments and foreign currency gains and losses. -40--------------------------------------------------------------------------------- Table of Contents Results of Operations for the Fiscal Years Ended June 30, 2009, 2010 and 2011 Revenue The following table presents our revenue for the periods indicated and related changes as compared to the prior periods (dollars in thousands): Year Ended Year Ended June 30, Change in June 30, Change in 2009 2010 $ % 2010 2011 $ % Revenue $ 10,150 $ 36,216 $ 26,066 257 % $ 36,216 $ 197,204 $ 160,988 445 % 2010 Compared to 2011. Revenue increased $161.0 million from fiscal 2010 to fiscal 2011, primarily due to the increase in the overall volume of our products shipped. 2009 Compared to 2010. Revenue increased $26.1 million from fiscal 2009 to fiscal 2010, primarily due to the increase in the overall volume of our products shipped. Revenue from the 10 largest customers, including the applicable OEMs, for each fiscal year was 47%, 75% and 92% of revenue for fiscal 2009, 2010 and 2011, respectively. Three customers accounted for 13%, 10% and 10% of our revenue in fiscal 2010 and three customers accounted for 36%, 24%, and 14% of our revenue in fiscal 2011. No other customer accounted for greater than 10% of revenue in fiscal 2010 and 2011, and no customer accounted for greater than 10% of revenue in fiscal 2009. Revenue from customers with a ship-to location in the United States accounted for 86%, 76% and 82% of revenue for fiscal 2009, 2010 and 2011, respectively. Cost of Revenue and Gross Margin The following table presents our cost of revenue and gross margin for the periods indicated and related changes as compared to the prior periods (dollars in thousands): Year Ended Year Ended June 30, Change in June 30, Change in 2009 2010 $ % 2010 2011 $ % Cost of revenue $ 5,000 $ 16,018 $ 11,018 220 % $ 16,018 $ 84,043 $ 68,025 425 % Gross profit 5,150 20,198 15,048 292 20,198 113,161 92,963 460 Gross margin 51 % 56 % 56 % 57 % 2010 Compared to 2011. Cost of revenue increased $68.0 million and gross profit increased $93.0 million from fiscal 2010 to fiscal 2011, primarily due to the increase in volume of product shipped. Gross margin increased due to efficiencies resulting from economies of scale as our revenue has increased. The increase was partially offset by sales of excess raw materials of approximately $4.0 million related to end-of-life products in fiscal 2011, which were sold at their approximate carrying value. 2009 Compared to 2010. Cost of revenue increased $11.0 million and gross profit increased $15.0 million from fiscal 2009 to fiscal 2010, primarily due to the increase in the volume of our products shipped. Our gross margin increased from fiscal 2009 to fiscal 2010 due to favorable pricing of NAND Flash raw materials and efficiencies resulting from economies of scale as our revenue has increased. The increase in gross margin in fiscal 2010 was offset by a $0.6 million inventory carrying value adjustment that we recorded for obsolete inventory. -41- -------------------------------------------------------------------------------- Table of Contents Operating Expenses Sales and Marketing The following table presents our sales and marketing expenses for the periods indicated and related changes as compared to the prior periods (dollars in thousands): Year Ended Year Ended June 30, Change in June 30, Change in 2009 2010 $ % 2010 2011 $ % Sales and marketing $ 13,476 $ 23,386 $ 9,910 74 % $ 23,386 $ 55,698 $ 32,312 138 % 2010 Compared to 2011. Sales and marketing expenses increased $32.3 million from fiscal 2010 to fiscal 2011, primarily due to an increase in the number of sales and marketing employees, from 123 as of June 30, 2010 to 232 as of June 30, 2011. This resulted in a $25.4 million increase in personnel-related costs, including a $9.6 million increase in commission expense. The increase was also due to a $2.4 million increase in marketing program costs, a $2.2 million increase in travel-related costs and a $0.8 million increase in allocated rent and facilities expenses. 2009 Compared to 2010. Sales and marketing expenses increased $9.9 million from fiscal 2009 to fiscal 2010, primarily due to an increase in sales and marketing personnel from 76 employees at the end of fiscal 2009 to 123 at the end of fiscal 2010, as we hired additional employees to focus on acquiring new customers and expanding our business into new geographic regions. This increase in headcount resulted in an $8.1 million increase in personnel-related costs, including a $2.6 million increase in sales commissions. The majority of the remaining increase in sales and marketing expenses from fiscal 2009 to fiscal 2010 was due to a $0.8 million increase in travel-related costs, a $0.5 million increase in product demonstration expenses, a $0.4 million increase in consulting services, and a $0.2 million increase in allocated rent and facilities expenses. These increases were offset by a $0.3 million decrease in marketing program costs, primarily related to tradeshows. Research and Development The following table presents our research and development expenses for the periods indicated and related changes as compared to the prior periods (dollars in thousands): Year Ended Year Ended June 30, Change in June 30, Change in 2009 2010 $ % 2010 2011 $ % Research and development $ 11,707 $ 15,977 $ 4,270 36 % $ 15,977 $ 27,238 $ 11,261 70 % 2010 Compared to 2011. Research and development expenses increased $11.3 million from fiscal 2010 to fiscal 2011, primarily due to an increase in the number of research and development employees, from 97 as of June 30, 2010 to 152 as of June 30, 2011. This resulted in a $7.3 million increase in personnel-related costs. The increase was also due to a $1.7 million increase in manufacturing costs for new product prototypes, a $1.2 million increase in allocated rent and facilities expenses and a $0.3 million increase in depreciation expense. 2009 Compared to 2010. Research and development expenses increased $4.3 million from fiscal 2009 to fiscal 2010, primarily due to an increase in research and development personnel from 74 employees at the end of fiscal 2009 to 97 at the end of fiscal 2010, resulting in a $3.4 million increase in personnel-related costs. The increase was also due to a $0.4 million increase in manufacturing costs for new product prototypes, a $0.3 million increase in engineering consulting services and a $0.2 million increase in depreciation expense. General and Administrative The following table presents our general and administrative expenses for the periods indicated and related changes as compared to the prior periods (dollars in thousands): Year Ended Year Ended June 30, Change in June 30, Change in 2009 2010 $ % 2010 2011 $ % General and administrative $ 4,849 $ 12,383 $ 7,534 155 % $ 12,383 $ 20,556 $ 8,173 66 % -42- -------------------------------------------------------------------------------- Table of Contents 2010 Compared to 2011. General and administrative expenses increased $8.2 million from fiscal 2010 to fiscal 2011, primarily due to an increase in stock-based compensation of $4.6 million, of which $3.2 million specifically related to non-employee stock option awards and the significant increase in the fair value of these awards from period to period. In addition, the increase is due to the number of general and administrative employees, from 42 as of June 30, 2010 to 57 as of June 30, 2011. These increases contributed to a $7.9 million increase in personnel-related costs. The increase was offset by a $3.1 million decrease in legal costs, including a $1.0 million insurance claim reimbursement related to the resolution of litigation that was ongoing in fiscal 2010. The majority of the remaining increase was due to a $2.4 million increase in depreciation expense, a $0.5 million increase in professional accounting services, and a $0.3 million increase in allocated rent and facilities expenses. 2009 Compared to 2010. General and administrative expenses increased $7.5 million from fiscal 2009 to fiscal 2010, in part due to an increase in general and administrative personnel from 22 employees at the end of fiscal 2009 to 42 employees at the end of fiscal 2010, resulting in a $2.6 million increase in personnel-related costs. In addition, there was a $2.7 million increase in legal costs related to the resolution of legal proceedings. The majority of the remaining increase from fiscal 2009 to fiscal 2010 consisted of a $0.6 million increase in depreciation expense, primarily related to computer equipment and leasehold improvements, a $0.4 million increase in software support and expensed equipment, a $0.3 million increase in professional accounting fees, a $0.3 million increase in allocated rent and facilities expenses and a $0.2 million increase in travel-related expenses. Other Income (Expense), net The following table presents our other income (expense), net for the periods indicated and related changes as compared to the prior periods (dollars in thousands): Year Ended Year Ended June 30, Change in June 30, Change in 2009 2010 $ % 2010 2011 $ %Other income (expense), net $ (690 ) $ (156 ) $ 534 77 % $ (156 ) $ (3,420 ) $ (3,264 ) (2,092 )% 2010 Compared to 2011. Other income (expense), net increased $3.3 million from fiscal 2010 to fiscal 2011, primarily due to $2.1 million increased expense attributable to the revaluation of a warrant to purchase shares of convertible preferred stock and a $1.0 million increase due to a change in the fair value of a common stock repurchase derivative liability. 2009 Compared to 2010. Other income (expense), net decreased by $0.5 million from fiscal 2009 to fiscal 2010, primarily due to a $0.5 million decrease in interest expense related to the conversion or repayment of $15.4 million of outstanding convertible notes. Income Tax Expense The following table presents our income tax expense for the periods indicated and related changes as compared to the prior periods (dollars in thousands): Year Ended Year Ended June 30, Change in June 30, Change in 2009 2010 $ % 2010 2011 $ % Income tax expense $ 1 $ 12 $ 11 1,100 % $ 12 $ 1,694 $ 1,682 14,017 % 2010 Compared to 2011. Income tax expense increased by $1.7 million due to income tax expense related to certain state jurisdictions for which taxable income exists and for which net operating loss carryforwards are not available, federal alternative minimum taxes, and foreign income taxes. -43--------------------------------------------------------------------------------- Table of Contents Selected Quarterly Results of Operations The following table presents, unaudited selected quarterly consolidated results of operations data for each of the quarters presented. The unaudited consolidated financial statements for each of these quarters were prepared on a basis consistent with our audited consolidated financial statements and include all adjustments, consisting of normal and recurring adjustments, that we consider necessary for a fair presentation of the financial position and results of operations as of and for such periods. You should read this table in conjunction with our consolidated financial statements and the related notes located elsewhere in this filing. The results of operations for any quarter are not necessarily indicative of the results of operations for any future periods. Quarter Ended Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31, June 30, 2009 2009 2010 2010 2010 2010 2011 2011 (In thousands, expect for gross margin and per share data) Revenue $ 4,790 $ 7,137 $ 13,363 $ 10,926 $ 27,046 $ 31,218 $ 67,251 $ 71,689 Gross profit 2,725 4,420 7,937 5,116 11,634 18,340 35,753 47,434 Gross margin 56.9 % 61.9 % 59.4 % 46.8 % 43.0 % 58.7 % 53.2 % 66.2 % Total operating expenses 9,531 10,737 14,626 16,852 17,379 20,289 28,024 37,800 (Loss) income from operations (6,806 ) (6,317 ) (6,689 ) (11,736 ) (5,745 ) (1,949 ) 7,729 9,634 Net (loss) income $ (6,808 ) $ (6,331 ) $ (6,705 ) $ (11,872 ) $ (5,771 ) $ (2,473 ) $ 7,035 $ 5,764 Net (loss) income attributable to common stockholders $ (6,808 ) $ (7,079 ) $ (6,705 ) $ (11,872 ) $ (5,771 ) $ (2,473 ) $ 7,035 $ 5,764 Net (loss) income per common share, basic $ (0.66 ) $ (0.66 ) $ (0.60 ) $ (1.00 ) $ (0.46 ) $ (0.19 ) $ 0.50 $ 0.21 Net (loss) income per common share, diluted $ (0.66 ) $ (0.66 ) $ (0.60 ) $ (1.00 ) $ (0.46 ) $ (0.19 ) $ 0.09 $ 0.06 Revenue has increased sequentially in most of the quarters presented due to increases in the volume of products sold. Revenue increased $6.2 million from the three months ended December 31, 2009 to the three months ended March 31, 2010 primarily due to sales to three customers. Revenue increased $16.1 million from the three months ended June 30, 2010 to the three months ended September 30, 2010 primarily due to sales to one customer. Revenue increased $36.0 million from the three months ended December 31, 2010 to the three months ended March 31, 2011 primarily due to sales to two customers. Revenue increased $4.4 million from the three months ended March 31, 2011 to the three months ended June 30, 2011 primarily due to sales to one customer. Gross margin for the three months ended June 30, 2010 was lower due to a $0.6 million inventory carrying value adjustment that we recorded for obsolete inventory. Gross margin for the three months ended September 30, 2010 decreased sequentially, primarily due to lower gross margins on high volume sales to one significant customer. The gross margin for the three months ended December 31, 2010 increased sequentially due to a significantly lower volume of sales to the same significant customer. Gross margin for the three months ended March 31, 2011 decreased sequentially primarily due to sales of excess raw materials of approximately $4.0 million related to end-of-life products, which were sold at their approximate carrying values and to a higher concentration of lower gross margin sales to this same significant customer. Gross margin for the three months ended June 30, 2011 increased due to the higher gross margin mix of products sold. Operating expenses in all quarters increased sequentially as we continued to add headcount and incurred related costs to accommodate our growth. -44--------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Primary sources of liquidity As of June 30, 2011, our principal sources of liquidity consisted of cash and cash equivalents of $219.6 million, accounts receivable of $44.4 million and amounts available under our revolving line of credit of approximately $21.7 million. In June 2011, we completed an initial public offering of our common stock, in which we sold and issued 12,600,607 shares and received proceeds of approximately $218.9 million, net of approximately $3.8 million in offering costs. We had working capital of $270.1 million as of June 30, 2011. In August 2011, we used approximately $26.6 million of the net IPO proceeds to purchase IO Turbine. We anticipate using the remaining net proceeds from the IPO for working capital and general corporate purposes, including expansion of our sales organization, further development and expansion of our product offerings and possible acquisitions of, or investments in, businesses, technologies or other assets. We have no present understandings, commitments or agreements to enter into any acquisitions or investments. Our excess cash is primarily invested in money market funds. Historically, our primary sources of liquidity have been from the issuance of common and convertible preferred stock, customer payments for our products and services, convertible notes and proceeds from our revolving line of credit. Cash Flow Analysis Year Ended June 30, 2009 2010 2011 (In thousands) Net cash provided by (used in): Operating activities $ (24,816 ) $ (39,553 ) $ (9,857 ) Investing activities (3,577 ) (14,298 ) (916 ) Financing activities 42,648 46,719 221,113 Operating Activities Our operating cash flow primarily depends on the timing and amount of cash receipts from our customers, inventory purchases and payments for operating expenses. Our net cash used in operating activities for fiscal 2011 was $9.9 million. During this period our operating cash outflows, which consisted primarily of purchases of inventory and investments made to hire additional headcount to support our current and anticipated growth, were partially offset by cash collections from our customers. Our net income for 2011 was $4.6 million. Significant non-cash expenses included in net income were stock-based compensation of $8.6 million, depreciation and amortization expense of $4.5 million and the non-cash expense recorded related to the convertible preferred stock warrant and the common stock repurchase derivative liability. Our net cash used in operating activities for fiscal 2010 was $39.6 million and was primarily due to an increase in our inventory balance of $21.2 million as a result of the increasing demand for our products. We also had headcount increases in all areas of our business from 172 employees as of June 30, 2009 to 262 employees as of June 30, 2010. Our net loss for 2010 was $31.7 million. Significant non-cash expenses included in net loss were stock-based compensation of $1.9 million and depreciation and amortization expense of $1.5 million. Our net cash used in operating activities for fiscal 2009 was $24.8 million and was primarily due to the investments we made to grow the operating infrastructure necessary to support the growth in our business. From June 30, 2008 to June 30, 2009, we increased the total number of employees in our company from 86 to 172. Our -45- -------------------------------------------------------------------------------- Table of Contents inventory balances also increased from $0.7 million as of June 30, 2008 to $4.0 million as of June 30, 2009 due to increased demand for our products. Our net loss for fiscal 2009 was $25.6 million. Our fiscal 2009 net loss included non-cash stock-based compensation expense of $1.0 million and depreciation and amortization of $0.7 million. Investing Activities Cash flows from investing activities primarily relate to purchases of computer equipment, leasehold improvements and machinery and equipment to support our growth. Investing activities also includes purchases, sales and maturities of our short-term investments in available-for-sale securities. In fiscal year 2011, our net cash used in investing activities was $0.9 million and was primarily due to the cash used for the purchase of property and equipment of $13.0 million offset by net proceeds from the sale of short-term investments of $12.0 million and $0.1 million from the sale of property and equipment. For fiscal 2010, our net cash used in investing activities was $14.3 million, including $13.9 million for purchases of short-term investments and $3.4 million for purchases of property and equipment. For fiscal 2009, our net cash used in investing activities was $3.6 million, including $2.4 million from purchases of property and equipment and $1.2 million from purchases of short-term investments. Financing Activities Cash flows from financing activities primarily include net proceeds from issuances of common and convertible preferred stock and proceeds and payments related to issuances of convertible notes and loans from a financial institution. We generated $221.1 million of net cash from financing activities in fiscal 2011, primarily due to $219.2 million in net proceeds from the issuance of common stock, $11.0 million that we borrowed from a financial institution, $1.5 million in proceeds from the exercise of stock options and a $1.2 million tax benefit from the exercise of stock options and $0.7 million related to a change in restricted cash. These increases were offset by the repayment of $11.3 million of notes payable and capital lease obligations and $1.2 million in repurchases of common stock. We generated $46.7 million in net cash from financing activities in fiscal 2010, including $43.8 million of net proceeds from the issuance of our Series C convertible preferred stock, $5.0 million from the issuance of convertible notes and $4.0 million from a loan with a financial institution. We repaid the $4.0 million loan prior to the end of fiscal 2010. We generated $42.6 million in cash from financing activities in fiscal 2009, primarily due to the $28.1 million received from the issuance of our Series B convertible preferred stock, the $15.4 million from the issuance of convertible notes and the $6.0 million from a loan with a financial institution. We repaid the $6.0 million loan prior to the end of fiscal 2009. Revolving Line of Credit In September 2010, we amended and restated our loan and security agreement, or the revolving line of credit, with a financial institution. In August 2011, we entered into an amendment to this loan and security agreement to provide for the consent of the financial institution to the acquisition of IO Turbine and to provide us with further flexibility to consummate mergers and acquisitions in the future. The revolving line of credit allows us to borrow up to a limit of $25.0 million, with a sublimit of $6.0 million for letters of credit, certain cash management services and foreign exchange forward contracts. The borrowing limit can fluctuate due to a -46- -------------------------------------------------------------------------------- Table of Contents borrowing base consisting of our combined accounts receivable and inventory balances. Borrowings under the revolving line of credit accrue interest at a floating per annum rate equal to one-half of one percentage point (0.50%) above the prime rate as published in the Wall Street Journal. An unused commitment fee equal to 0.375% of the difference between the $25.0 million limit and the average daily balance of borrowings outstanding each quarter is due on the last day of such quarter. The revolving line of credit includes a prepayment penalty of approximately $0.3 million if outstanding advances are prepaid and the line is cancelled prior to September 2011. The revolving line of credit is secured by substantially all our assets. During fiscal 2011, we borrowed and repaid a total of $11.0 million. As of June 30, 2011 no borrowings were outstanding under this agreement and we had obtained letters of credit totaling approximately $3.3 million. We can borrow against the revolving line of credit until its maturity date in September 2012, at which time all unpaid principal and interest shall be due and payable. Under the terms of the revolving line of credit, we are required to maintain the following minimum financial covenants on a consolidated basis: • A ratio of current assets to current liabilities plus, without duplication, any of our obligations to the financial institution, of at least 1.25 to 1.00 measured on a quarterly basis. • A tangible net worth of at least $25.0 million, plus 25% of the net proceeds received by us from the sale or issuance of our equity or subordinated debt, such increase, which is measured on a quarterly basis. As of June 30, 2011, we were in compliance with these covenants. Future Capital Requirements Our future capital requirements will depend on many factors, including our rate of revenue growth, possible acquisitions of, or investments in, businesses, technologies or other assets, the expansion of our sales and marketing activities, the timing and extent of spending to support product development efforts and the expansion into new territories, the timing of new product introductions, the building of infrastructure to support our growth, the continued market acceptance of our products, and strategic investments in businesses. We believe that our cash and cash equivalents and available amounts under the revolving line of credit, will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months. Although we are not currently a party to any agreement or letter of intent regarding potential investments in, or acquisitions of, complementary businesses, applications or technologies, we may enter into these types of arrangements, which could require us to seek additional equity or debt financing. If required, additional financing may not be available on terms that are favorable to us, if at all. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and these securities might have rights, preferences and privileges senior to those of our current stockholders. We cannot assure you that additional financing will be available or that, if available, such financing can be obtained on terms favorable to our stockholders and us. Off Balance Sheet Arrangements During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purpose. -47--------------------------------------------------------------------------------- Table of Contents Contractual Obligations and Material Commitments The following is a summary of our contractual obligations as of June 30, 2011 (in thousands): Payments Due by Period Less Than 1 to 3 3 to 5 After 5 Total 1 Year Years Years Years Operating lease obligations $ 36,941 $ 3,783 $ 6,327 $ 7,014 $ 19,817 Capital lease obligations 113 107 6 - - Purchase obligations(1) 1,495 1,495 - - - Other obligations(2) 1,137 1,137 - - - Total $ 39,686 $ 6,522 $ 6,333 $ 7,014 $ 19,817 (1) Purchase obligations include non-cancelable purchase orders for raw materials inventory. Purchase obligations under purchase orders or contracts that we can cancel without a significant penalty, such as routine purchases for operating expenses, are not included in the above table. (2) In May 2011, we repurchased a total of 165,000 shares of our common stock from two of our stockholders, in separate transactions, for a total purchase price of approximately $1.2 million, pursuant to the exercise of our right of first refusal to which the shares were subject. The terms of the repurchase transaction for 150,000 of such shares require us to pay additional consideration to one of the stockholders equal to half the difference between the applicable liquidity event price per share and $15.00. The liquidity event price per share is the closing per share sale price as of the first trading day following the December 5, 2011 expiration date of the lock-up period applicable to our stockholders in connection with our initial public offering effective June 8, 2011. Operating lease payments primarily relate to our leases of office space with various expiration dates through 2021. The terms of these leases often include periods of free rent, or rent holidays, and increasing rental rates over time. In May 2010, we entered into new leases to expand our primary office facilities in Salt Lake City, Utah. The term of these leases include an initial lease term that ends in September 2021, plus the option for us to extend the lease for an additional five years. These leases include rent holidays during the first year beginning with the lease effective date and also require us to provide the lessor letters of credit in aggregate amount of $3.0 million. Indemnification We agreed to indemnify our officers and directors for certain events or occurrences, while the officer or director is or was serving at our request in such capacity. The maximum amount of potential future indemnification is unlimited; however, we have a director and officer insurance policy that limits our exposure and could enable us to recover a portion of any future amounts paid. We are unable to reasonably estimate the maximum amount that could be payable under these arrangements since these obligations are not capped but are conditional to the unique facts and circumstances involved. Accordingly, we have no liabilities recorded for these agreements as of June 30, 2011. Many of our agreements with channel partners and customers generally include certain provisions for indemnifying the channel partners and customers against liabilities if our products infringe a third party's intellectual property rights. To date, we have not incurred any material costs as a result of such indemnification provisions and have not accrued any liabilities related to such obligations in our consolidated financial statements. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles, or GAAP. The preparation of these consolidated financial statements requires us to make estimates -48--------------------------------------------------------------------------------- Table of Contents and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. These estimates and assumptions are often based on judgments that we believe to be reasonable under the circumstances at the time made, but all such estimates and assumptions are inherently uncertain and unpredictable. Actual results may differ from those estimates and assumptions, and it is possible that other professionals, applying their own judgment to the same facts and circumstances, could develop and support alternative estimates and assumptions that would result in material changes to our operating results and financial condition. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates. We believe that the assumptions and estimates associated with revenue recognition, stock-based compensation, inventory valuation, warranty liability and income taxes have the greatest potential impact on our consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates. For further information on all of our significant accounting policies, see note 1 of the accompanying notes to our consolidated financial statements. Revenue Recognition We derive our revenue from sales of products and support services and enter into multiple-element arrangements in the normal course of business with our customers and channel partners. In all of our arrangements, we do not recognize revenue until we can determine that persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and we deem collection to be reasonably assured. In making these judgments, we evaluate these criteria as follows: • Evidence of an Arrangement - We consider a non-cancelable agreement signed by a customer or channel partner or purchase order generated by a customer or channel partner to be persuasive evidence of an arrangement. • Delivery has Occurred - We consider delivery to have occurred when product has been delivered to the customer and no post-delivery obligations exist other than ongoing support obligations under sold support services. In instances where customer acceptance is required, delivery is deemed to have occurred when customer acceptance has been achieved. • Fees are Fixed or Determinable - We consider the fee to be fixed or determinable unless the fee is subject to refund or adjustment or is not payable within normal payment terms. If the fee is subject to refund or adjustment, we recognize revenue net of estimated returns or if a reasonable estimate cannot be made, when the right to a refund or adjustment lapses. • Collection is Reasonably Assured - We conduct a credit worthiness assessment on all our customers, OEMs and channel partners. Generally we do not require collateral. We continue to evaluate collectability by reviewing our customers' and channel partners' credit worthiness including a review of past transaction history. Our payment terms are typically net-30 days with terms up to net-60 days for certain customers and channel partners. Collection is reasonably assured if, based upon our evaluation, we expect that the customer will be able to pay amounts under the arrangement as payments become due. If we determine that collection is not reasonably assured, revenue is deferred and recognized upon the receipt of cash. For multiple-element arrangements originating on or prior to June 30, 2009, the total consideration in these arrangements was not allocated between product and support services revenue because we did not have objective and reliable evidence of fair value of the support services. Accordingly, the total consideration in such arrangements was deferred and is being recognized ratably over the support service period ranging from one to three years. In October 2009, the Financial Accounting Standards Board ("FASB") amended the accounting standards for multiple-element revenue arrangements. One of the new standards amends previously issued guidance to -49--------------------------------------------------------------------------------- Table of Contents exclude tangible products containing software components and non-software components that function together to deliver the tangible product's essential functionality from the scope of the software revenue recognition rules. The other new standard related to multiple-element arrangements changed the requirements for establishing separate units of accounting in a multiple-element arrangement and requires the allocation of arrangement consideration to each deliverable using the relative selling price of each element. We early adopted these accounting standards effective as of the beginning of fiscal year 2010. For multiple-element arrangements originating or materially modified on or after July 1, 2009, we evaluated whether each deliverable could be accounted for as separate units of accounting. A deliverable constitutes a separate unit of accounting when it has stand-alone value and for an arrangement where a general right of return exists relative to a delivered item, delivery or performance of the undelivered item must be considered probable and substantially in our control. Stand-alone value exists if the product or service is sold separately. Our multiple-element arrangements typically include two elements: ioDrive hardware, which includes embedded VSL virtualization software, and support services. We have determined that our ioDrive hardware and the embedded VSL virtualization software are considered a single unit of accounting because the hardware and software individually do not have standalone value and are never sold separately. Support services are considered a separate unit of accounting as they are sold separately and have standalone value. We allocate arrangement consideration at the inception of an arrangement to all deliverables based on the relative selling price method in accordance with the selling price hierarchy, which includes: (1) vendor-specific objective evidence, or VSOE, if available; (2) third-party evidence, or TPE, if vendor-specific objective evidence is not available; and (3) best estimate of selling price, or BESP, if neither VSOE nor TPE is available. • VSOE - We determine VSOE based on our historical pricing and discounting practices for the specific product or support service when sold separately. In determining VSOE, we require that a substantial majority of the selling prices for products or support services fall within a reasonably narrow pricing range. We have historically priced our products within a narrow range and have used VSOE to allocate the selling price of deliverables for product sales. • TPE - When VSOE cannot be established for deliverables in multiple element arrangements, we apply judgment with respect to whether we can establish selling price based on TPE. TPE is determined based on competitor prices for similar deliverables when sold separately. Generally, our products differ from those of our peers such that the comparable pricing of support services with similar functionality cannot be obtained. Furthermore, we are unable to reliably determine what similar competitor services' selling prices are on a stand-alone basis. As a result, we have not been able to establish selling price based on TPE. • BESP - When we are unable to establish selling price using VSOE or TPE, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or support service was sold on a stand-alone basis. We determine BESP for deliverables by considering multiple factors including, but not limited to, prices we charge for similar offerings, sales volume, geographies, market conditions, competitive landscape and pricing practices. Our agreements with certain customers, including certain OEMs and other channel partners, contain provisions for sales returns in limited circumstances, price protection and rebates. In limited circumstances and on an infrequent basis, even if we are not obligated to accept returned products, we may determine it is in our best interest to accept returns in order to maintain good relationships with our customers. We recognize revenue net of the effects of these estimated obligations at the time revenue is recorded. We estimate product returns based upon our periodic analysis of historical returns as a percentage of revenue as well as known future returns. We periodically assess the accuracy of our historical estimates and to date the actual results have been reasonably consistent with our estimates. While we believe we have sufficient -50- -------------------------------------------------------------------------------- Table of Contents experience and knowledge of the market and customer buying patterns to reasonably estimate such returns, actual market conditions or customer behavior could differ from our expectations and as a result, our actual results could change materially. Our price protection obligations with certain OEMs and other channel partners require us to notify them of any decreases in pricing and to provide them with a refund or credit for any units of our product that they have on hand as of the date of the pricing change. Historically, most of our sales to our OEMs and other channel partners have an identified end-user at the time we ship our products and thus the amount of inventory carried by our OEMs and other channel partners at any given time is limited. To date, we have not issued refunds or credits to our OEMs and other channel partners for price protection. Certain of our contracts allow for rebates that are based on a fixed percentage of our sales to the customer or sales to the end-user or a fixed dollar amount per unit. Deferred revenue primarily represents customer billings in excess of revenue recognized, primarily for support services. Support services are typically billed in advance on an annual basis or at the inception of a multiple year support contract and revenue is recognized ratably over the support period of one to three years. Stock-Based Compensation Under ASC 718, stock-based compensation cost for each award is estimated at the grant date based on the award's fair value as calculated by an option-pricing model and is recognized as expense over the requisite service period. We use the Black-Scholes-Merton option-pricing model which requires various highly judgmental assumptions including the estimated fair value of our common stock, volatility over the expected life of the option, stock option exercise and cancellation behaviors, risk-free interest rate and expected dividends. We estimated the fair value of each employee option granted using the following assumptions for the periods presented in the table below. Year Ended June 30, 2009 2010 2011 (unaudited) Expected stock price volatility 49 % 49 % 48-60 % Expected life of options 6.1 years 6.1 years 3.2-7.0 years Expected dividend yield - - - Risk-free interest rate 2.8-3.4 % 2.4-2.9 % 0.6-2.7 % • Volatility - As we do not have a trading history for our common stock, the expected stock price volatility for our common stock was estimated by taking the average historic price volatility for a group of companies we consider our peers based on a number of factors including, but not limited to, similarity to us with respect to industry, business model, stage of growth, financial risk or other factors, along with considering the future plans of our company to determine the appropriate volatility over the expected life of the option. We used the daily price of these peers over a period equivalent to the expected term of the stock option grants. We did not rely on implied volatilities of traded options in our peers' common stock because the volume of activity was relatively low. We intend to continue to consistently apply this process using the same or similar public companies until a sufficient amount of historical information regarding the volatility of our own common stock share price becomes available, or unless circumstances change such that the identified companies are no longer similar to us, in which case, more suitable companies whose share prices are publicly available would be utilized in the calculation. • Expected Life - The expected life was based on the simplified method allowed under SEC guidance, which is calculated as the average of the option's contractual term and weighted-average vesting period. We use this method as we have limited historical stock option data that is sufficient to derive a reasonable estimate of the expected life of an option. -51- -------------------------------------------------------------------------------- Table of Contents • Dividend Yield - We have never declared or paid any cash dividends and do not presently plan to pay cash dividends in the foreseeable future. Consequently, we used an expected dividend yield of zero. • Risk-free Interest Rate - The risk-free interest rate was determined by reference to the U.S. Treasury rates with the remaining term approximating the expected option life assumed at the date of grant. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those options expected to vest. We estimate the forfeiture rate based on our historical experience. Further, to the extent our actual forfeiture rate is different from our estimate, stock-based compensation expense is adjusted accordingly. If any of the assumptions used in the Black-Scholes-Merton stock-option model change significantly, the fair value and stock-based compensation expense on future grants is impacted accordingly and stock-based compensation expense may differ materially in the future from that recorded in the current period. Prior to June 9, 2011, the date our common stock began trading on the New York Stock Exchange, the fair value of common stock had been determined by the board of directors at each grant date based on a variety of factors, including periodic valuations of our common stock, our financial position, historical financial performance, projected financial performance, valuations of publicly traded peer companies arm's-length sales of our common stock, and the illiquid nature of common stock. Since our initial public offering, we determine the fair value of our common stock based on the closing price as quoted on the New York Stock Exchange, of our common stock on the stock option grant date. Inventory Valuation Inventories consist of raw materials, work in progress, and finished goods and are stated at the lower of cost, on the average cost method, or market value. Our finished goods consist of manufactured finished goods. We assess the valuation of all inventories, including raw materials, work in progress and finished goods, on a periodic basis. Inventory carrying value adjustments are established to reduce the carrying amounts of our inventories to their net estimated realizable values. Carrying value adjustments are based on historical usage, expected demand and evaluation unit conversion rate. Inherent in our estimates of market value in determining inventory valuation are estimates related to economic trends, future demand for our products and technological obsolescence of our products. For example, because our revenue often is comprised of large, concentrated sales to a limited number of customers, we may carry high levels of inventory prior to shipment. In addition, in circumstances where a supplier discontinues the production of a key raw material component, such as a specific type of NAND Flash memory, we may be required to make significant "last-time" purchases in order to ensure supply continuity until the transition is made to products based on next generation components. If a significant order were cancelled after we had purchased the related inventory, or if estimates of "last-time" purchases exceed actual demand, we may be required to record additional inventory carrying value adjustments. Warranty Liability We provide our customers a limited product warranty of three years for products shipped prior to January 1, 2010 and five years for products shipped on or after January 1, 2010. Our standard warranties require us to repair or replace defective products during such warranty period at no cost to the customer. We estimate the costs that may be incurred under our basic limited warranty and record a liability in the amount of such costs at the time product sales are recognized. Factors that affect our warranty liability include the number of installed units, historical experience and management's judgment regarding anticipated rates of warranty claims and cost per claim. We assess the adequacy of our recorded warranty liability each period and make adjustments to the liability as necessary. Income Taxes Significant judgment is required in determining our provision for income taxes and evaluating our uncertain tax positions. We record income taxes using the asset and liability method, which requires the recognition of -52--------------------------------------------------------------------------------- Table of Contents deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. In estimating future tax consequences, generally all expected future events other than enactments or changes in the tax law or rates are considered. Valuation allowances are provided when necessary to reduce deferred tax assets to the amount expected to be realized. We provide reserves as necessary for uncertain tax positions taken on our tax filings. First, we determine if the weight of available evidence indicates that a tax position is more likely than not to be sustained upon audit, including resolution of related appeals or litigation processes, if any. Second, based on the largest amount of benefit, which is more likely than not to be realized on ultimate settlement we recognize any such differences as a liability. Because of our full valuation allowance against the net deferred tax assets, any change in our uncertain tax positions would generally not impact our effective tax rate. In evaluating our ability to recover our deferred tax assets, in full or in part, we consider all available positive and negative evidence, including our past operating results, our forecast of future market growth, forecasted earnings, future taxable income and prudent and feasible tax planning strategies. The assumptions utilized in determining future taxable income require significant judgment and are consistent with the plans and estimates we are using to manage the underlying businesses. Due to the net losses incurred and the uncertainty of realizing the deferred tax assets, for all the periods presented, we have a full valuation allowance against our deferred tax assets. As of June 30, 2011, we had federal and state net operating loss carryforwards of $37.4 million and $42.3 million, respectively, and federal and state research and development tax credit carryforwards in the amount of $1.7 million and $0.7 million, respectively. In the future, we intend to utilize any carryforwards available to us to reduce our tax payments. A limited amount of these carryforwards will be subject to annual limitations that may result in their expiration before some portion of them has been fully utilized. Recently Issued and Adopted Accounting Pronouncements For information with respect to recent accounting pronouncements and the impact of these pronouncements on our consolidated financial statements, see Note 1 - Description of Business and Summary of Significant Accounting Policies in the notes to consolidated financial statements. Segments Operating segments are defined in accounting standards as components of an enterprise about which separate financial information is available and is regularly evaluated by management, namely the chief operating decision maker of an organization, in order to make operating and resource allocation decisions. We have concluded that we operate in one business segment, which is the development, marketing and sale of storage memory platforms. All of our revenue for all periods presented in the accompanying consolidated statements of operations has been from sales of the ioDrive product line and related customer support services. Certain Relationships and Related Party Transactions For a discussion of certain relationships and related party transactions, see Note 10 - Related Party Transactions in the notes to consolidated financial statements. |