[March 20, 2013] MERU NETWORKS INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Tweet (Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section entitled "Risk Factors" included elsewhere in this Form 10-K. Overview We provide a virtualized wireless LAN solution that is designed to cost-effectively optimize the enterprise network to deliver the performance, reliability, predictability and operational simplicity of a wired network, with the advantages of mobility. Our solution represents an innovative approach to wireless networking that utilizes virtualization technology to create an intelligent and self-monitoring wireless network. We sell a virtualized wireless LAN solution built around our System Director Operating System, which runs on our controllers and access points. We also offer additional products designed to deliver centralized network management, predictive and proactive diagnostics and enhanced security. We were founded in January 2002 with the vision of developing a virtualized wireless LAN solution that enables enterprises to deliver business-critical applications over wireless networks, and become what we refer to as All-Wireless Enterprises. From our inception through 2003, we were principally engaged in the design and development of our virtualized wireless LAN solution. We focused on developing technology that could reliably and predictably deliver business-critical applications using voice, video and data over wireless networks in dense environments. We began commercial shipments of our products in December 2003, and initially targeted markets where the wireless delivery of applications in dense environments is critical, such as healthcare and education. Since that time, we have broadened our focus to include organizations in more markets, and have significantly expanded our geographic reach. To date, our products have been deployed by approximately 7,400 customers worldwide in many markets, including education, healthcare, hospitality, manufacturing, retail, technology, finance, government, telecom, transportation and utilities. We outsource the manufacturing of our hardware products, including all of our access points and controllers, to original design manufacturers and contract manufacturers. We also outsource the warehousing and delivery of our products to a third-party logistics provider in the United States for worldwide fulfillment. Our products and support services are sold worldwide, primarily through value-added resellers, or VARs, and distributors, which serve as our channel partners. We employ a sales force that is 49 -------------------------------------------------------------------------------- Table of Contents responsible for managing sales within each geographic territory in which we market and sell our products. Since inception, we have expended significant resources on our research and development operations. Our research and development activities were primarily conducted at our headquarters in Sunnyvale, California until 2005, when we significantly expanded our research and development operations in Bangalore, India. In 2006, we began developing products specifically to leverage the capabilities of a new wireless communication standard promulgated by the Institute of Electrical and Electronics Engineers, or IEEE, the 802.11n standard, and began commercial shipments of our 802.11n products in the second half of 2007. We believe several emerging trends and developments will be integral to the future growth of our business. The growing number of wireless devices and the increased expectations of the users of these devices are driving demand for better performing wireless networks. Enterprises increasingly view wireless networks as a means to deliver better service to their customers and increase the productivity of their workforce, and as a result, they are shifting from the casual use of wireless networks to the strategic use of wireless networks for business-critical applications. Further, enterprises are increasingly realizing that wireless networks designed to optimize the 802.11n standard and the planned 802.11ac standard can deliver the capacity and performance to support their business-critical applications. Our ability to capitalize on emerging trends and developments will depend, in part, on our ability to execute our growth strategy of increasing the recognition of our brand and the effectiveness of our solution, expanding the adoption of our solution across markets, and expanding and leveraging our relationships with the channel partners. We continue to evolve our entire organization to further capitalize on growth opportunities. On March 18, 2012, our board of directors appointed Dr. Bami Bastani, who previously served as the president, chief executive officer, and board member of companies in the mobility, consumer, and broadband markets, as our president and CEO, and a member of our board of directors. Our ability to achieve and maintain profitability as well as our other goals in the future will be affected by, among other things, the continued acceptance of our products, the timing and size of our orders, the average selling prices for our products and services, the costs of our products, and the extent to which we invest in our sales and marketing, research and development, and general and administrative resources. Our revenues have grown from $1.1 million in 2005 to $97.5 million in 2012. It is difficult to predict our revenues in the near term. Our revenues have in the past fluctuated significantly, and may continue to fluctuate in the future. Further, our revenues during any given quarter depend on multiple factors, including, but not limited to, the amount of orders booked in a prior quarter but not shipped until the given quarter, new orders received and shipped in the given quarter, the amount of deferred revenue recognized in the given quarter and the amount of revenues that meet the accounting standards for revenue recognition. These factors could impact our revenues significantly in any given quarter. In addition, we believe that there can be significant seasonal factors that may cause the first and third quarters of our fiscal year to have relatively weaker products revenues than the second and fourth fiscal quarters. We believe that this seasonality results from a number of factors, including: º • º customers with a December 31 fiscal year end may choose to spend remaining budgets before their year end resulting in a positive impact on our products revenues in the fourth quarter of our fiscal year; º • º the structure of our direct sales compensation program may provide additional financial incentives to our sales personnel for exceeding their annual goals; 50 -------------------------------------------------------------------------------- Table of Contents º • º the timing of our annual training for the entire sales force in our first fiscal quarter combined with the above fourth quarter factors can potentially cause our first fiscal quarter to be seasonally weak; º • º many of our education customers have procurement and deployment cycles that can result in stronger order flow in our second fiscal quarter than other quarters assuming the continued availability of traditional funding sources, such as the E-Rate program in the United States; and º • º seasonal reductions in business activity during the summer months in the United States, Europe and certain other regions may have a negative impact on our third quarter revenues. We believe that our historical growth, variations in the number of orders booked in a prior quarter but not shipped until a later quarter and other variations in the amount of deferred revenues may have overshadowed the nature or magnitude of seasonal or cyclical factors that might have influenced our business to date. In addition, the timing of one or more large transactions may overshadow seasonal factors in any particular quarterly period. Seasonal or cyclical variations in our operations may become more pronounced over time and may materially affect our results of operations in the future. We have incurred losses since inception as we grew our business and invested in research and development, sales and marketing, and administrative functions. As of December 31, 2012, we had an accumulated deficit of $253.0 million. In April 2012, we entered into a settlement, license and release agreement with Extricom. As part of this agreement, we paid Extricom $2.4 million in 2012. In June 2011, we entered into a license agreement with Motorola and, as part of which, we paid Motorola $7.3 million in 2011. Vendor Specific Objective Evidence Our recognition of revenues in a particular period depends on the satisfaction of specific revenue recognition criteria, which we describe in more detail below. We adopted two new accounting standards for certain revenue arrangements at the beginning of fiscal year 2011 that include software elements and multiple deliverable revenue arrangements. The manner in which we recognize our revenues has changed significantly over time, particularly in 2008 and 2009, when we established vendor specific objective evidence of fair value, or VSOE, for our support services. These changes have had a significant impact on the timing of when we recognize revenues from sales of our products and services. Generally, upon establishing VSOE for support services for a customer or class of customers, our total recognized revenues from sales to these customers increased in subsequent periods because we were able to recognize all of the products revenues from these sales in these periods once all revenue recognition criteria were satisfied, and we were no longer required to defer the recognition of products revenues over the support period. We also continued to recognize ratable products and services revenues from sales to customers made prior to establishing VSOE for support services. This impact will decrease over time as our deferred revenue balance declines from the time we established VSOE for support services. We recognize the costs of revenues in the same period in which we recognize the associated revenues. When reviewing our financial performance and making period-to-period comparisons, you should consider the impact that the timing of the adoption of the two new accounting standards and the establishment of VSOE had on our financial results, including the amount of our revenues and costs of revenues. Key Metrics We monitor the key financial metrics set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies. We discuss product revenues, support and services revenues and the components of operating income below under "Components of Revenues, Cost of Revenues and Operating Expenses" 51 -------------------------------------------------------------------------------- Table of Contents and we discuss our cash and cash equivalents and short-term investments under "Liquidity and Capital Resources." Fiscal Years or as of Fiscal Years Ended 2012 2011 2010 (dollars in thousands) Products revenues $ 80,770 $ 74,279 $ 63,197 Support and services revenues 16,561 12,957 10,479 Gross margin-products and support and services 64 % 64 % 67 % Loss from operations(1) $ (28,941 ) $ (26,071 ) $ (1,718 ) Cash and cash equivalents and short-term investments 22,855 40,259 67,269 Net cash used in operating activities (25,370 ) (22,402 ) (2,119 ) -------------------------------------------------------------------------------- (1) Includes stock-based compensation expense of: $ 7,549 $ 6,174 $ 3,845 Gross margin-products and support and services. We monitor gross margin to measure our cost efficiencies, including primarily whether our manufacturing costs and component costs are in line with our product revenues and our personnel costs associated with our technical support, professional services and training teams are in line with our support and services revenues. Net cash used in operating activities. We monitor cash flow from operations as a measure of our overall business performance. Our primary uses of cash from operating activities are for personnel-related expenditures, purchases of inventory, costs related to our facilities and litigation reserve expense. Monitoring cash flow from operations enables us to analyze our financial performance without the non-cash effects of certain items such as depreciation and amortization, stock-based compensation expenses, accrued interest on long-term debt, amortization of issuance costs and warrant expense, thereby allowing us to better understand and manage the cash needs of our business. Components of Revenues, Costs of Revenues and Operating Expenses Revenues. We derive our revenues from sales of our products, and support and services. Our total revenues are comprised of the following: º • º Products Revenues-We generate products revenues from sales of our software and hardware products, which primarily consist of our System Director Operating System running our access points and controllers, as well as additional software applications. º • º Support and Services Revenues-We generate support and services revenues primarily from service contracts for our Meru Assure customer support program, which includes software updates, maintenance releases and patches, telephone and internet access to our technical support personnel and hardware support. We also generate support and services revenues from the professional and training services that we provide to our VARs, distributors and customers. º • º Ratable Products and Services Revenues-Prior to January 1, 2009, we recognized ratable products and services revenues from sales of our products and services in circumstances where VSOE for support services being provided could not be segregated from the value of the entire sales arrangement, or where we provided technical support or unspecified software upgrades outside of contractual terms. In these cases, revenues were deferred and recognized ratably over either the economic life of the product or the contractual period. As of January 1, 2009, we established VSOE for support services for all our channel partners and customers, and we no longer offer support outside of contractual terms, and therefore, we are able to recognize products revenues and support and services revenues separately. 52 -------------------------------------------------------------------------------- Table of Contents Deferred Revenue. Prior to establishing VSOE for our support services provided to VARs, distributors and customers, we recognized the revenues from such sales over either the economic life of the related products or the contractual support period, depending on the party and the time at which the sale occurred. As such, prior to establishing VSOE for support services sold to VARs, distributors and customers, only a small amount of our invoiced products and services within a quarter were recognized as revenues in such quarter, with the majority recorded as deferred revenue. We established VSOE for support services sold to our channel partners, including VARs, distributors and customers, at different times during 2007, 2008 and 2009. The decreases in deferred revenue due to the related recognition of ratable revenue are partially offset by the sale of support services that will be recognized over the term of the support agreements. The total deferred revenue as of December 31, 2012 and 2011 were $18.3 million and $16.2 million, respectively. Costs of Revenues. Our total costs of revenues is comprised of the following: º • º Costs of Products Revenues-A substantial majority of the costs of products revenues consists of third-party manufacturing costs and component costs. Our costs of products revenues also include shipping costs, third-party logistics costs, write-offs for excess and obsolete inventory and warranty costs. º • º Costs of Support and Services Revenues-Costs of support and services revenues is primarily comprised of personnel costs associated with our technical support, professional services and training teams. º • º Costs of Ratable Products and Services Revenues-Costs of ratable products and services revenues is comprised primarily of deferred costs of products revenues and an allocation of costs of services revenues. Operating Expenses. Our operating expenses consist of research and development, sales and marketing, general and administrative expenses and litigation reserve expense. The largest component of our operating expenses is personnel costs. Personnel costs consist of salaries, commissions, bonuses and benefits for our employees. We grant our employees and members of our board of directors equity awards and recognize stock-based compensation cost as part of operating expenses. We expect to continue to incur significant stock-based compensation expense as our employee base grows. º • º Research and Development Expenses. Research and development expenses primarily consist of personnel, engineering, testing and compliance, facilities and professional services costs. We expense research and development costs as incurred. We are devoting a substantial amount of our resources to the continued development of additional functionality for our existing products and the development of new products. º • º Sales and Marketing Expenses. Sales and marketing expenses represent the largest component of our operating expenses and primarily consist of personnel costs, sales commissions, travel costs, cost for marketing programs and facilities costs. º • º General and Administrative Expenses. General and administrative expenses primarily consist of personnel, professional services and facilities costs related to our executive, finance, human resource and information technology functions. Professional services consist of outside legal and accounting services and information technology consulting costs. We have incurred additional accounting and legal costs related to compliance with rules and regulations enacted by the SEC, including the additional costs of complying with Section 404 of the Sarbanes-Oxley Act, as well as additional insurance, investor relations and other costs associated with being a public company. º • º Litigation Reserve Expense. Litigation reserve expense consists of settlements or anticipated settlements of litigation. In 2012, the litigation reserve expense was related to the settlement, 53 -------------------------------------------------------------------------------- Table of Contents license and release agreement with Extricom. As part of this agreement, we paid Extricom $2.4 million and expensed the full amount in 2012. In 2011, we entered into a license agreement with Motorola and, as part of which, we agreed to pay Motorola $7.3 million and expensed the full amount in 2011. We record litigation accruals for legal matters which are both probable and estimable. For potential losses for which there is a reasonable possibility (meaning the likelihood is more than remote but less than probable) that a loss exists, we will disclose an estimate of the potential loss or range of such potential loss or include a statement that an estimate of the potential loss cannot be made. Interest Expense, Net. For 2012, interest expense, net consists primarily of interest expense on debt and customer prompt payment discounts. For 2011 and 2010, interest expense, net consists primarily of interest expense on debt, prompt payment discounts and interest income on cash, cash equivalents and short-term investments balances. As of December 31, 2012, we had $10.1 million of outstanding debt before debt discounts. Other Income (Expense), Net. In 2012 and 2011, other income (expense), net consists primarily of gains and losses on foreign currency transactions. In 2010, other income (expense), net consists primarily of charges to record fair value adjustments for our warrants to purchase convertible preferred stock and warrants to purchase common stock. Until the closing of our initial public offering on April 6, 2010, our outstanding warrants were classified as a liability on our consolidated balance sheets and any changes in fair value were recognized as a component of other income (expense), net. Major Channel Partners We sell products and services directly to our channel partners, including VARs and distributors. The following table sets forth our channel partners representing greater than 10% of revenues in the periods presented (in percentages): Years Ended December 31, Major Channel Partners 2012 2011 2010 Westcon Group, Inc. 25 % 29 % 34 % Siracom, Inc. 19 11 * Catalyst Telecom, Inc. 13 13 12 Ingram Micro Inc. 11 * * -------------------------------------------------------------------------------- º * º Less than 10% Critical Accounting Policies Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period-to-period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management's judgments and estimates. 54 -------------------------------------------------------------------------------- Table of Contents Revenue Recognition Our revenues are derived primarily from hardware and software products and related support and services. We often enter into multiple deliverable arrangements and as such the elements of these arrangements are separated and valued based on their relative fair value. The majority of our products are networking communications hardware with embedded software components such that the software functions together with the hardware to provide the essential functionality of the product. Therefore, our hardware deliverables are considered to be non-software elements and are excluded from the scope of industry-specific software revenue recognition guidance. Our products revenues also include revenues from the sale of stand-alone software products. Stand-alone software products may operate on our networking communications hardware, but are not considered essential to the functionality of the hardware. Sales of stand-alone software generally include a perpetual license to our software. Sales of stand-alone software continue to be subject to the industry-specific software revenue recognition guidance. Product support typically includes software updates on a when and if available basis, telephone and internet access to our technical support personnel and hardware support. Software updates provide customers with rights to unspecified software product upgrades and to maintenance releases and patches released during the term of the support period. Certain arrangements with multiple deliverables continued to have stand-alone software elements that are subject to the existing software revenue recognition guidance along with non-software elements that are subject to the amended revenue accounting guidance. The revenue for these multiple deliverable arrangements is allocated to the stand-alone software elements as a group and the non-software elements based on the relative selling prices of all of the elements in the arrangement using the fair value hierarchy in the amended revenue accounting guidance. For sales of stand-alone software after December 31, 2010 and for all transactions entered into prior to January 1, 2011, we recognize revenue based on software revenue recognition guidance. Under the software revenue recognition guidance, we use the residual method to recognize revenue when a product agreement includes one or more elements to be delivered at a future date and VSOE of all undelivered elements exists. We establish VSOE for these arrangements based on sales of multi-year support services arrangements on a stand-alone basis. The normal pricing for multi-year support services arrangements was based on the normal price of a one year support services arrangement multiplied by the number of years of support services which was then adjusted for the time value of money and the decreased sales and fulfillment effort for support service periods of longer than one year. In the majority of our contracts, the only element that remains undelivered at the time of delivery of the product is support services. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the contract fee is recognized as products revenues. If evidence of the fair value of one or more undelivered elements does not exist, all revenue is generally deferred and recognized when delivery of those elements occurs or when fair value can be established. When the undelivered element for which we do not have VSOE is support, revenue for the entire arrangement is bundled and recognized ratably over the support period. VSOE for elements of an arrangement is based upon the normal pricing and discounting practices for those services when sold separately. In determining VSOE, we require that a substantial majority of the selling prices for an element falls within a reasonably narrow pricing range, generally evidenced by a substantial majority of such historical stand-alone transactions falling within a reasonably narrow range of the median rates. In addition, we consider major service groups, geographies, customer classifications, and other variables in determining VSOE. Third-party evidence of selling price, or TPE, is determined based on competitor prices for similar deliverables when sold separately. We establish estimated selling prices, or ESP, for support services based on our normal pricing and discounting practices for support services. This ESP analysis requires that a substantial majority of the support services selling prices fall within a reasonably narrow pricing 55 -------------------------------------------------------------------------------- Table of Contents range, which is typically broader than the range used to evidence VSOE. We believe that this is the price that we would sell support services if support services were regularly sold on a stand-alone basis. However, we are typically not able to determine TPE for our products or services. Generally, our go-to-market strategy differs from that of its peers and our offerings contain a significant level of differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, we are unable to reliably determine what similar competitor products' selling prices are on a stand-alone basis. When we are unable to establish the selling price of our non-software elements using VSOE or TPE, we use ESP in the allocation of arrangement consideration. The objective of ESP is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. We determine ESP for a product or service by considering multiple factors including, but not limited to, pricing policies, internal costs, gross margin objectives, competitive landscapes, geographies, customer classes and distribution channels. We regularly review VSOE and ESP and maintain internal controls over the establishment and updates of these estimates. There was not a material impact during the year, nor do we currently expect a material impact in the near term, from changes in VSOE or ESP. We recognize revenues when all of the following have occurred: (1) we have entered into a legally binding arrangement with a customer; (2) delivery has occurred; (3) customer payment is deemed fixed or determinable and free of contingencies and significant uncertainties; and (4) collection is probable. The sales prices for our products are typically considered to be fixed or determinable at the inception of an arrangement. Delivery is considered to have occurred when product title has transferred to the customer, when the service or training has been provided, when software is delivered, or when the support period has lapsed. To the extent that agreements contain rights of return or acceptance provisions, revenues are deferred until the acceptance provisions or rights of return lapse. The majority of our sales are generated through distributors. Revenues from distributors with return rights are recognized when the distributor reports that the product has been sold through, provided that all other revenue recognition criteria have been met. We obtain sell-through information from these distributors. For transactions with all other distributors, we do not provide for rights of return and recognize products revenues at the time of shipment, assuming all other revenue recognition criteria have been met. Prior to April 1, 2008, we allowed some customers to receive support services outside of the contractual terms. Accordingly, we deferred and recognized revenues on all transactions, except for transactions with one customer, ratably over the economic life of the products sold as we determined that this was the best estimate of the period of time over which we provided these support services. The one exception relates to a customer for which we established VSOE for the related support contracts during the year ended December 31, 2007. Accordingly, we began to account for these support contracts as separate elements from the hardware sales. We estimated the economic life of the hardware to be three and a half years based on several factors such as: (1) the history of technology development of related products; (2) a Company-specific evaluation of product life cycles from both a sales and product development perspective; and (3) information on customer usage of our products. On April 1, 2008, we ceased providing support services outside of the contractual terms. As a result, we began recognizing ratable revenues from sales in which VSOE for the related support services had not been established over the contractual support period and not the three and a half year economic life of the product. Also on April 1, 2008, we established VSOE for support services to distributors. Accordingly, we recognized revenues from sales to distributors after this date and prior to January 1, 2011 using the residual method, assuming all revenue recognition criteria were met. 56 -------------------------------------------------------------------------------- Table of Contents On January 1, 2009, we established VSOE for all remaining support services. Accordingly, we recognized revenues for other than support services for all sales made on and after January 1, 2009 and prior to January 1, 2011 using the residual method, assuming all revenue recognition criteria were met. Revenues for support services are recognized on a straight-line basis over the support period, which typically ranges from one year to five years. Shipping charges billed to customers are included in products revenues and the related shipping costs are included in costs of products revenues. Stock-Based Compensation We recognize stock-based compensation for equity awards on a straight-line basis over the requisite service period, usually the vesting period, based on the grant date fair value. We use the Black-Scholes option-pricing model to estimate the fair value of our stock options and shares under our employee stock purchase plan. The determination of the fair value of these awards on the date of grant using the Black-Scholes option-pricing model is affected by our stock price, the expected holding period of the awards, the risk-free interest rate and the expected stock price volatility. Further, the forfeiture rate also affects the amount of aggregate compensation that we are required to record as an expense. These inputs are subjective and generally require significant judgment. If any of the assumptions used in the Black-Scholes option-pricing model change significantly, stock-based compensation for future awards may differ materially from the awards granted previously. We account for stock options issued to non-employees based on their estimated fair value determined using the Black-Scholes option-pricing model. However, the fair value of the equity awards granted to non-employees is remeasured as the awards vest, and the resulting increase in value, if any, is recognized as expense during the period the related services are rendered. Fair Value of Financial Instruments Prior to our IPO, freestanding warrants to purchase shares of our convertible preferred stock and some of our warrants to purchase common stock were classified as a liability on our consolidated balance sheets at fair value because the warrants may have conditionally obligated us to transfer assets at some point in the future. The warrants were subject to remeasurement at each balance sheet date, and any changes in fair value were recognized as a component of other income (expense), net in the consolidated statements of operations. We estimated the fair value of these warrants at the respective balance sheet dates using the Black-Scholes option-pricing model which includes a number of highly judgmental inputs such as the fair value and expected volatility of our common stock. During the year ended December 31, 2010, we recorded expense of $33.6 million due to the change in fair value of the warrant liability. Upon the closing of our IPO and amending the common stock warrants, the warrants were no longer considered a liability and the warrant liability was reclassified to additional paid-in capital. We measure the fair value of financial instruments using a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels, as follows: Level I-Inputs used to measure fair value are observable inputs such as quoted prices in active markets. Level II-Pricing is provided by inputs other than the quoted prices in active markets that are observable either directly or indirectly. We consider the most reliable information available for the valuation of our Level II securities, which includes pricing data from our investment advisors and other independent sources. 57 -------------------------------------------------------------------------------- Table of Contents Level III-Unobservable inputs in which there is little or no market data that requires us to develop our own assumptions. The determination of fair value for Level III investments and other financial instruments involves the most management judgment and subjectivity. Inventory Valuation Inventory consists of hardware and related component parts and is stated at the lower of cost or fair market value. We record inventory write-downs for potentially excess inventory based on forecasted demand, economic trends and technological obsolescence of our products. If future demand or market conditions are less favorable than our projections, additional inventory write-downs could be required and would be reflected in costs of product revenues in the period the revision is made. At the point of the loss recognition, a new, lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. If actual demand and market conditions are less favorable than anticipated, additional inventory adjustments could be required in future periods. Allowances for Doubtful Accounts We record a provision for doubtful accounts based on historical experience and a detailed assessment of the collectibility of our accounts receivable. To assist with the estimate, our management considers, among other factors, (1) the aging of the accounts receivable, including trends within the age of the accounts receivable, (2) our historical write-offs, (3) the credit-worthiness of each purchaser, (4) the economic conditions of the purchaser's industry, and (5) general economic conditions. In cases where we are aware of circumstances that may impair a specific purchaser's ability to meet their financial obligations to us, we record a specific allowance against amounts due from the customer, and thereby reduce the net recognized receivable to the amount we reasonably believe will be collected. There is significant judgment involved in estimating the allowance for doubtful accounts. During the years ended December 31, 2012 and 2011, we recorded bad debt expense of $44,000 and $143,000. There was no bad debt expense during the year ended December 31, 2010. We collected previously written-off bad debt expense of $54,000 and $61,000 during the years ended December 31, 2012 and 2010. Write-offs of previously reserved bad debts were approximately $110,000, $375,000 and $3,000 during the years ended December 31, 2012, 2011 and 2010. Income Taxes Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We make these estimates and judgments about our future taxable income that are based on assumptions that are consistent with our future plans. As of December 31, 2012 and 2011, we have recorded a full valuation allowance on our net deferred tax assets due to uncertainties related to our ability to utilize our deferred tax assets in the foreseeable future. These deferred tax assets primarily consist of certain net operating loss carryforwards and research and development tax credits. Should the actual amounts differ from our estimates, the amount of our valuation allowance could be materially impacted. Since inception, we have incurred operating losses, and, accordingly, we have not recorded a provision for income taxes for any of the periods presented other than foreign and state provisions for income tax. Accordingly, there have not been significant changes to our provision for income taxes during the years ended December 31, 2012, 2011 or 2010, and we do not expect any significant changes until we are no longer incurring losses. As of December 31, 2012, we had federal net operating loss carryforwards of $147.5 million and state net operating loss carryforwards of $141.1 million. We also had federal and state research credit 58 -------------------------------------------------------------------------------- Table of Contents carryforwards of $3.7 million and $4.0 million and foreign tax credits of $0.6 million. Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets have been fully offset by a valuation allowance. If not utilized, the federal net operating loss and tax credit carryforwards will expire beginning in 2022 and the state net operating losses began expiring in certain jurisdictions in 2009. Utilization of these net operating losses and credit carryforwards is subject to an annual limitation due to applicable provisions of the Internal Revenue Code of 1986, as amended, and state and local tax laws if we have experienced an "ownership change" in the past, or if an ownership change occurs in the future, including, for example, as a result of the shares issued in our initial public offering aggregated with certain other sales of our stock before or after the offering. Significant judgment is also required in evaluating our uncertain tax positions. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. These reserves are established when we believe that certain positions might be challenged despite our belief that our tax return positions are in accordance with applicable tax laws. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit, new tax legislation, or the change of an estimate based on new information. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the effect of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest and penalties. Loss/Contingencies We are or have been subject to proceedings, lawsuits and other claims arising in the ordinary course of business. We evaluate contingent liabilities, including threatened or pending litigation, for potential losses. If the potential loss from any claim or legal proceedings is considered probable and the amount can be estimated, we accrue a liability for the estimated loss. Because of uncertainties related to these matters, accruals are based upon the best information available. For potential losses for which there is a reasonable possibility (meaning the likelihood is more than remote but less than probable) that a loss exists, we will disclose an estimate of the potential loss or range of such potential loss or include a statement that an estimate of the potential loss cannot be made. As additional information becomes available, we reassess the potential liability related to pending claims and litigation and may revise its estimates, which could materially impact our results of operations, financial position and cash flows. 59 -------------------------------------------------------------------------------- Table of Contents Results of Operations Year ended December 31, 2012 compared to the year ended December 31, 2011 The following table presents our historical operating results in dollars (in thousands) and as a percentage of revenues for the periods presented: Years Ended December 31, 2012 2011 REVENUES: Products $ 80,770 82.8 % $ 74,279 82.1 % Support and services 16,561 17.0 12,957 14.3 Ratable products and services 179 0.2 3,235 3.6 Total revenues 97,510 100.0 90,471 100.0 COSTS OF REVENUES: Products 28,879 29.6 26,415 29.2 Support and services 6,463 6.7 4,581 5.1 Ratable products and services 103 0.1 1,863 2.0 Total costs of revenues* 35,445 36.4 32,859 36.3 Gross margin 62,065 63.6 57,612 63.7 OPERATING EXPENSES: Research and development* 15,053 15.4 13,966 15.5 Sales and marketing* 58,759 60.3 47,688 52.7 General and administrative* 14,844 15.2 14,779 16.3 Litigation reserve 2,350 2.4 7,250 8.0 Total operating expenses 91,006 93.3 83,683 92.5 Loss from operations (28,941 ) (29.7 ) (26,071 ) (28.8 ) Interest expense, net (1,656 ) (1.7 ) (253 ) (0.3 ) Other income (expense), net 58 0.1 41 0.0 Loss before provision for income taxes (30,539 ) (31.3 ) (26,283 ) (29.1 ) Provision for income taxes 549 0.6 411 0.4 Net loss $ (31,088 ) (31.9 )% $ (26,694 ) (29.5 )% -------------------------------------------------------------------------------- º * º The following table sets forth the stock-based compensation expense included in the Consolidated Statements of Operations for the periods presented (in thousands): Years Ended December 31, 2012 2011 Costs of revenues $ 320 $ 346 Research and development 1,126 1,131 Sales and marketing 2,714 2,217 General and administrative 3,389 2,480 Revenues Our total revenues increased by $7.0 million, or 7.8%, to $97.5 million in 2012, from $90.5 million in 2011. Our products and support and services revenues, or total revenues excluding ratable revenues, increased by $10.1 million, or 11.6%, to $97.3 million in 2012, from $87.2 million in 2011. This increase 60 -------------------------------------------------------------------------------- Table of Contents was primarily the result of increased demand for our products, particularly in the United Kingdom and Asia Pacific regions. Products revenues. Products revenues increased by $6.5 million, or 8.7%, to $80.8 million in 2012, from $74.3 million in 2011. The increase was primarily a result of an increase in unit shipments particularly in the United Kingdom and the Asia Pacific regions in 2012. Support and services revenues. Support and services revenues increased by $3.6 million, or 27.8%, to $16.6 million in 2012, from $13.0 million in 2011. The increase in support and services revenues is a result of increased product sales, particularly in the United Kingdom and Asia Pacific regions, resulting in first-year support sales, and the renewal of support contracts by existing customers. As our customer base grows over time, we expect our support revenues to increase. Ratable products and services revenues. Ratable products and services revenues decreased by $3.1 million, or 94.5%, to $0.2 million in 2012, from $3.2 million in 2011. This ratable revenue is being amortized from transactions initiated prior to 2009 and is expected to continue to decline over time as the related deferred revenue balance is depleted through 2013. Costs of Revenue and Gross Margin Total costs of revenues increased by $2.6 million, or 7.9%, to $35.4 million in 2012 from $32.9 million in 2011. Overall gross margins, as a percentage of total revenues, decreased to 63.6% in 2012 from 63.7% in 2011. Our product gross margins, as a percentage of product revenues, decreased to 64.2% in 2012 from 64.4% in 2011. Our support and services gross margins, as a percentage of support and services revenues, decreased to 61.0% in 2012 from 64.6% in 2011. These decreases were primarily the result of our increased headcount related to customer support and professional services and a reduction in the amount of support costs allocated to ratable revenues. Our ratable gross margins, as a percentage of ratable revenues, increased to 42.5% in 2012 from 42.4% in 2011. Operating Expenses Our operating expenses increased by $7.3 million, or 8.8%, to $91.0 million in 2012 from $83.7 million in 2011. Our operating expenses increased as a percentage of revenue from 92.5% in 2011 to 93.3% in 2012. This increase is primarily the result of an increase of $10.6 million in personnel costs as a result of increased headcount, an increase of $1.4 million in stock-based compensation expense, an increase of $0.8 million in facility expenses and an increase of $0.3 million in depreciation expenses related to our expansion, an increase of $0.5 million in sales and marketing program expenses, an increase of $0.4 million in travel expenses offset partially by a decrease of $4.9 million in litigation reserve expense, a decrease of $0.9 million in legal fees related to the settlement of certain litigation matters and a decrease of $0.7 million in other related engineering expenses as compared to 2011. Research and Development Expenses Research and development expenses increased by $1.1 million, or 7.8%, to $15.1 million in 2012 from $14.0 million in 2011. This increase is primarily the result of an increase of $1.1 million in research and development personnel costs, an increase of $0.5 million in facility expenses and an increase of $0.2 million in depreciation expenses related to our expansion in India partially offset by a decrease of $0.7 million in other related engineering expenses as compared to 2011. Sales and Marketing Expenses Sales and marketing expenses increased by $11.1 million, or 23.2%, to $58.8 million in 2012 from $47.7 million in 2011. This increase is primarily the result of an increase of $9.2 million in sales and marketing personnel costs as a result of increased headcount, an increase of $0.5 million in stock-based 61 -------------------------------------------------------------------------------- Table of Contents compensation expense, an increase of $0.5 million in sales and marketing program expenses, an increase of $0.4 million in travel expenses and an increase of $0.4 million in facility expense related to our expansion in the U.S. as compared to 2011. General and Administrative Expenses General and administrative expenses remained flat at $14.8 million in 2012 as compared to 2011. During the year ended December 31, 2012, there was an increase of $0.9 million in stock-based compensation expense and an increase of $0.2 million in personnel costs as a result of increased headcount were offset by a decrease of $0.9 million in legal fees related to the settlement of certain litigation matters and a decrease of $0.2 million in costs related to our former CEO's transitional employment agreement and the executive search fees for the current CEO as compared to 2011. Litigation Reserve Expense Our litigation reserve expense decreased by $4.9 million, or 67.6%, from approximately $7.3 million 2011 to approximately $2.4 million in 2012. We entered into a settlement, license and release agreement with Extricom in 2012 and recorded $2.4 million as expense as we do not believe the agreement provides any future value. We entered into a license agreement with Motorola in 2011. As part of the Motorola License Agreement, we agreed to pay Motorola $7.3 million and expensed the full amount in 2011. Interest Expense, Net Interest expense, net increased by $1.4 million, or 554.5%, to $1.7 million in 2012, from $0.3 million in 2011. This increase is primarily due to a result of an increase in interest expense related to the $12.0 million loan agreement entered into with Venture Lending and Leasing VI, Inc., or VLL, in June 2012. See the discussion of the arrangements with VLL under "Liquidity and Capital Resources." Provision for Income Taxes Our income taxes increased by $0.1 million, or 33.6%, to $0.5 million in 2012 from $0.4 million in 2011. This increase in the provision for income taxes was due to the growth of our international entities. 62 -------------------------------------------------------------------------------- Table of Contents Year ended December 31, 2011 compared to the year ended December 31, 2010 The following table presents our historical operating results in dollars (in thousands) and as a percentage of revenues for the periods presented: Years Ended December 31, 2011 2010 REVENUES: Products $ 74,279 82.1 % $ 63,197 74.4 % Support and services 12,957 14.3 10,479 12.3 Ratable products and services 3,235 3.6 11,328 13.3 Total revenues 90,471 100.0 85,004 100.0 COSTS OF REVENUES: Products 26,415 29.2 22,060 25.9 Support and services 4,581 5.1 2,297 2.7 Ratable products and services 1,863 2.0 6,021 7.1 Total costs of revenues* 32,859 36.3 30,378 35.7 Gross margin 57,612 63.7 54,626 64.3 OPERATING EXPENSES: Research and development* 13,966 15.5 12,399 14.6 Sales and marketing* 47,688 52.7 33,483 39.4 General and administrative* 14,779 16.3 10,462 12.3 Litigation reserve 7,250 8.0 - - Total operating expenses 83,683 92.5 56,344 66.3 Loss from operations (26,071 ) (28.8 ) (1,718 ) (2.0 ) Interest expense, net (253 ) (0.3 ) (813 ) (1.0 ) Other income (expense), net 41 0.0 (33,821 ) (39.8 ) Loss before provision for income taxes (26,283 ) (29.1 ) (36,352 ) (42.8 ) Provision for income taxes 411 0.4 254 0.3 Net loss $ (26,694 ) (29.5 )% $ (36,606 ) (43.1 )% -------------------------------------------------------------------------------- º * º The following table sets forth the stock-based compensation expense included in the Consolidated Statements of Operations for the periods presented (in thousands): Years Ended December 31, 2011 2010 Costs of revenues $ 346 $ 197 Research and development 1,131 767 Sales and marketing 2,217 985 General and administrative 2,480 1,896 Revenues Our total revenues increased by $5.5 million, or 6.4%, to $90.5 million in 2011, from $85.0 million in 2010. Our products and support and services revenues, or total revenues excluding ratable revenues, increased by $13.6 million, or 18.4%, to $87.2 million in 2011, from $73.7 million in 2010. This increase 63 -------------------------------------------------------------------------------- Table of Contents was primarily the result of increased demand for our products, particularly in the EMEA and Asia Pacific regions Products revenues. Products revenues increased by $11.1 million, or 17.5%, to $74.3 million in 2011, from $63.2 million in 2010. The increase was primarily a result of an increase in unit shipments particularly in the EMEA and the Asia Pacific regions in 2011. Support and services revenues. Support and services revenues increased by $2.5 million, or 23.6%, to $13.0 million in 2011, from $10.5 million in 2010. The increase in support and services revenues is a result of increased product sales, particularly in the EMEA and Asia Pacific regions, resulting in first-year support sales, and the renewal of support contracts by existing customers. As our customer base grows over time, we expect our support revenues to increase. Ratable products and services revenues. Ratable products and services revenues decreased by $8.1 million, or 71.4%, to $3.2 million in 2011, from $11.3 million in 2010. This ratable revenue is being amortized from transactions initiated prior to 2009 and is expected to continue to decline over time as the related deferred revenue balance is depleted through 2013. Costs of Revenue and Gross Margin Total costs of revenues increased by $2.5 million, or 8.2%, to $32.9 million in 2011 from $30.4 million in 2010. Overall gross margins, as a percentage of total revenues, decreased to 63.7% in 2011 from 64.3% in 2010. Our product gross margins, as a percentage of product revenues, decreased to 64.4% in 2011 from 65.1% in 2010. This decrease was primarily the result of a geographic mix. Our support and services gross margins, as a percentage of support and services revenues, decreased to 64.6% in 2011 from 78.1% in 2010. This decrease was primarily the result of our increased headcount related to customer support and professional services and a reduction in the amount of support costs allocated to ratable revenues. Our ratable gross margins, as a percentage of ratable revenues, decreased to 42.4% in 2011 from 46.8% in 2010. Operating Expenses Our operating expenses increased by $27.3 million, or 48.5%, to $83.7 million in 2011 from $56.3 million in 2010. Our operating expenses increased as a percentage of revenue from 66.3% in 2010 to 92.5% in 2011. The increase was primarily due to an increase of $8.7 million in personnel costs related to increased headcount, a litigation reserve expense of $7.3 million related to the Motorola settlement, an increase of $2.2 million in stock-based compensation expense, an increase of $1.8 million in travel expenses, an increase of $1.8 million in sales and marketing program expenses, an increase of $1.4 million in legal fees related to the acquisition of Identity Networks and our ongoing litigation matters, an increase of $0.6 million in facility expense as well as an increase of $0.5 million in research and development project costs in 2011 as compared to the prior year. Research and Development Expenses Research and development expenses increased by $1.6 million, or 12.6%, to $14.0 million in 2011 from $12.4 million in 2010. This increase is primarily the result of an increase of $0.2 million in research and development personnel costs, an increase of $0.5 million in project costs to support continued enhancements to existing products and the development of new products, an increase of $0.4 million in stock-based compensation expense and an increase of $0.2 million in facility expense in 2011 as compared to the prior year. 64 -------------------------------------------------------------------------------- Table of Contents Sales and Marketing Expenses Sales and marketing expenses increased by $14.2 million, or 42.4%, to $47.7 million in 2011 from $33.5 million in 2010. This increase is primarily the result of an increase of $7.7 million in sales and marketing personnel costs as a result of increased headcount, an increase of $1.8 million in travel expenses, an increase of $1.1 million in sales and marketing program expenses, an increase of $1.2 million in stock-based compensation expense and an increase of $0.2 million in facility expense in 2011 as compared to the prior year. General and Administrative Expenses General and administrative expenses increased by $4.3 million, or 41.3%, to $14.8 million in 2011 from $10.5 million in 2010. This increase is primarily the result of $1.1 million transition costs related to our Chief Executive Officer's transitional employment agreement, an increase of $0.8 million in general and administrative personnel costs, an increase of $1.4 million in legal expense related to the acquisition of Identity Networks and ongoing litigation and $0.6 million in stock-based compensation expense. We have incurred additional accounting and legal costs related to compliance with the rules and regulations that govern us as a public company, including the additional costs of Section 404 of the Sarbanes-Oxley Act compliance, as well as additional insurance, investor relations and other costs associated with being a public company. Litigation Reserve Expense In 2011, we entered into a license agreement with Motorola. As part of the Motorola License Agreement, we agreed to pay Motorola $7.3 million and expensed the full amount during the quarter ended June 30, 2011. Interest Expense, Net Interest expense, net decreased by $0.6 million, or 68.9%, to $0.3 million in 2011 from $0.8 million in 2010. This decrease is primarily due to the paydown of the principal balances on our long-term debt. Other Income (Expense), Net Other income (expense), net changed from a net expense of $33.8 million in 2010 to a net income of $41,000 in 2011. This change is primarily due to the increase in the fair value of our warrants to purchase convertible preferred stock and common stock and the related adjustment to the warrant liability in the amount of $33.6 million in 2010. Upon the closing of our initial public offering on April 6, 2010, we remeasured the warrants and reclassified the related fair value to additional paid-in capital. Accordingly, we no longer recognize gains and losses as a result of changes in the fair value of these warrants and incurred no such expense in 2011. Provision for Income Taxes Our income taxes increased by $0.2 million, or 61.8%, to $0.4 million in 2011 from $0.3 million in 2010. Our tax expense was mainly driven by income earned by certain of our oversee entities. This increase in the provision for income taxes was due to the growth of our international entities. Liquidity and Capital Resources Since inception, we have funded our operations primarily with proceeds from issuances of convertible preferred stock, common stock, long-term debt and our credit facility. From 2007 through 2009, we raised an aggregate of $62.3 million from the sale of our convertible preferred stock, including amounts received through the conversion of promissory notes. We also funded purchases of equipment 65 -------------------------------------------------------------------------------- Table of Contents and other general corporate services with proceeds from long-term debt in the amount of $16.5 million during that period. In 2010, we received $57.1 million from our initial public offering, representing the net proceeds of the offering after deducting underwriters' commissions and discounts and other issuance costs. In 2012, the average daily outstanding balance on our line of credit was approximately $0.6 million. We paid off our outstanding line of credit in May 2012. Accordingly, as of December 31, 2012, the total amount outstanding under the line of credit was zero. On July 31, 2012, we renewed the line of credit for twelve months. The debt is collateralized by substantially all of our assets and intellectual property, with first priority liens relative to the VLL Term Loan Agreement described in the next paragraph, on accounts receivable, loan proceeds and our cash. The maximum amount available under this line of credit is based on eligible accounts receivable up to a maximum of $7.0 million, subject to an overall aggregate total outstanding borrowing limit under the VLL Term Loan Agreement of $20.0 million. The VLL Term Loan Agreement also provides that we are limited to borrowings under the line of credit for a period of no more than three business days before and after the end of the quarter, until we are able to achieve two consecutive quarters of increasing profitability of at least $1.0 million per quarter (based on non-GAAP income, excluding stock based compensation and other non-cash items), so long as we maintain such profitability and subject to the overall aggregate borrowing limit of $20.0 million. During June 2012, we entered into a term loan and security agreement with VLL, pursuant to which we borrowed an aggregate principal amount of $11.7 million before debt discounts. We repay the term loan in 39 monthly installments of principal plus accrued interest beginning on June 6, 2012 and ending on August 1, 2015. Amounts borrowed under the loan agreement bear interest per annum at a fixed rate equal to 12.0%. We may voluntarily prepay the term loan in full by tendering a cash payment equal to the sum of: (i) the accrued and unpaid interest on the term loan as of the date of the prepayment; (ii) the unpaid principal balance of the term loan as of the date of the prepayment, and (iii) the interest that would have accrued and been payable from the date of the prepayment through the stated date of maturity of such term loan had it remained outstanding and been paid in accordance with the terms of the related note (multiplied by 0.80 in the case of repayment after January 1, 2014). We will also be required to make a payment in an amount equal to $2.0 million at the earlier of (i) a change of control and (ii) September 1, 2015. As security for amounts outstanding under the loan agreement, we have granted VLL a security interest in substantially all of our assets. The loan agreement contains customary affirmative and negative covenants. Pursuant to the terms of the loan agreement, and subject to certain exceptions, we are not permitted, without VLL's prior written consent, among other things, to: º • º incur additional indebtedness except for specified permitted indebtedness; º • º incur any liens on our property, except for specified permitted liens; º • º change our business from that in which we were engaged or reasonably related businesses at the time of the loan agreement; º • º merge or consolidate, or permit any of our subsidiaries to merge or consolidate, with any person, or acquire, or permit any of our subsidiaries to acquire, all or substantially all of the capital stock or property of another person; or º • º pay any dividends or make any distributions on our equity securities or repurchase any of our equity, except we may pay dividends payable solely in common stock and may repurchase securities from employees and consultants in a limited manner. Amounts outstanding under the term loan agreement may become due and payable on demand upon the occurrence of certain customary events of default, including our failure to make payments 66 -------------------------------------------------------------------------------- Table of Contents when due, failure to observe the covenants in the loan agreement (subject to a designated grace period in certain cases), our bankruptcy and certain adverse judgments or adverse regulatory actions or determinations against us. A default interest rate equal to 5.0% plus the otherwise applicable interest rate applies from and after the occurrence of any event of default. As of December 31, 2012, we had debt outstanding under the loan in the amount of $10.1 million, before debt discounts, that bears a fixed interest rate of 12% per year. As of December 31, 2012, we had cash and cash equivalents of $22.9 million as compared to a combined cash and cash-equivalents and short-term investments balance of $40.3 million as of December 31, 2011. Cash Flows from Operating Activities Our primary use of cash from operating activities have been related to personnel-related and other operating expenditures as well as increased inventory, increased accounts receivable and accounts payable due to the growth and expansion of our business. Our cash flows from operating activities will continue to be impacted by working capital requirements as well as the level of operating expenses and revenues. Total cash used in operating activities was $25.4 million, $22.4 million and $2.1 million in fiscal years 2012, 2011 and 2010, respectively. Cash used in operating activities of $25.4 million in 2012 reflected a net loss of $31.1 million and changes in our net operating assets and liabilities of $3.8 million, partially offset by non-cash charges of $9.6 million. The non-cash charges were mainly comprised of $7.5 million in stock-based compensation, $1.2 million in depreciation and amortization and $0.6 million in accrued interest on long-term debt. The changes in our net operating assets and liabilities were comprised of an increase of $2.3 million in inventory, a net decrease of $1.8 million in accounts payable and accrued liabilities and an increase of $2.0 million in accounts receivable, net that was partially offset by an increase of $2.0 million in deferred revenues. Cash used in operating activities of $22.4 million in 2011 reflected a net loss of $26.7 million and changes in our net operating assets and liabilities of $2.8 million, partially offset by non-cash charges of $7.1 million, $6.2 million of which relates to stock-based compensation in 2011. The change in our net operating assets and liabilities was comprised of an increase of $4.3 million in accounts receivable, net due to larger than usual concentration of sales in December 2011 and an increase of $1.9 million in inventory that was partially offset by a net increase of $2.9 million in accounts payable and accrued liabilities and a decrease of $1.2 million in deferred inventory costs. Cash used by operating activities of $2.1 million in 2010 reflected a net loss of $36.6 million, offset by non-cash charges of $38.1 million, $33.6 million of which relates to the increase in the fair value of the common stock underlying our warrants and $3.8 million of which relates to stock-based compensation. Cash from our net operating assets and liabilities decreased by $3.6 million in 2010. A decrease of $8.5 million in deferred revenue, an increase of $2.8 million in accounts receivable and an increase of $1.8 million in inventory was partially offset by a decrease of $4.6 million in deferred inventory costs and an increase of $4.4 million in accrued liabilities. Cash Flows from Investing Activities Our investing activities in 2012 consisted of our short-term investments, capital expenditures and the payment of remaining earnouts from our Identity Networks acquisition. The cash provided by investing activities of $2.8 million in 2012 reflected $5.0 million in proceeds from the maturities of short-term investments that was partially offset by $1.9 million of capital expenditures. In 2011, our investing activities consisted of our short-term investments, our Identity Networks acquisition, investment in non-marketable securities, and capital expenditures. The purchase of 67 -------------------------------------------------------------------------------- Table of Contents $10.0 million of short-term investments was offset by the maturity of $10.0 million of short-term investments. We used $1.4 million for capital expenditures. In addition, we acquired Identity Networks for a purchase price of $2.5 million, of which $2.2 million was paid in 2011 and the remaining $0.3 million was paid in 2012. Further, we invested $1.3 million in a non-public company. The cash used in investing activities of $5.7 million in 2010 reflected a purchase of $5.0 million of short-term investments and $0.7 million of capital expenditures. Cash Flows from Financing Activities To date, we have financed our operations primarily with proceeds from the sale of our common stock in our initial public offering, issuance of common stock in conjunction with the exercises options to purchase our stock, the sale of convertible preferred stock, the incurrence of debt and the use of a line of credit facility. As of December 31, 2012, we had outstanding debt in the amount of $10.1 million before debt discounts. Cash provided by financing activities was $10.3 million in 2012 primarily as a result of net proceeds of $11.5 million from our debt financing in June 2012 and proceeds from the exercise of stock options and the purchases under the employee stock purchase plan in the amount of $0.4 million, which were partially offset by payments on our long-term debt of $1.6 million. Cash provided by financing activities was $0.4 million in 2011 primarily as a result of the proceeds from the exercise of stock options and the purchases under the employee stock purchase plan in the amount of $3.2 million offset by the principal payments on our long-term debt of $2.9 million. Cash provided by financing activities was $48.8 million in 2010 primarily as a result of the net proceeds from our initial public offering in the amount of $57.1 million and proceeds from the exercise of warrants on convertible preferred stock, from employee stock purchase plan and from the exercise of stock options in the amount of $3.3 million, partially offset by net payments on our long-term debt of $11.6 million. Capital Resources We believe our existing cash and cash equivalents will be sufficient to meet our working capital and capital expenditure needs for the next 12 months. Our future capital requirements may vary materially from those currently planned and will depend on many factors, including, among other things, market acceptance of our products, the cost of our research and development activities and overall economic conditions. If our cash sources are insufficient to satisfy our cash requirements, we may be required to sell debt or equity securities to raise additional capital or to borrow or increase the amount available to us for borrowing under our credit facility. We may be unable to raise additional capital through the sale of securities, or to do so on terms that are favorable to us, particularly if capital market and overall economic conditions change adversely. Any sale of convertible debt securities or additional equity securities could result in substantial dilution to our stockholders. Additionally, the terms of our existing term loan and line of credit may prevent us borrow under or increase the size of our credit facility, or to do so on terms that are acceptable to us, particularly if credit market conditions change adversely. 68 -------------------------------------------------------------------------------- Table of Contents Contractual Obligations The following summarizes our contractual obligations as of December 31, 2012: Payments Due by Period Less Than 1 to 3 3 to 5 Contractual Obligations: 1 Year Years Years Total (in thousands) Principal and interest and other payments on debt(1) $ 4,433 $ 9,388 $ - $ 13,821 Operating lease obligations 1,446 1,253 - 2,699 Purchase commitments 6,775 - - 6,775 Total $ 12,654 $ 10,641 $ - $ 23,295 -------------------------------------------------------------------------------- º (1) º Our long-term debt carries a fixed interest rate of 12%. As of December 31, 2012, our obligation to make principal, interest and other payments on our debt totaled $13.8 million. Off-Balance Sheet Arrangements As of December 31, 2012, we did not have any off balance sheet arrangements as defined in Item 303(a)(4) of the SEC's Regulation S-K. Debt and Interest As of December 31, 2012 and 2011, the principal amount of our long-term debt before debt discounts was $10.1 million and zero, respectively. During 2012, a 10% appreciation or depreciation in the prime rate would not have a material impact on our interest expense. Recent Accounting Pronouncements In July 2012, the Financial Accounting Standards Board issued an update for Intangibles-Goodwill and Other Testing Indefinite-Lived Intangible Assets for Impairment. The update simplifies the guidance for testing the decline in the realizable value (impairment) of indefinite-lived intangible assets other than goodwill. The amendments allow an organization the option to first assess qualitative factors to determine whether it is necessary to perform the quantitative impairment test. An organization electing to perform a qualitative assessment is no longer required to calculate the fair value of an indefinite-lived intangible asset unless the organization determines, based on a qualitative assessment, that it is "more likely than not" that the asset is impaired. The amendments in this update are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted. We will adopt this standard in the first quarter of 2013 and do not expect the adoption to have a material impact on our consolidated financial position, results of operations or cash flows. [ Back To TMCnet.com's Homepage ]