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SYNACOR, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion of our results of operations and financial condition should be read in conjunction with the information set forth in "Selected Financial Data" and our financial statements and the notes thereto included in this Annual Report on Form 10-K. This discussion contains forward-looking statements based upon our current expectations, estimates and projections that involve risks and uncertainties. Actual results could differ materially from those anticipated in these forward-looking statements due to, among other considerations, the matters discussed under "Risk Factors" and "Special Note Regarding Forward-Looking Statements." Overview We are a leading provider of start experiences (startpages and homescreens), TV Everywhere, Identity Management (IDM), and various cloud-based services across multiple devices for cable, satellite, telecom and consumer electronics companies. For these customers, we are also a leading provider of authentication and aggregation solutions enabling the delivery of personalized, online content. Our technology allows our customers to package a wide array of personalized, online content and cloud-based services with their high-speed Internet, communications, television and other offerings. Our customers offer our services under their own brands on Internet-enabled devices such as PCs, tablets, smartphones and connected TVs. We generate revenue from search and display advertising and by charging subscriber-based fees for services and products delivered through our start experiences. Our results are driven primarily by our customer mix, the product and service mix preferences of those customers and the pricing of those products and services. We generate the majority of our revenue from search and display advertising on our start experiences, which comprise consumer-facing components of our technology. Adding new customers with large consumer bases and expansion of our relationships with existing customers have historically resulted in an increasing shift in our revenue mix towards search and display advertising revenue. Growth in our business (through growth in search and display advertising revenue) is dependent on new customers adopting our solutions and their respective consumers' use of our start experiences ramping up as described below. Increases in search and display advertising revenue are largely driven by our model of sharing a portion of this search and advertising revenue with our customers. As we expand our cloud-based and value added services offerings, we expect to generate increased subscriber-based revenue from our customers. During the year ended December 31, 2013, search and display advertising revenue was $90.4 million, a decrease of 11% over $101.6 million for the year ended December 31, 2012. Over the same period, our unique visitors decreased by 3%, our search queries decreased by 26% and our advertising impressions decreased by 3%. Search revenue decreased by $10.9 million for the year ended December 31, 2013 compared to the year ended December 31, 2012. We believe a material portion of the decrease was due to the placement of our start experiences on the second tab of the default Windows 8 Internet browser by our consumer electronics customers. In addition, and to a lesser extent, we believe the decrease was due to lower search activity associated with the increased usage of other devices such as tablets and smartphones generally across the consumer base. We anticipate that search activity will increase on smartphones and tablets in the future and, although our search queries are down, we believe that our continuing investment in mobile products, such as our acquisitions of Carbyn and Teknision, will allow us to compete more effectively for search activity on smartphones and tablets. Display advertising revenue decreased slightly by $0.2 million for the year ended December 31, 2013 compared to the year ended December 31, 2012. We anticipate video advertising may become an increasing percentage of our advertising revenue which may also serve to increase our advertising CPMs. We also anticipate that the signing, and launching, of new customers and our mobile product initiatives may help add new search and display advertising revenue in future years. Our subscriber-based revenue consists of fees charged for the use of our proprietary technology and for the use of, or access to, services, such as e-mail, security, TV Everywhere, online games, music and other value added services and paid content. During the year ended December 31, 2013, subscriber-based revenue was $21.4 million, an increase of 5% from $20.4 million during the year ended December 31, 2012. This increase is primarily driven by growth in our e-mail and TV Everywhere services to our customers. We believe there are opportunities to generate new sources of subscriber-based revenue, such as the introduction of new value added services, including those delivered on smartphones and tablets. We believe that the variety of value added services and the introduction of new value added services will also drive increased search and display advertising revenue. As we obtain new customers and those new customers introduce our start experiences to their consumers, we expect that usage of our solutions and our revenue from our start experiences to increase over time. There are a variety of reasons for this ramp-up process. For example, a new customer may migrate its consumers from its existing technology to our technology 32-------------------------------------------------------------------------------- Table of Contents over a period of time. Moreover, a new customer may initially launch a selection of our services and products, rather than our entire suite of offerings, and subsequently broaden their service and product offerings over time. When a customer launches a new service or product, marketing and promotional activities may be required to generate awareness and interest among consumers. Search and display advertising revenue typically grows significantly during the first one to three years after a customer launch, although there can be notable variances from customer to customer. Thereafter, changes in revenue tend to mirror changes in the consumer base of the applicable customer. For the year ended December 31, 2013, we derived revenue from over 50 customers, with revenue attributable to four customers, CenturyLink (including revenue attributable to Qwest), Charter, Verizon and Toshiba, together accounting for approximately 68% of our revenue for the year ended December 31, 2013, or $75.6 million. One of these customers accounted for 20% or more of revenue in such period, and revenue attributable to each of the other three customers accounted for more than 10% in such period. Revenue attributable to our customers includes the subscriber-based revenue earned directly from them, as well as the search and display advertising revenue generated through our relationships with our search and display advertising partners (such as Google for search advertising and advertising networks, advertising agencies and advertisers for display advertising). This revenue is attributable to our customers because it is produced from the traffic on our start experiences. These partners provide us with advertisements that we then deliver with search results and other content on our start experiences. Since our search advertising partner, Google, and our advertising network partners generate their revenue by selling those advertisements, we create a revenue stream for these partners. In the year ended December 31, 2013, search advertising through our relationship with Google generated approximately 51% of our revenue, or $57.5 million (all of which was attributable to our customers). The initiatives described below under "Key Initiatives" are expected to contribute to our ability to maintain and grow revenue and return to profitability via increases in advertising revenue, increases in customers and our consumer reach, and increases in availability of products across more devices. We expect the period in which we experience a return on future investments in each of these initiatives to differ. For example, more direct advertising at higher CPMs would be expected to have an immediate and direct impact on profitability while expansion into international markets may require an investment that involves a longer term return. We intend to utilize some of the net proceeds of our initial public offering to improve our ability to achieve consistent profitability in the future by enhancing our technology and our systems capabilities to more efficiently support our customers, develop new products and features and report upon, analyze and manage the financial performance of the business. Trends Affecting Our Business Our customers, who are predominantly high-speed Internet service providers that also offer television services, are facing increasing competition from companies that deliver video content over the Internet, more commonly referred to as "over-the-top," or OTT. These new competitors include a number of large and growing companies, such as Google, Netflix, Inc., or Netflix, Hulu, LLC, or Hulu, and Amazon.com Inc., or Amazon. With the increased availability of high-speed Internet access and over-the-top programming, consumers' video content consumption preferences may shift away from current viewing habits. As a result, many of our customers and potential customers are compelled to find new ways to deliver services and content to their consumers via the Internet. We expect this pressure to become even greater as more video content becomes available online. We expect to continue to benefit from this trend as customers adopt our solutions to package and deliver video programming and other related authentication services on our start experiences. Another trend affecting our customers and our business is the proliferation of Internet-connected devices, especially mobile devices. Smartphones, tablets and connected TVs have made it more convenient for consumers to access services and content online, including television programming. To remain competitive, our customers and potential customers must have the capability to deliver their services and products to consumers on these new devices. Our technology enables them to extend their presence beyond traditional personal computers, and we expect that some portion of our revenue growth will come from traffic on these devices. Our business is also affected by growth in advertising on the Internet, for which the proliferation of high-speed Internet access and Internet-connected devices will be the principal drivers. We expect our results of operations will benefit from the growth in the number of mobile Internet users as our customers adopt our mobile and tablet offerings. The launch of the Microsoft Windows 8 operating system in October 2012 has had an impact on our business. As it relates to our business with consumer electronics customers that have the Windows 8 operating system pre-installed on their laptop or desktop computers, our start experiences are now placed on a second tab when the Internet browser is launched. This has caused us to reduce our revenue expectations from our consumer electronics customers. 33-------------------------------------------------------------------------------- Table of Contents Key Initiatives We are focused on several key initiatives to drive our business: • add new, and expand our existing offerings with current, cable, telecom, satellite and consumer electronics customers to increase our consumer reach; • continue to expand our offerings of, and invest in, mobile technology and cloud-based services such as e-mail and TV Everywhere and increase the number of customers using our TV Everywhere technology; • extend the availability of our existing and new products and services to additional devices including tablets and smartphones; • enhance our direct advertising sales effort to increase the CPMs derived from advertising; • expand our presence into international markets; and • invest in and acquire new technologies and products. Key Business Metrics In addition to the line items in our financial statements, we regularly review a number of business metrics related to Internet traffic and search and display advertising to evaluate our business, determine the allocation of resources and make decisions regarding business strategies. We believe disclosing these metrics is useful for investors and analysts to understand the underlying trends in our business. The following table summarizes our key business metrics, which are unaudited, for the years ended December 31, 2011, 2012 and 2013: Year Ended December 31, 2011 2012 2013 Key Business Metrics: Unique Visitors (1) 14,619,254 20,440,169 19,818,670 Search Queries (2) 748,576,869 968,233,560 711,992,036Advertising Impressions (3) 27,749,105,979 42,170,186,571 40,982,588,804 Notes: (1) Reflects the number of unique visitors to our start experiences computed on an average monthly basis during the applicable period. (2) Reflects the total number of search queries during the applicable period. (3) Reflects the total number of advertising impressions during the applicable period. Unique Visitors We define unique visitors as consumers who have visited one of our start experiences at least once during a particular time period. We rely on comScore to provide this data. comScore estimates this data based on the U.S. portion of the Internet activity of its worldwide panel of consumers and its proprietary data collection method. Search Queries We define search queries as the number of instances in which a consumer entered a query into a search bar on our start experiences during a particular time period. We rely on reports from our search partner, Google, to measure the number of such instances. Advertising Impressions We define advertising impressions as graphical, textual or video paid advertisements displayed to consumers on our start experiences during a particular time period. We rely on reports from technology and advertising partners, including DoubleClick (a division of Google), to measure the number of advertising impressions delivered on our platform. Components of our Results of Operations Revenue 34-------------------------------------------------------------------------------- Table of Contents We derive our revenue from two categories: revenue generated from search and display advertising activities and subscriber-based revenue, each of which is described below. We record our search and display advertising revenue on a gross basis, which includes the net amount received from Google under our agreement with them. The following table shows the revenue in each category, both in amount and as a percentage of revenue, for 2011, 2012, and 2013. Year Ended December 31, 2011 2012 2013 (in thousands) Revenue: Search and display advertising $ 72,084 $ 101,559 $ 90,447 Subscriber-based 18,976 20,422 21,360 Total revenue $ 91,060 $ 121,981 $ 111,807 Percentage of revenue: Search and display advertising 79 % 83 % 81 % Subscriber-based 21 17 19 Total revenue 100 % 100 % 100 % Search and Display Advertising Revenue We use Internet search and display advertising to generate revenue from the traffic on our start experiences. • In the case of search advertising, we have a revenue-sharing relationship with Google, pursuant to which we include a Google-branded search tool on our start experiences. When aconsumer makes a search query using this tool, we deliver the query to Google and they return search results to consumers that include advertiser-sponsored links. If the consumer clicks on a sponsored link, Google receives payment from the sponsor of that link and shares a portion of that payment with us, which we in turn share with the applicable customer. The net payment we receive from Google is recognized as revenue. • We generate display advertising revenue when consumers view or click on a text, graphic or video advertisement that was delivered on a Synacor-operated start experience. We fill our advertisinginventory with advertisements sourced by our direct salesforce, independent advertising sales representatives and advertising networkpartners. Revenue may be calculated differently depending on our agreements with our advertisers or the agreements between our advertising network partners and their advertisers. It may be calculated on a cost per impression basis, which means the advertiser pays based on the number of times its advertisements appear, or a cost per action basis, which means that an advertiser pays when a consumer performs an action after engaging one of its advertisements, or on a fixed fee basis. Historically only a small percentage of our display advertising revenue has been calculated on a cost per action basis or fixed fee basis. Subscriber-Based Revenue We define subscriber-based revenue as subscription fees and other fees that we receive from our customers for the use of our proprietary technology and the use of, or access to, e-mail, TV Everywhere, security, games and other services, including value added services and paid content. Monthly subscriber levels typically form the basis for calculating and generating subscriber-based revenue. They are generally determined by multiplying a per-subscriber per-month fee by the number of subscribers using the particular services being offered or consumed. In other cases, the fee is fixed. We recognize revenue from our customers as the service is delivered. Costs and Expenses Cost of Revenue Cost of revenue consists of revenue sharing, content acquisition costs and co-location facility costs. Revenue sharing consists of amounts accrued and paid to our customers for the traffic on the start experiences we operate for them that results in the generation of search and display advertising revenue. The revenue-sharing agreements with our customers are primarily variable payments based on a percentage of the search and display advertising revenue. Content acquisition agreements may be based on a fixed payment schedule, on the number of subscribers per month, or a combination of both. Fixed-payment 35-------------------------------------------------------------------------------- Table of Contents agreements are expensed over the term defined in the agreement. Agreements based on the number of subscribers are expensed on a monthly basis. Co-location facility costs consist of rent and operating costs for our data center facilities. Research and Development Research and development expenses consist primarily of compensation-related expenses incurred for the development of, enhancements to, and maintenance and operation of our technology and related infrastructure. Sales and Marketing Sales and marketing expenses consist primarily of compensation-related expenses to our direct sales and marketing personnel, as well as costs related to advertising, industry conferences, promotional materials, and other sales and marketing programs. Advertising cost is expensed as incurred. General and Administrative General and administrative expenses consist primarily of compensation related expenses for executive management, finance, accounting, human resources and other administrative functions. Depreciation Depreciation includes depreciation of our computer hardware and software, furniture and fixtures, leasehold improvements, and other property, and depreciation on capital leased assets. Other Income (Expense) Other income (expense) consists primarily of interest income earned and foreign exchange gains and losses. Interest Expense Interest expense primarily consists of expenses associated with our capital leases. Provision (benefit) for Income Taxes Income tax expense (benefit) consists of federal and state income taxes in the United States and taxes in certain foreign jurisdictions. Loss in Equity Interest Loss in equity interest represents our percentage share of losses in investments in entities in which we can exercise significant influence, but do not own a majority equity interest or otherwise control. Critical Accounting Policies The preparation of financial statements in conformity with GAAP requires estimates and assumptions that affect the reported amounts and classifications of assets and liabilities, revenue and expenses, and the related disclosures of contingent liabilities in the financial statements and accompanying notes. The SEC has defined a company's critical accounting policies as the ones that are most important to the portrayal of the company's financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the following critical accounting policies and estimates addressed below. We also have other key accounting policies, which involve the use of estimates, judgments, and assumptions that are significant to understanding our results. See Note 1, The Company and Summary of Significant Accounting Policies, of Notes to the Financial Statements. Although we believe that our estimates, assumptions, and judgments are reasonable, they are based upon information available at the time. Actual results may differ significantly from these estimates under different assumptions, judgments, or conditions. Revenue Recognition We recognize revenue when the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred; the selling price is fixed or determinable; and collectability is reasonably assured. The terms of our arrangements with our customers, Google and our advertising network partners are specified in written agreements. These written agreements constitute the persuasive evidence of the arrangements with our customers that 36-------------------------------------------------------------------------------- Table of Contents are a pre-condition to the recognition of revenue. The evidence used to document that delivery or performance has occurred generally consists of communication of either numbers of subscribers or the revenue generated in a reporting period from customers, advertising partners, vendors and our own internally-generated reports. Occasionally, a customer will notify us of subsequent adjustments to previously reported subscriber data. These adjustments, once accepted by us, will result in adjustments to revenue and cost of revenue. The historical occurrences of such adjustments, and the amounts involved, have not been significant. Although prices used in our revenue recognition formulas are generally fixed pursuant to the written arrangements with our customers, Google and our advertising network partners, the number of subscribers or the amount of search and display advertising revenue that are subject to our pricing arrangements are not known until the reporting period has ended. Although this data is, in most cases, available prior to the completion of our periodic financial statements, this data may need to be estimated. When made, these estimates are based upon our historical experience with the relevant party. Adjustments to these estimates have historically not been significant. The receipt of this volume data also serves to verify that we have appropriately satisfied our obligation to our customers for that reporting period. Adjustments are recorded in the period in which the data is received. Pursuant to the terms of our customer contracts, we recognize revenue in each period for our services once the contract has been signed, its terms reviewed and understood, the service, content or both have been made available to the customer and reliable active subscriber information is made available to us. We undertake an evaluation of the creditworthiness of both new and, on a periodic basis, existing customers. Based on these reviews we determine whether collection of our prospective revenue is probable. Revenue Sharing We pay our customers a portion of the revenue generated from search and display advertising. The portion paid to our customers depends on, among other things, the consumer base of the customer and their expected ability to drive consumer traffic to our start experiences. This revenue consists of the consideration we receive from Google and our display advertising partners in connection with traffic supplied by the applicable customer. Gross Versus Net Presentation of Revenue for Revenue Sharing We evaluate our relationship between our search and display advertising partners and our customers in accordance with Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC, 605-45, Principal Agent Considerations. We have determined that the revenue derived from traffic supplied by our customers is reported on a gross basis because we are the primary obligor (we are responsible to our customers for fulfilling search and display advertising services and value added and other services), are involved in the service specifications, perform part of the service, have discretion in supplier selection, have latitude in establishing price and bear credit risk. Stock-Based Compensation We account for stock-based compensation in accordance with the authoritative guidance on stock compensation. Under the fair value recognition provisions of this guidance, stock-based compensation is measured at the grant date based on the fair value of the award and is recognized as expense, net of estimated forfeitures, over the requisite service period, which is generally the vesting period of the respective award. As a result, we are required to estimate the amount of stock-based compensation we expect to be forfeited based on our historical experience. If actual forfeitures differ significantly from our estimates, stock-based compensation expense and our results of operations could be materially impacted. Determining the fair value of stock-based awards at the grant date requires judgment. We use the Black-Scholes option-pricing model to determine the fair value of stock options. The determination of the grant date fair value of options using an option-pricing model is affected by our estimated common stock fair value as well as assumptions regarding a number of other complex and subjective variables. These variables include the fair value of our common stock, our expected stock price volatility over the expected term of the options, stock option exercise and cancellation behaviors, risk-free interest rates, and expected dividends, which are estimated as follows: Fair Value of Our Common Stock. Because our stock was not publicly traded prior to our initial public offering, the fair value of our common stock underlying our stock options was determined by our board of directors based on valuations prepared by an independent valuation specialist. The board of directors intended all options granted to be exercisable at a price per share not less than the per share fair value of our common stock underlying those options on 37-------------------------------------------------------------------------------- Table of Contents the date of grant. Following the completion of our initial public offering in February 2012, our common stock has been valued by reference to its publicly traded price. Expected Term. The expected term was estimated using the simplified method allowed under SEC guidance. As we develop more experience, our estimate of the life of awards may change. Volatility. As we do not have a significant 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 industry peers based on daily price observations over a period equivalent to the expected term of the stock option grants. Industry peers consist of several public companies in the technology industry similar in size, stage of life cycle and financial leverage. We did not rely on implied volatilities of traded options in our industry 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. Risk-free Rate. The risk-free interest rate is based on the yields of U.S. Treasury securities with maturities similar to the expected term of the options for each option group. Dividend Yield. We have never declared or paid any cash dividends and do not presently plan to pay cash dividends in the foreseeable future. Accordingly, we used an expected dividend yield of zero. Income Taxes We record income taxes using the asset and liability method, which requires the recognition of 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 also provide reserves as necessary for uncertain tax positions taken on our tax filings. First, we determine if a tax position is more likely than not to be sustained upon audit solely based on technical merits, 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. In the event that any unrecognized tax benefits are recognized, the effective tax rate will be affected. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome of these matters will be the same as these estimates. These estimates are updated quarterly based on factors such as changes in facts or circumstances, changes in tax law, new audit activity, and effectively settled issues. We follow specific and detailed guidelines in each tax jurisdiction regarding the recoverability of any tax assets recorded on the balance sheet and provide necessary valuation allowances as required. Future realization of deferred tax assets ultimately depends on the existence of sufficient taxable income of the appropriate character (for example, ordinary income or capital gain) within the carryback or carryforward periods available under the tax law. We regularly review our deferred tax assets for recoverability based on historical taxable income, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies. Our judgments regarding future profitability may change due to many factors, including future market conditions and our ability to successfully execute our business plans and/or tax planning strategies. Should there be a change in our ability to recover our deferred tax assets, our tax provision would increase or decrease in the period in which the assessment is changed. Results of Operations 38-------------------------------------------------------------------------------- Table of Contents The following tables set forth our results of operations for the periods presented in amount and as a percentage of revenue for those periods. The period to period comparison of financial results is not necessarily indicative of future results. Year Ended December 31, 2011 2012 2013 (in thousands) Revenue $ 91,060 $ 121,981 $ 111,807 Costs and operating expenses: Cost of revenue (1) 48,661 66,620 59,622Research and development (1)(2) 20,228 25,603 28,458 Sales and marketing (2) 8,582 9,120 8,124 General and administrative (1)(2) 6,879 11,011 11,663 Depreciation 2,667 3,779 4,650 Total costs and operating expenses 87,017 116,133 112,517 Income (loss) from operations 4,043 5,848 (710 ) Other (expense) income (17 ) 1 (37 ) Interest expense (109 ) (270 ) (193 ) Income (loss) before income taxes 3,917 5,579 (940 ) (Benefit) provision for income taxes (6,015 ) 1,764 (134 ) Loss in equity interest - - (561 ) Net income (loss) $ 9,932 $ 3,815 $ (1,367 ) Notes: (1) Exclusive of depreciation shown separately. (2) Includes stock-based compensation as follows: Year Ended December 31, 2011 2012 2013 (in thousands) Research and development $ 295 $ 523 $ 1,184 Sales and marketing 203 404 348 General and administrative 422 1,072 1,029 $ 920 $ 1,999 $ 2,561 Year Ended December 31, 2011 2012 2013 Revenue 100 % 100 % 100 % Costs and operating expenses: Cost of revenue (1) 53 55 53 Research and development (1) 22 21 25 Sales and marketing 9 7 7 General and administrative (1) 8 9 10 Depreciation 3 3 4 Total costs and operating expenses 96 95 101 Income (loss) from operations 4 5 (1 ) Other income (expense) - - - Interest expense - - - Income (loss) before income taxes 4 5 (1 ) (Benefit) provision for income taxes (7 ) 1 - Loss in equity interest - - - Net income (loss) 11 % 3 % (1 )% 39-------------------------------------------------------------------------------- Table of Contents Note: (1) Exclusive of depreciation shown separately. Comparison of Years Ended December 31, 2011, 2012, and 2013 Revenue Year Ended December 31, 2011 to 2012 to 2012% 2013% 2011 2012 2013 Change Change (in thousands) Revenue: Search and display advertising $ 72,084 $ 101,559 $ 90,447 41 % (11 )% Subscriber-based 18,976 20,422 21,360 8 % 5 % Total revenue $ 91,060 $ 121,981 $ 111,807 34 % (8 )% Percentage of revenue: Search and display advertising 79 % 83 % 81 % Subscriber-based 21 17 19 Total revenue 100 % 100 % 100 % In 2013 our revenue decreased by $10.2 million, or 8%, compared to 2012. Search revenue decreased by 10.9 million, or 16%. We believe a material portion of the decrease was due to the placement of our start experiences on the second tab of the default Windows 8 Internet browser by our consumer electronics customers. In addition, and to a lesser extent, we believe the decrease was due to lower search activity associated with the increased usage of other devices such as tablets and smartphones generally across the consumer base and due to a change in the way we monetize searches through our start experiences. Display advertising revenue decreased slightly by $0.2 million. Subscriber-based revenue increased $0.9 million, or 5% primarily due to increases in our email and TV Everywhere services to our customers. In 2012 our revenue increased by $30.9 million, or 34%, compared to 2011. Search and display advertising revenue increased by $29.5 million, or 41% as a result of increased search queries and advertising impressions on our start experiences, driven in part by the launch and subsequent ramping of significant new customers in September 2010 and July 2011. The total number of search queries increased by 29% in 2012, and the total number of advertising impressions increased by 52% in 2012 as compared with 2011. The increase in search queries accounted for approximately 58% of the increase in search and display advertising revenue in 2012, while the increase in advertising impressions accounted for approximately 42%. Subscriber-based revenue increased $1.4 million, or 8% due to increases in TV Everywhere and e-mail revenue, partially offset by a decrease in value added services revenue. The increases in TV Everywhere and email revenue were driven by adding new customers and increased consumer usage. The decrease in value-added services revenue is a result of decreased demand of our value-added service offerings by consumers. Cost of Revenue Year Ended December 31, 2011 to 2012 to 2012% 2013% 2011 2012 2013 Change Change (in thousands)Cost of revenue $ 48,661 $ 66,620 $ 59,622 37 % (11 )% Percentage of revenue 53 % 55 % 53 % Our cost of revenue decreased by $7.0 million, or 11%, in 2013 compared to 2012. The decrease in our cost of revenue was driven by a decrease in revenue-sharing costs due to decreased search and display advertising. Cost of revenue as a percentage of revenue decreased to 53% of revenue in 2013 from 55% of revenue in 2012 because of changes in display advertising revenue attributable to the mix of customers and related revenue-sharing arrangements. Our cost of revenue increased by $18.0 million, or 37%, in 2012 compared to 2011. The increase in our cost of revenue was mainly driven by additional revenue-sharing costs from increased search and display advertising. Cost of revenue 40-------------------------------------------------------------------------------- Table of Contents as a percentage of revenue increased to 55% of revenue in 2012 from 53% of revenue in 2011 because of changes in search and display advertising revenue attributable to the mix of customers and related revenue-sharing arrangements. Research and Development Expenses Year Ended December 31, 2011 to 2012 to 2012% 2013% 2011 2012 2013 Change Change (in thousands)Research and development $ 20,228 $ 25,603 $ 28,458 27 % 11 % Percentage of revenue 22 % 21 % 25 % Research and development expenses increased by $2.9 million, or 11%, in 2013 compared to 2012. The increase was primarily due to a $2.5 million increase in employee-related costs as a result of the increase in headcount to support new product initiatives and customer deployments. Research and development expenses increased by $5.4 million, or 27%, in 2012 compared to 2011. The increase was primarily due to a $4.1 million increase in employee-related costs as a result of the increase in headcount to support new product initiatives and customer deployments. The remaining increase includes a $0.5 million increase for reporting tools and a $0.3 million increase for contractors. Sales and Marketing Expenses Year Ended December 31, 2011 to 2012 to 2012% 2013% 2011 2012 2013 Change Change (in thousands)Sales and marketing $ 8,582 $ 9,120 $ 8,124 6 % (11 )% Percentage of revenue 9 % 7 % 7 % Sales and marketing expenses decreased by $1.0 million, or 11%, in 2013 compared to 2012. The decrease was primarily due to a $1.0 million decrease in compensation-related expenses. Sales and marketing expenses increased by $0.5 million, or 6%, in 2012 compared to 2011. The increase was primarily due to a $0.9 million increase in employee-related costs as a result of the increase in headcount as we hired salespeople in our advertising department. The offsetting decrease of $0.4 million includes decreases for legal fees and reporting services. General and Administrative Expenses Year Ended December 31, 2011 to 2012 to 2012% 2013% 2011 2012 2013 Change Change (in thousands)General and administrative $ 6,879 $ 11,011 $ 11,663 60 % 6 % Percentage of revenue 8 % 9 % 10 % General and administrative expenses increased by $0.7 million, or 6%, in 2013 compared to 2012. The increase was primarily due to a $0.3 million increase in legal fees in connection with the formation of the JV Company and $0.2 million increase in rent. General and administrative expenses increased by $4.1 million, or 60%, in 2012 compared to 2011. The increase was primarily due to a $2.0 million increase in spending on administrative expenses associated with being a public company and a $0.5 million increase in employee-related costs as a result of hiring in our finance department. The remainder of the increase includes $0.6 million for stock-based compensation partially driven by the accelerated vesting of stock options upon retirement of service of our former board members upon our initial public offering and $0.4 million increase in rent and other facility-related costs. Depreciation 41-------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2011 to 2012 to 2012% 2013% 2011 2012 2013 Change Change (in thousands)Depreciation $ 2,667 $ 3,779 $ 4,650 42 % 23 % Percentage of revenue 3 % 3 % 4 % Depreciation increased by $0.9 million or 23% in 2013 compared to 2012. This increase was primarily driven by the purchase of assets such as computer equipment to support our investment in new projects. Depreciation increased by $1.1 million, or 42%, in 2012 compared to 2011. This increase was primarily driven by the purchase of assets to support the addition of new customers. Other (Expense) Income Year Ended December 31, 2011 2012 2013 (in thousands) Other (expense) income $ (17 ) $ 1 $ (37 ) For each of 2011, 2012 and 2013, other (expense) income consisted primarily of interest income coupled with foreign currency transaction losses related to our operations in the United Kingdom. Interest Expense Year Ended December 31, 2011 2012 2013 (in thousands) Interest expense $ 109 $ 270 $ 193 Interest expense decreased in 2013 compared to 2012 as a result of lower average capital lease balances. The interest rates applied to those balances remained substantially the same. Interest expense increased in 2012 compared to 2011 as a result of higher average capital lease balances. The interest rates applied to those balances remained substantially the same. (Benefit) provision for Income Taxes Year Ended December 31, 2011 2012 2013 (in thousands) (Benefit) provision for income taxes $ (6,015 ) $ 1,764 $ (134 ) In the fourth quarter of 2011, as a result of weighing the positive and negative evidence we determined that we would more likely than not be able to generate sufficient taxable income in the future and would be able to utilize our net operating loss ("NOL") carryforwards. As a result, we recognized an $8.5 million income tax benefit related to the reduction of our deferred tax asset valuation allowance. In 2012 our income tax provision included $2.9 million of deferred income tax expense, partially offset by a tax benefit of $1.1 million relating to a research and development credit. In 2013 our income tax provision included a $0.2 million deferred benefit for income taxes which resulted in a $0.1 million tax benefit for income taxes. 42-------------------------------------------------------------------------------- Table of Contents Loss in Equity Interest Year Ended December 31, 2011 2012 2013 (in thousands) Loss in equity interest $ - $ - $ (561 ) In 2013 we entered into a Joint Venture Agreement, pursuant to which we own 50% of the outstanding common stock and 100% of the preferred shares of the JV Company. For year ended December 31, 2013, we recorded our share of the losses of the JV Company of $0.6 million. The investment in the JV Company is being accounted for using the equity method and is classified as an investment in equity interest. The Company provided nearly all of the capital to form the JV Company; accordingly, the Company has recorded 100% of the losses incurred by the JV Company in 2013. Unaudited Quarterly Results of Operations and Other Data The following tables present our unaudited quarterly results of operations and other data for the eight quarters ended December 31, 2013. This unaudited quarterly information has been prepared on the same basis as our audited consolidated financial statements and, in the opinion of management, the statement of operations data includes all adjustments, consisting of normal recurring adjustments, necessary for the fair presentation of the results of operations for these periods. You should read this table in conjunction with our financial statements and related notes located elsewhere in this Annual Report on Form 10-K. The results of operations for any quarter are not necessarily indicative of the results of operations for any future periods. For the Three Months Ended March 31, June 30, September 30, December 31, March 31, June 30, September 30, December 31, 2012 2012 2012 2012 2013 2013 2013 2013 (in thousands, except per-share data) Statements of Operations Data: Revenue $ 30,670 $ 30,807 $ 28,326 $ 32,178 $ 29,143 $ 26,708 $ 26,551 $ 29,406 Costs and operating expenses: Cost of revenue (1) 16,764 16,876 15,792 17,188 15,764 14,017 14,083 15,757 Research and development (1) 6,288 6,123 6,218 6,974 6,865 7,336 7,404 6,911 Sales and marketing 2,377 2,399 2,000 2,344 2,130 2,147 2,058 1,792 General and administrative (1) 2,840 2,868 2,676 2,627 3,144 2,957 2,805 2,891 Depreciation 781 934 981 1,083 1,130 1,138 1,119 1,262 Total costs and operating expenses 29,050 29,200 27,667 30,216 29,033 27,595 27,469 28,613 Income (loss) from operations 1,620 1,607 659 1,962 110 (887 ) (918 ) 793 Net income (loss) 1,174 1,199 652 790 27 (637 ) (832 ) 173 Net income (loss) per share attributable to common stockholders: Basic $ 0.07 $ 0.04 $ 0.02 $ 0.03 $0.00 $ 0.02 $ 0.03 $ 0.01 Diluted $ 0.04 $ 0.04 $ 0.02 $ 0.03 $0.00 $ 0.02 $ 0.03 $ 0.01 Note:(1) Exclusive of depreciation shown separately Liquidity and Capital Resources Our primary liquidity and capital resource requirements are for financing working capital, investing in capital expenditures such as computer hardware and software, supporting research and development efforts, introducing new technology, enhancing existing technology, and marketing our services and products to new and existing customers. To the extent that existing cash and cash equivalents, cash from operations, cash from short-term borrowings and the net proceeds from our initial public offering are insufficient to fund our future activities, we may need to raise additional funds through public or private equity offerings or debt financings. 43-------------------------------------------------------------------------------- Table of Contents In connection with our initial public offering in February 2012, we received aggregate gross proceeds of $27.3 million. The net proceeds to Synacor from the offering were approximately $22.4 million after deducting underwriting discounts of $1.9 million and offering costs of $3.0 million. In September 2013, we entered into a new Loan and Security Agreement, or Loan Agreement, with Silicon Valley Bank, or Lender. The Loan Agreement provides for a $10.0 million secured revolving line of credit with a stated maturity of September 27, 2015. The credit facility is available for cash borrowings, subject to a formula based upon eligible accounts receivable. As of December 31, 2013, due to the operation of the borrowing formula, $7.5 million was available under the revolving credit line, with no outstanding borrowings. Borrowings under the Loan Agreement bear interest, at our election, at an annual rate of either 0.50% above the "prime rate" as published in The Wall Street Journal or LIBOR for the relevant period plus 3.00%. For LIBOR advances, interest is payable (i) on the last day of a LIBOR interest period or (ii) on the last day of each calendar quarter. For prime rate advances, interest is payable (a) on the first day of each month and (b) on each date a prime rate advance is converted into a LIBOR advance. We paid a commitment fee of $50,000 upon the closing of the facility, and must pay quarterly, in arrears, an unused facility fee of 0.50% per annum of the average unused portion of the facility (as determined by the Lender). Additionally, if we terminate the facility prior to the first anniversary of the closing date, we must pay the Lender a termination fee of $100,000 unless the facility is replaced with a new facility from the Lender. Our obligations to the Lender are secured by a first priority security interest in all our assets, including our intellectual property. The Loan Agreement contains customary events of default, including non-payment of principal or interest, violations of covenants, material adverse changes, cross-default, bankruptcy and material judgments. Upon the occurrence of an event of default, the Lender may accelerate repayment of any outstanding balance. The Loan Agreement also contains certain financial covenants and other agreements that are customary in loan agreements of this type, including restrictions on paying dividends and making distributions to our stockholders. As of December 31, 2013, we were in compliance with the covenants and anticipate continuing to be so. Under the terms of the joint venture agreement with the JV Company, we have agreed, upon the satisfaction of certain conditions, to provide up to an additional $1.1 million in additional funding to the JV Company over two years through the purchase of non-voting, non-convertible Series A preferred shares of the JV Company. As of December 31, 2013, we had approximately $36.4 million of cash and cash equivalents and money market funds. We did not have any short-term or long-term investments. We believe that our existing cash and cash equivalents, along with cash flows from operations and availability under our revolving credit line, will be sufficient to meet our anticipated working capital, capital lease payment obligations, JV Company funding obligations, and capital expenditure requirements for at least the next 12 months. Cash Flows Year Ended December 31, 2011 2012 2013 (in thousands) Statements of Cash Flows Data: Cash flows provided by operating activities $ 8,678 $ 14,657 $ 5,228 Cash flows used in investing activities (1,848 ) (4,869 ) (8,857 ) Cash flows (used in) provided by financing activities (1,317 ) 21,237 (1,926 ) Cash Provided by Operating Activities Operating activities provided $5.2 million of cash in 2013. The positive cash flow from operating activities primarily resulted from our net loss, adjusted for non-cash items, and changes in our operating assets and liabilities. We had a net loss of $1.4 million, which included a non-cash benefit from deferred income taxes of $0.2 million, non-cash depreciation of $4.7 million, non-cash stock-based compensation of $2.6 million, and $0.6 million loss in equity interest. Changes in our operating assets and liabilities used $1.0 million of cash, primarily due to a decrease in our accounts receivable of $1.1 million and a decrease in our accrued expenses and other current liabilities of $2.2 million. The decrease in our accounts receivable was 44-------------------------------------------------------------------------------- Table of Contents primarily attributable to the decrease in revenue. The decrease in our accrued expenses and other liabilities of $2.2 million was primarily driven by a $1.7 million decrease in our bonus accrual. Operating activities provided $14.7 million of cash in 2012. The cash flow from operating activities primarily resulted from our net income, adjusted for non-cash items, and changes in our operating assets and liabilities. We had net income of $3.8 million, which included a non-cash benefit from deferred income taxes of $1.6 million, non-cash depreciation of $3.8 million and non-cash stock-based compensation of $2.0 million. Changes in our operating assets and liabilities provided $3.5 million of cash, primarily due to an increase in our accounts payable of $2.3 million and an increase in our accrued expenses and other current liabilities of $1.7 million, partially offset by increases in our accounts receivable of $1.3 million. The increase in our accounts payable was attributable to a $1.4 million increase due to the timing of, and a change in payment terms with, a customer for their revenue share payment. The remaining increase of $0.9 million was primarily driven by increased spending due to the growth of our revenue-share payments associated with our revenue growth. The increase in our accrued expenses and other liabilities of $1.7 million was primarily driven by a $1.0 million increase for operating related expenses and components of our cost of revenue and a $0.5 million increase in our bonus accrual. The increase in our accounts receivable was primarily due to our revenue growth in 2012. Operating activities provided $8.7 million of cash in 2011. The cash flow from operating activities primarily resulted from our net income, adjusted for non-cash items, and changes in our operating assets and liabilities. We had net income in 2011 of $9.9 million, which included a non-cash benefit from deferred income taxes of $6.1 million, non-cash depreciation of $2.7 million and non-cash stock-based compensation of $0.9 million. Changes in our operating assets and liabilities provided $1.2 million of cash in 2011, primarily due to an increase of $4.1 million in our accounts payable and an increase of $1.7 million of other accrued expenses partially offset by increases in our accounts receivable of $4.7 million. The increase in accounts payable was the result of increased spending due to the growth of our revenue-share payments associated with our revenue growth and the timing of payments to customers for revenue-sharing agreements and to content providers. The increase in other accrued expenses was mainly due to an increase in our bonus accrual. The increase in our accounts receivable was primarily due to our revenue growth in 2011. Cash Used in Investing Activities Our primary investing activities have consisted of purchases of property and equipment, payments for the acquisitions of Carbyn and Teknision and for investments made in the JV Company. Purchases of property and equipment may vary from period to period due to the timing of the expansion of our operations and internal-use software development. We expect to continue to invest in property and equipment and development of software for the remainder of 2014 and thereafter. Cash used in investing activities in 2013 was $8.9 million consisting of $5.9 million of purchases of property, equipment and software (specifically related to the build out of our data centers and internal-use software development and including $0.5 million used for payment for the acquisition of Carbyn), $0.9 million contributed to an equity method investment, $1.0 million paid for the acquisition of Teknision, Inc. (an Ontario-based company), and a $1.0 million purchase of a promissory note having to do with our investment in B&FF. Included within purchases of property, equipment, and software are external and internal costs of $3.0 million incurred during the application development stage. We expect much of the development effort to transition into the operation stage during 2014. Cash used in investing activities in 2012 was $4.9 million consisting of $4.3 million of purchases of property, equipment and software to build out our data centers and $0.6 million paid for the acquisition of Carbyn. Cash used in investing activities in 2011 was $1.8 million consisting principally of purchases of property, equipment and software to build out our data centers. Cash (Used in) Provided by Financing Activities For the year ended December 31, 2013, net cash used by financing activities was $2.0 million, consisting of $2.1 million of repayments for our capital lease obligations, offset by $0.2 million of proceeds from the exercise of common stock options. For the year ended December 31, 2012, net cash provided by financing activities was $21.2 million, consisting of $25.4 million of proceeds from issuance of common stock in our public offering, partially offset by cash paid for issuance costs of $2.8 million, and $1.2 million of proceeds from the exercise of common stock options, partially offset by $2.6 million for repayments on our capital lease obligations and bank financing. 45-------------------------------------------------------------------------------- Table of Contents For the year ended December 31, 2011, net cash used in financing activities was approximately $1.3 million primarily for repayments of $2.2 million on our capital lease obligations and bank financing partially offset by $0.8 million of proceeds from a sale/leaseback transaction relating to computer equipment. Off-Balance Sheet Arrangements At December 31, 2013, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated by the SEC, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. Contractual Obligations We lease office space and data center space under operating lease agreements and certain equipment under capital lease agreements. We are also obligated to make payments under various contracts with vendors and customers, principally for revenue-sharing and content arrangements. The following table sets forth our future contractual obligations as of December 31, 2013: Payments due by period 2018 and Total 2014 2015 2016 2017 thereafter Capital lease obligations $ 2,959 $ 2,038 $ 531 $ 390 $ - $ - Operating lease obligations 3,323 1,478 988 348 191 318 Contract commitments 7,680 4,610 1,630 1,080 360 - Total $ 13,962 $ 8,126 $ 3,149 $ 1,818 $ 551 $ 318 The contract commitments shown in the foregoing table represent fixed payment obligations to some of our customers and content providers. Agreements with certain customers and certain content providers require us to make fixed payments to them. |