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VIOLIN MEMORY INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(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 the related notes included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. In addition to our historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Annual Report on Form 10-K, particularly in Part I, Item 1A, "Risk Factors." Overview We were incorporated in 2005 with the goal of bringing storage performance in line with advancements in server and network technologies. Since our inception, we have focused on persistent memory-based technology as the key to solving the performance limitations of traditional storage solutions in the data center environment. We have invested significantly in our research and development efforts to design hardware and software at each level of the system architecture starting with memory and optimized through the array level to capitalize on the benefits of flash technology. We were recapitalized in 2009. In 2009, we transitioned to build an enterprise-class all-flash storage solution serving diverse end markets and applications. In May 2010, we introduced our 3000 Series Flash Memory Array to accelerate business-critical applications. In March 2010, we established a relationship with Toshiba, one of the two largest providers of flash memory. Through this relationship, we have developed a fundamental understanding of Toshiba's flash specifications at the chip level, which allows us to optimize our hardware and software technologies to unlock the inherent performance capabilities of flash memory. In September 2011, we expanded our product offering with the introduction of our 6000 Series Flash Memory Arrays, which is based on our four-layer architecture that significantly improves performance density, or IOPS per rack unit. In March 2013, we expanded our innovation in persistent memory technologies and proprietary techniques in flash management from our memory arrays to our Velocity Peripheral Component Interconnect Express, or PCIe, Flash Memory Cards. Our PCIe Flash Memory Cards leverage our expertise in persistent memory-based storage and controller design, as well as our vMOS software stack, to offer a differentiated architecture in a widely deployable PCIe form factor. In December 2013, in connection with our restructuring activities and with our decision to focus on our core Flash Memory Array market, we decided to evaluate strategic alternatives for our PCIe Flash Memory Card product line. We have engaged an investment banker and expect to conclude this process in the second quarter of fiscal 2015. During fiscal 2014, we also introduced the Violin Symphony System Management software and Violin Maestro Memory Services software. We intend to devote substantial resources to continue to develop innovative solutions that optimize the performance capability of flash memory technology and enhance our vMOS software stack to incorporate additional data management functionality. It typically takes us between 18 to 24 months to develop a new product, and we would expect to phase out existing product lines when a new generation of a product line becomes available. Generally, we begin our product development cycle when the release by our supplier of next generation NAND flash memory is anticipated. We market and sell our products directly to end-customers and through channel partners, including systems vendors, technology partners and resellers. As of January 31, 2014, we had 189 sales and marketing employees worldwide as well as over 100 channel partners in over 30 countries. As of January 31, 2014, we believe our Flash Memory Arrays had been deployed by over 300 end-customers. We and our authorized service providers also sell support services to our end-customers. 51 -------------------------------------------------------------------------------- Table of Contents An initial sale by us to an end-customer typically requires three to nine months of selling effort because we devote time to educating the prospective end-customer about the technical merits, potential cost savings and other benefits of our products in contrast to our competitors' products. In addition, our sales process typically includes a trial deployment of our systems in the end-customer's data center. We currently derive and expect to continue to derive a significant portion of our revenue from existing end-customers. The selling effort required for repeat orders from end-customers is usually less time-consuming than that required for initial orders. We maintain a close relationship with our end-customers through our client teams consisting of sales, service and support and technical personnel. It has generally taken between six and twelve months for us to establish a relationship with a systems vendor or technology partner, because our products are often integrated into a broader enterprise solution offered by them. Once we establish a relationship with a systems vendor or technology partner, we work with them to co-market our solutions. A limited number of customers have accounted for a substantial majority of our revenue, and the composition of the group of our largest customers has changed from period to period. Some of our end-customers make periodic purchases of our system solutions in large quantities to complete or upgrade specific large-scale storage installations. Purchases are typically made on a purchase order basis rather than pursuant to long-term contract. Revenue from our five largest customers was 35%, 37% and 83% for fiscal 2014, 2013 and 2012, respectively. As a consequence of these concentrated purchases by a shifting customer base, we believe that revenue may fluctuate in future periods, and period-to-period comparisons of revenue and operating results are not necessarily meaningful and should not be relied upon as an indication of future performance. Our sales are principally denominated in U.S. dollars. Revenue from customers with a bill-to location in the United States accounted for 62%, 76% and 65% of total revenue for fiscal 2014, 2013 and 2012, respectively. We outsource the manufacturing of our hardware products to a single contract manufacturer, Flextronics. We believe this arrangement makes our operations more efficient and flexible. We procure the flash memory components used in our products directly from Toshiba. Our manufacturer procures, on our behalf, the remaining components used in our products. To date, we have not experienced a material shortage of supply of any components. However, because we only have one manufacturer qualified to manufacture our products and some of our components, such as flash memory, are procured from a single-source supplier, we could face product shortages and component shortages, which could prevent us from fulfilling customer orders. We have experienced significant losses as we have continued to invest in our product development, customer service and sales and marketing organizations. We have funded our activities primarily through equity financings. As of January 31, 2014, we had an accumulated deficit of $352.6 million. In February 2014, we announced a strategic restructuring plan designed to accelerate our growth and increase our operating leverage. The restructuring plan included three elements: a reorganization of our sales and marketing functions to align our resources around a more partner and channel-centric go-to-market model; a realignment of our engineering resources to concentrate our efforts on core product areas while reducing or eliminating investments in non-core areas; and a review of strategic alternatives for our PCIe Flash Memory Card product line. Since the end of the third quarter of fiscal 2014 through the first quarter of fiscal 2015, we will have reduced peak employment by more than 20%. While our financial model has become more balanced in the last two quarters, we still anticipate that we will incur net losses for at least the next several quarters. We have continued to grow our business over for the past several years with total revenue of $107.7 million, $73.8 million and $53.9 million for fiscal 2014, 2013 and 2012, respectively. Our headcount decreased slightly to 437 as of January 31, 2014 from 449 employees as of January 31, 2013. However, we added headcount for the first three quarters of fiscal 2014 as we grew our sales force, but began realigning resources in the fourth quarter as describe above. We had a net loss of $149.8 million, $109.1 million and $44.8 million for fiscal 2014, 2013 and 2012, respectively. 52-------------------------------------------------------------------------------- Table of Contents Initial public offering On October 2, 2013, we closed our IPO of 18,000,000 shares of common stock. The public offering price of the shares sold in the IPO was $9.00 per share. The total gross proceeds to us from the IPO were $162 million. After deducting underwriting discounts and commissions and IPO expenses, the aggregate net proceeds to us totaled $145.8 million. Key Trends Affecting Our Results of Operations Adoption of Flash-Based Solutions There has been an increasing shift towards the use of persistent memory-based solutions by organizations. Traditional data center architectures have typically deployed disk-based storage approaches. We believe that flash memory technology has the significant potential to displace HDDs in primary storage solutions and bring storage solutions in line with other advanced data center technologies. Our success, however, depends on the adoption of flash-based solutions in enterprise data centers. A lack of demand for flash-based storage solutions for any reason, including technological challenges associated with the use of flash memory or the adoption of competing technologies and products, would adversely affect our growth prospects. To the extent more enterprise IT organizations recognize the benefits of flash memory in data center storage solutions and as the adoption of flash memory technology as primary storage increases, our target customer base will expand. Relationships with Systems Vendors and Technology Partners One of the keys to growing our business is our ability to broaden our routes to market and our geographic reach. A key component of this strategy is our intention to establish relationships with systems vendors and technology partners. Systems vendors incorporate our products into a broader enterprise solution offered by them. These relationships also allow us to leverage the account control, marketing, brand and other resources of our systems vendor partners to reach more potential customers and broaden our target markets. Technology partners allow us to enhance our product offerings by leveraging leading technologies that are well-accepted in the marketplace. Our relationships with technology partners also extend our reach into different end markets and new target end-customers. Continued success in establishing relationships with systems vendors and technology partners would allow us to grow our business by expanding our target markets and distribution capabilities. Size of our Field Organization, Including Sales, Field Application Engineers and Customer Support Personnel We target large customer storage deployments in the data center. Often, our end-customer relationships start with a limited initial deployment of our products to demonstrate the performance benefits of our solution. Our objective is to leverage initial deployments into large-scale deployments as our customers' experience with our products and their storage performance and capacity requirements increase. In an effort to do this, we maintain a very close relationship with our end-customers through the efforts of our field organization. Our ability to grow our business and to establish a growing number of these high-touch end-customer relationships is dependent upon our ability to expand the size of our field organization in an efficient and effective manner. As we grow our field organization, we must closely monitor productivity to ensure our investments in personnel are translating into product sales and positive operating results. Cost of Flash Memory A significant percentage of our cost of revenue is the cost of flash memory. We have a relationship with Toshiba, our sole supplier of our flash memory components. Although we have historically received competitive pricing from Toshiba, our agreement with Toshiba does not provide us with fixed pricing. We are required to purchase 70% of our annual requirements of flash memory from Toshiba, subject to specified 53 -------------------------------------------------------------------------------- Table of Contents conditions, and design our products to be substantially compatible with Toshiba. However, our supply of flash memory from Toshiba is not guaranteed. There are many variables that may change our cost to procure flash memory. If the component costs of flash memory were to increase, we may not be able to pass on the cost increase to our customers, which could harm our gross margin and operating results. If the component costs of flash memory were to decrease, we may be able to leverage these cost savings into offering a more competitive solution to our end-customers. Components of Consolidated Statements of Operations Revenue We derive revenue primarily from the sale of our Flash Memory Array products, software and related support and services. We sell our products on a purchase order basis directly to end-customers and through channel partners, including systems vendors and resellers. Our mix of sales between end-customers and channel partners impacts the average selling price of our products. We derive support services revenue from the sale of our premium support services. These support services are provided pursuant to support terms that generally are for either one- or three-year durations. Support services are typically billed in advance on an annual basis or at the inception of a multiple year support contract, and revenue is recognized ratably over the support period. We expect our support services revenue to continue to grow in future periods as support contracts are renewed and the installed base of Flash Memory Arrays grows. Cost of Revenue Cost of revenue consists primarily of component costs, amounts paid to our contract manufacturer to assemble our products, shipping and logistics costs and estimated warranty obligations. The largest portion of our cost of revenue consists of the cost of flash memory components. Neither our contract manufacturer nor we enter into supply contracts with fixed pricing for our product components, including our flash memory, which can cause our cost of revenue to fluctuate from quarter to quarter. We may not be able to pass flash or component cost increases to our customers immediately or at all resulting in lower gross margins. Cost of revenue is recorded when the related product revenue is recognized. Cost of revenue also includes personnel expenses related to customer support and carrying value adjustments recorded for excess and obsolete inventory. We intend to add customer support personnel to increase our customer support efforts as we increase the installed base of our Flash Memory Arrays globally. Operating Expenses Operating expenses consist of sales and marketing, research and development, and general and administrative expenses. The largest component of our operating expenses is personnel costs, consisting of salaries, benefits and incentive compensation for our employees, including stock-based compensation. As a result, operating expenses have increased significantly over the periods presented. We expect operating expenses to decrease in absolute dollars over the next several quarters as we continue to restructure our operations; however, they may fluctuate from quarter to quarter or as a percentage of revenue from period to period, as we grow our revenue. Sales and Marketing Sales and marketing expenses consist primarily of personnel costs, incentive compensation, marketing programs, travel-related expenses, consulting expenses associated with sales and marketing activities and allocated facilities costs. Our sales personnel are typically not immediately productive, and therefore, the increase in sales and marketing expenses is not immediately offset by increased revenue and may not result in increased revenue over the long-term. The timing of our hiring of new sales personnel and the rate at which they generate incremental revenue could cause our future period-to-period financial performance to fluctuate. We 54 -------------------------------------------------------------------------------- Table of Contents have generated a larger percentage of our sales from direct sales or through resellers with whom we will be directly involved in the sales process with the end-customer. This type of selling typically requires greater involvement of our direct sales force than sales to systems vendors and may increase our sales and marketing expense as a percentage of revenue. We are focused on improving the productivity of our direct sales teams. In addition, we continue to work with our technology partners on joint solutions and to develop go-to-market capabilities through channel partners. To the extent we are successful, these activities will provide incremental sales leverage to our existing direct selling efforts. Research and Development Research and development expenses consist primarily of personnel costs, prototype expenses, software tools, consulting services and allocated facilities costs. Consulting services generally consist of contracted engineering consulting for specific projects on an as-required basis. We recognize research and development expense as incurred. We expect to continue to devote substantial resources to the development of our products including the development of new software capabilities within our vMOS software stack. We believe that these investments are necessary to maintain and improve our competitive position. In particular, our recent hiring has been focused on software engineers. We believe our current level of personal is sufficient to develop our products in the near term. General and Administrative General and administrative expenses consist primarily of personnel costs, legal expenses, consulting and professional services, insurance and allocated facilities costs for our executive, finance, human resources and legal organizations. While we expect personnel costs to be the primary component of general and administrative expenses, we also expect to incur significant additional legal and accounting costs related to compliance with rules and regulations implemented by the SEC and the NYSE, as well as additional insurance, investor relations and other costs associated with being a public company. Other Income (Expense), Net Other income (expense), net consists of interest income, impairment of cost method investments and foreign currency gains and losses. Interest Expense Interest expense consists of interest related to convertible notes and debt. Provision for Income Taxes From inception through January 31, 2014, we incurred operating losses and, accordingly, have not recorded a provision for U.S. federal income taxes but have recorded provisions for foreign income and state taxes. As of January 31, 2014, we had approximately $150.5 million and $65.8 million of net operating loss carry forwards available to offset future taxable income for both Federal and State purposes, respectively. If not utilized, these carry forward losses will expire in various amounts for Federal and State tax purposes beginning in 2026 and 2014, respectively. 55 -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table summarizes our consolidated statements of operations data for the periods shown (in thousands, except per share data): Year Ended January 31, 2014 2013 2012 Revenue: Product revenue $ 88,321 $ 69,584 $ 52,541 Service revenue 19,335 4,214 1,347 Total revenue 107,656 73,798 53,888 Cost of revenue : Cost of product revenue (1) 47,773 38,180 38,110 PCIe card inventory provision 9,154 - - Cost of service revenue (1) 7,846 4,474 1,156 Total cost of revenue 64,773 42,654 39,266 Gross profit 42,883 31,144 14,622 Operating expenses : Sales and marketing (1) 81,104 61,094 21,493 Research and development (1) 73,743 57,840 26,641 General and administrative (1) 29,622 21,105 6,222 Restructuring and transition charges 4,869 - - Litigation settlement 350 - 2,100 Total operating expenses 189,688 140,039 56,456 Loss from operations (146,805 ) (108,895 ) (41,834 ) Other income (expense), net (1,389 ) (79 ) 89 Interest expense (1,539 ) (31 ) (3,033 ) Loss before income taxes (149,733 ) (109,005 ) (44,778 ) Income taxes 76 97 7 Net loss $ (149,809 ) $ (109,102 ) $ (44,785 ) Net loss per share of common stock, basic and diluted $ (3.88 ) $ (8.01 ) $ (4.77 ) Shares used to compute net loss per share of common stock, basic and diluted (2) 38,591 13,624 9,396 (1) Includes stock-based compensation expense as follows: Cost of product revenue $ 100 $ 150 $ 15 Cost of service revenue 889 474 4 Sales and marketing 10344 4,061 299 Research and development 6900 3,228 236 General and administrative 18166 10,010 492 $ 36,399 $ 17,923 $ 1,046 (2) See Note 13 of the consolidated financial statements for an explanation of the calculations of basic and diluted net loss per share available to common stock holders. 56 -------------------------------------------------------------------------------- Table of Contents Comparison of Fiscal Years 2014, 2013 and 2012 Revenue Year Ended January 31, Change in Year Ended January 31, Change in 2014 2013 $ % 2013 2012 $ % Product revenue $ 88,321 $ 69,584 $ 18,737 27 % $ 69,584 $ 52,541 $ 17,043 32 % Service revenue 19,335 4,214 15,121 359 % 4,214 1,347 2,867 213 % $ 107,656 $ 73,798 $ 33,858 46 % $ 73,798 $ 53,888 $ 19,910 37 % Fiscal Year Ended January 31, 2014 Compared to Fiscal Year Ended January 31, 2013 Total revenue increase $33.9 million from fiscal 2013 to fiscal 2014. The increase in total revenue was primarily due to an increase in product revenue of $18.8 million and service revenue of $15.1 million. The product revenue increase was primarily due to an increase of approximately 21% in the total number of Flash Memory Arrays sold and our initial sales of our PCIe cards of $4.2 million and software of $4.0 million. During fiscal 2014 and 2013, revenue associated with our 6000 Series Flash Memory Arrays represented 85% and 82% of product revenue, respectively. The increase in service revenue primarily relates to the continued growth of support contracts as our installed base grew and due to the recognition of $6.0 million associated with the development services related to PCIe cards for Toshiba. Fiscal Year Ended January 31, 2013 Compared to Fiscal Year Ended January 31, 2012 Total revenue increased $19.9 million from fiscal 2012 to fiscal 2013. The increase in total revenue was primarily due to an increase in product revenue of $17.0 million and services revenue of $2.9 million. The increase in product revenue was primarily due to an increase in average selling prices related to larger capacity Flash Memory Arrays sold and, to a lesser extent, an increase in the number of Flash Memory Arrays sold. Sales of our 6000 Series Flash Memory Arrays, introduced in January 2013, represented approximately 82% of our product revenue for fiscal 2013. The increase in service revenue of $2.9 million was primarily due to increased support contracts as we grew our installed base. Revenue from our five largest customers for the years ended January 31, 2014, 2013 and 2012 was 35%, 37% and 83% of total revenue, respectively. Cost of Revenue and Gross Margin Year Ended January 31, Change in Year Ended January 31, Change in 2014 2013 $ % 2013 2012 $ % Cost of product revenue $ 47,773 $ 38,180 $ 9,593 25 % $ 38,180 $ 38,110 $ 70 - PCIe card inventory provision 9,154 - 9,154 - - - - Cost of service revenue 7,846 4,474 3,372 75 % 4,474 1,156 3,318 287 % $ 64,773 $ 42,654 $ 22,119 52 % $ 42,654 $ 39,266 $ 3,388 9 % Gross Profit $ 42,883 $ 31,144 $ 11,739 38 % $ 31,144 $ 14,622 $ 16,522 113 % Product gross margin 46 % 45 % 45 % 27 % Service gross margin 59 % (6 )% (6 )% 14 % Total gross margin 40 % 42 % 42 % 27 % 57 -------------------------------------------------------------------------------- Table of Contents Fiscal Year Ended January 31, 2014 Compared to Fiscal Year Ended January 31, 2013 Cost of revenue increased $22.1 million from $42.7 million for fiscal 2013 to $64.8 million for fiscal 2014. The increase was primarily due to provision for excess and obsolete inventory of $9.2 million in fiscal 2014 that we recognized relating to inventory and non-cancellable purchase commitments associated with PCIe card inventory combined with an approximately 21% increase in the number of Flash Memory Arrays sold. The increase in cost of service revenue was primarily due to an increase in personnel costs as we increased headcount to support our increased customer base and, to a lesser extent, costs associated with the Toshiba development agreement. Gross profit increased $11.7 million from fiscal 2013 to fiscal 2014. Gross margin decreased to 40% for the year ended January 31, 2014 compared to 42% for fiscal 2013 primarily due to provision for excess and obsolete inventory of $9.2 million that we recognized relating to inventory and non-cancellable purchase commitments associated with PCIe card inventory, partially offset by improved product margins resulting from the introduction of our 6264 Flash Memory Array, which has a higher gross margin due to its larger capacity and higher average selling price. Service margin increased due primarily to services provided under our development agreement with Toshiba and to improved economies of scale associated with our support services as our larger installed base grew. Fiscal Year Ended January 31, 2013 Compared to Fiscal Year Ended January 31, 2012 Cost of revenue increased $3.4 million from $39.3 million for fiscal 2012 to $42.7 million for fiscal 2013. The increase was primarily due to higher manufacturing costs associated with our 6000 Series Flash Memory Arrays as a result of the increased amount of flash memory used in the 6000 Series Flash Memory Arrays to support its increased performance and capacity compared to our 3000 Series Flash Memory Arrays and, to a lesser extent, an increase in the volume of product shipped. Gross profit increased $16.5 million from fiscal 2012 to fiscal 2013. Gross margin increased to 42% in fiscal 2013 as compared to 27% in fiscal 2012. Our product gross margin was significantly higher as a result of higher average selling prices associated with our 6000 Series Flash Memory Arrays and greater economies of scale as we increased production. This increase was partially offset by a decrease in our services gross margin due to an increase in headcount to support our increased customer base. We also recorded a provision for excess and obsolete inventory of $5.8 million in fiscal 2012 compared to $1.1 million in fiscal 2013. Operating Expenses Year Ended January 31, Change in Year Ended January 31, Change in 2014 2013 $ % 2013 2012 $ % Sales and marketing $ 81,104 $ 61,094 $ 20,010 33 % $ 61,094 $ 21,493 $ 39,601 184 % Research and development 73,743 57,840 15,903 27 % 57,840 26,641 31,199 117 % General and administrative 29,622 21,105 8,517 40 % 21,105 6,222 14,883 239 % Restructuring and transition charges 4,869 - 4,869 100 % - - - Litigation settlement 350 - 350 100 % - 2,100 (2,100 ) - 100 % $ 189,688 $ 140,039 $ 49,649 $ 140,039 $ 56,456 $ 83,583 Fiscal Year Ended January 31, 2014 Compared to Fiscal Year Ended January 31, 2013 Sales and marketing expense increased $20.0 million from fiscal 2013 to fiscal 2014. The increase was primarily due to an increase in personnel related expenses of $13.0 million. We continued to increase the number of sales and marketing employees from 218 as of January 31, 2013 to 259 as of October 31, 2013. In the fourth quarter of fiscal 2014, we began reducing our sales and marketing organization to better align our expense 58-------------------------------------------------------------------------------- Table of Contents structure with revenue. As of January 31, 2014, we had 189 sales and marketing employees compared to 218 sales and marketing employees at January 31, 2013. We also incurred increased expenses relating to stock-based compensation of $6.2 million and professional and consulting fees of $1.6 million. Research and development expenses increased $15.9 million from fiscal 2013 to fiscal 2014 primarily due to an increase in personnel-related costs of $5.1 million. The increase is primarily due to having more employees throughout the year as compared to the prior year. In fiscal 2013, we ramped up our research and development personnel. The number of research and development employees was 182 as of January 31, 2014 and compares to 194 as of January 31, 2013 and 131 employees as of January 31, 2012. We also incurred increased expenses related to licensed software fees of $6.1 million, stock-based compensation of $3.7 million, facility costs of $2.1 million and professional and consulting fees of $0.6 million partially offset by a decrease in software tools and prototypes of $1.2 million. General and administrative expenses increased $8.5 million from fiscal 2013 to fiscal 2014 primarily due to an increase in stock-based compensation of $8.1 million related primarily to the accelerated vesting of equity awards held by certain former executives and recruiting fees of $1.2 million, partially offset by a reduction in audit fees of $0.7 million and personnel related expenses of $0.3 million. For the year-ended January 31, 2014, we recognized restructuring and transition charges of $4.9 million related to the implementation of strategic restructuring initiatives. Our strategic restructuring plan focuses on accelerating growth and increasing operating leverage and includes a global reorganization of our sales, marketing and engineering functions designed to sharpen our focus on core segments of the flash-based storage market. During the fourth quarter of fiscal 2014, we incurred severance expenses related to restructuring charges of $2.7 million for involuntary termination of employees, an impairment of assets of $1.2 million, excess facility charges of $0.5 million, and other transition related expenses of $0.4 million. Fiscal Year Ended January 31, 2013 Compared to Fiscal Year Ended January 31, 2012 Sales and marketing expenses increased $39.6 million from fiscal 2012 to fiscal 2013. The increase was primarily due to an increase in personnel-related expenses of $26.8 million as we increased the number of sales and marketing employees from 95 employees as of January 31, 2012 to 218 employees as of January 31, 2013 to build our direct sales force. The increase was also due to increases in expenses associated with systems provided to partners for test and development of $4.4 million, stock-based compensation of $3.8 million, travel-related expenses of $3.4 million and consulting expenses of $1.1 million. Research and development expenses increased $31.2 million from fiscal 2012 to fiscal 2013 primarily due to an increase in personnel-related expenses of $16.0 million as we increased the number of research and development employees from 131 employees as of January 31, 2012 to 194 employees as of January 31, 2013, principally to enhance our software capabilities and expand our product portfolio. We also incurred increased expenses associated with the development of new product prototypes of $6.4 million, depreciation expense related to lab equipment of $3.9 million, stock-based compensation of $3.0 million and consulting services of $1.7 million. General and administrative expenses increased $14.9 million from fiscal 2012 to fiscal 2013 primarily due to an increase in personnel-related expenses of $1.2 million as we increased the number of general and administrative employees from 17 employees as of January 31, 2012 to 23 employees as of January 31, 2013. We also experienced increases in stock-based compensation of $9.5 million, legal expenses of $1.5 million, audit fees of $1.2 million, consulting fees of $0.9 million and bad debt expenses of $0.4 million. In fiscal 2012, we accrued a charge of $2.1 million related to outstanding patent infringement litigation. We settled this matter in the third quarter of fiscal 2013 for the same amount. 59-------------------------------------------------------------------------------- Table of Contents Quarterly Results of Operations Data The following tables set forth our unaudited quarterly consolidated statements of operations data in dollars and as a percentage of total revenue for each of the eight quarters in the period ended January 31, 2014. We have prepared the quarterly consolidated statements of operations data on a basis consistent with the audited consolidated financial statements included in Part II, Item 8, "Financial Statements and Supplementary Data" in this Annual Report on Form 10-K. In the opinion of management, the financial information reflects all adjustments, consisting only of normal recurring adjustments, which we consider necessary for a fair presentation of this data. This information should be read in conjunction with the audited consolidated financial statements and related notes included in Part II, Item 8, "Financial Statements and Supplementary Data" in this Annual Report on Form 10-K. The results of historical periods are not necessarily indicative of the results of operations for any future period. Three Months Ended Jan. 31, Oct. 31, Jul. 31 Apr. 30, Jan. 31, Oct. 31, Jul. 31, Apr. 30, 2014 2013 2013 2013 2013 2012 2012 2012 (In thousands) Revenue: Product revenue $ 20,832 $ 21,416 $ 23,595 $ 22,478 $ 21,204 $ 19,325 $ 19,312 $ 9,743 Service revenue 7,215 6,890 2,910 2,320 1,696 1,271 774 473 Total revenue 28,047 28,306 26,505 24,798 22,900 20,596 20,086 10,216 Cost of revenue : Cost of product revenue (1) 10,480 10,555 13,661 13,077 12,090 10,330 10,009 5,751 PCIe cards inventory provision 9,154 - - - - - - - Cost of service revenue (1) 2,142 2,382 1,673 1,649 1,596 1,354 856 668 Total cost of revenue 21,776 12,937 15,334 14,726 13,686 11,684 10,865 6,419 Gross profit 6,271 15,369 11,171 10,072 9,214 8,912 9,221 3,797 Operating expenses : Sales and marketing (1) 22,929 21,299 18,624 18,252 20,640 15,568 13,273 11,613 Research and development (1) 18,898 20,111 18,800 15,934 18,764 14,061 13,769 11,246 General and administrative (1) 14,845 6,627 4,040 4,110 5,149 4,606 7,546 3,804 Restructuring and transition 4,869 - - - - - - - Litigation settlement - 350 - - - - - - Total operating expenses 61,541 48,387 41,464 38,296 44,553 34,235 34,588 26,663 Loss from operations (55,270 ) (33,018 ) (30,293 ) (28,224 ) (35,339 ) (25,323 ) (25,367 ) (22,866 ) Other income (expense), net (1,086 ) (17 ) (6 ) (280 ) (20 ) (43 ) (38 ) 22 Interest expense (137 ) (1,060 ) (342 ) - - - - (31 ) Loss before income taxes (56,493 ) (34,095 ) (30,641 ) (28,504 ) (35,359 ) (25,366 ) (25,405 ) (22,875 ) Income taxes 31 18 7 20 49 33 15 - Net loss $ (56,524 ) $ (34,113 ) $ (30,648 ) $ (28,524 ) $ (35,408 ) $ (25,399 ) $ (25,420 ) $ (22,875 ) Net loss per share of common stock, basic and diluted $ (0.69 ) $ (0.85 ) $ (1.98 ) $ (1.86 ) $ (2.41 ) $ (1.79 ) $ (1.92 ) $ (1.88 ) Shares used to compute net loss per share of common stock, basic and diluted 82,514 40,362 15,507 15,358 14,668 14,196 13,258 12,145 (1) Includes stock-based compensation expense as follows: Cost of product revenue $ 24 $ 37 $ 22 $ 17 $ 10 $ 20 $ 11 $ 6 Cost of service revenue 114 124 425 226 232 243 35 67 Sales and marketing 4,963 2,101 1,763 1,517 1,166 1,356 694 845 Research and development 2,452 1,828 1,260 1,360 1,001 919 682 626 General and administrative 10,647 4,165 1,653 1,701 2,803 1,575 4,940 692 $ 18,200 $ 8,255 $ 5,123 $ 4,821 $ 5,212 $ 4,113 $ 6,362 $ 2,236 60 -------------------------------------------------------------------------------- Table of Contents The following table sets forth consolidated results of operations for the specified periods as a percentage of our revenues for those periods. Three Months Ended Jan. 31, Oct. 31, Jul. 31 Apr. 30, Jan. 31, Oct. 31, Jul. 31, Apr. 30, 2014 2013 2013 2013 2013 2012 2012 2012 (As percentage of total revenue) Revenue: Product revenue 74 % 76 % 89 % 91 % 93 % 94 % 96 % 95 % Service revenue 26 24 11 9 7 6 4 5 Total revenue 100 100 100 100 100 100 100 100 Cost of revenue : Cost of product revenue 50 49 58 58 57 53 52 59 PCIe card inventory provision 44 - - - - - - - Cost of service revenue 30 35 57 71 94 107 111 141 Total cost of revenue 78 46 58 59 60 57 54 63 Gross profit 22 54 42 41 40 43 46 37 Operating expenses : Sales and marketing 82 75 71 74 90 76 66 114 Research and development 67 71 71 64 82 68 69 110 General and administrative 53 23 15 17 23 22 38 37 Restructuring and transition 17 - - - - - - - Litigation settlement - 1 - - - - - - Total operating expenses 219 171 157 155 195 166 173 261 Loss from operations (197 ) (117 ) (115 ) (114 ) (155 ) (123 ) (127 ) (224 )Other income (expense), net (4 ) - - (1 ) - - - - Interest expense - (4 ) (1 ) - - - - - Loss before income taxes - - - - - - - - Income taxes - - - - - - - - Net loss (202 )% (121 )% (116 )% (115 )% (155 )% (123 )% (127 )% (224 )% Liquidity and Capital Resources Primary Sources of Liquidity As of January 31, 2014, our principal sources of liquidity were our cash, cash equivalents and short-term investments of $99.4 million and accounts receivable of $21.1 million. Historically, our primary sources of liquidity have been from the issuance of common stock, convertible notes and convertible preferred stock. In October 2013, we completed our IPO, in which we issued and sold 18,000,000 shares and received net proceeds of $145.8 million. In May 2013, we entered into a $50 million debt arrangement with TriplePoint Capital LLC, or TriplePoint, discussed in more detail below. In July 2013, we established a line of credit in the amount of $7.5 million with Comerica Bank, discussed in more detail below. Cash Flow Analysis Year Ended January 31, 2014 2013 2012 (In thousands) Net cash provided by (used in): Operating activities $ (81,548 ) $ (76,910 ) $ (50,043 ) Investing activities (68,999 ) (15,540 ) (5,007 ) Financing activities 173,442 87,224 71,572 61 -------------------------------------------------------------------------------- Table of Contents Operating Activities Our net cash used in operating activities for fiscal 2014 was $81.5 million and was primarily due to costs related to building the infrastructure to support our current and anticipated growth. Our net loss for fiscal 2014 was $149.8 million and included non-cash stock-based compensation of $36.4 million, depreciation of $12.6 million, impairment charges of $2.0 million and a provision for excess and obsolete inventory related to our PCIe card inventory of $9.2 million. Our net cash used in operating activities for fiscal 2013 was $76.9 million and was primarily due to increased headcount to support our current and anticipated growth. Our headcount increased in all areas of our business from 252 employees as of January 31, 2012 to 449 employees as of January 31, 2013. Our net loss for fiscal 2013 was $109.1 million and included non-cash stock-based compensation of $17.9 million and depreciation of $9.0 million. Our net cash used in operating activities for fiscal 2012 was $50.0 million. During this period, our operating cash flow consisted primarily of an increase in inventory of $21.1 million and trade accounts receivable of $15.1 million as well as additional expenditures to hire more employees to support our current and anticipated growth. Our headcount increased in all areas of our business from 72 employees as of January 31, 2011 to 252 employees as of January 31, 2012. Our net loss for fiscal 2012 was $44.8 million. Significant non-cash expenses included in our net loss were depreciation of $5.1 million, interest expense of $2.9 million related to the extinguishment loss on the conversion of convertible notes and stock-based compensation of $1.0 million. Investing Activities Cash flows from investing activities generally consist of purchase of property and equipment, including product development and testing lab equipment used to support engineers and support service personnel. Our purchases of product development and testing lab equipment have increased over time as we increased the number of our engineers and support service personnel and as we introduce new products. We have purchased property and equipment of $9.3 million, $10.6 million and $5.0 million for fiscal 2014, 2013 and 2012, respectively. A large portion of this equipment is Flash Memory Arrays that we have capitalized. In addition, we have transferred inventory into lab equipment within fixed assets of $4.4 million, $3.6 million and $7.2 million during fiscal 2014, 2013 and 2012, respectively, a portion of which has been reflected as a non-cash transaction in the statements of cash flows. In addition to purchases of property and equipment, cash used in investing activities for the year ended January 31, 2014 was attributable to purchases of short-term investments of $66.2 million, partially offset by maturity of short-term investments of $7.1 million. In addition to purchases of property and equipment, cash used in investing activities for the year ended January 31, 2013 was attributable to purchases of cost method investments of $5.0 million. Financing Activities We generated $173.4 million of net cash from financing activities in fiscal 2014. This consisted of proceeds from our IPO, net of underwriting discount and commission and offering costs, of $145.8 million and proceeds from issuance of preferred stock, net of issuance costs, and convertible notes of $21.0 million and $5.2 million, respectively. We generated $87.2 million of net cash from financing activities in fiscal 2013, primarily due to $86.3 million of net proceeds from the issuance of Series D convertible preferred stock and $2.7 million from the issuance of convertible notes. We generated $71.6 million of net cash from financing activities in fiscal 2012, primarily due to $70.5 million in net proceeds from the issuance of preferred stock, $0.7 million in proceeds from the issuance of convertible notes and $0.4 million in proceeds from the exercise of stock options. 62-------------------------------------------------------------------------------- Table of Contents Future Capital Requirements As of January 31, 2014, we have cash, cash equivalents and short-term investments of $99.4 million. For the fiscal year ended January 31, 2014, cash used in operations was primarily funded by proceeds from our debt and equity transactions during the year. Our future capital requirements will depend on many factors, including our rate of revenue growth, changes in gross margin, the transition of our sales and marketing activities, the timing and extent of spending to support product development efforts, the timing of new product introductions and related inventory commitments, the building of infrastructure to support our growth, the continued market acceptance of our products and possible acquisitions of, or investments in, businesses, technologies or other assets. In May 2013, we entered into a $50 million debt facility with TriplePoint Capital LLC. The TriplePoint facility has a first secured interest in substantially all of our assets and intellectual property other than $7.5 million of accounts receivable. The TriplePoint facility allows us to incur additional debt of up to $7.5 million from a party other than TriplePoint so long as this debt is subordinated to the debt we have with TriplePoint. We have one year to draw on the TriplePoint facility, which has a number of borrowing options ranging in duration from three months up to five years. Depending on the loan option, annualized interest rates range from 7.0% to 13.5%. In addition, the loans have an end-of-term payment, ranging from 0.5% to 14.0% of the principal amount depending on the duration of the loan. There are no financial covenants in this facility. However, we have agreed with TriplePoint to certain operating covenants, including a requirement to obtain TriplePoint's consent to a merger or acquisition of us if our obligations to TriplePoint are not repaid in connection with such merger or acquisition, a requirement to obtain TriplePoint's consent before we acquire another company under certain circumstances, a prohibition on certain investments in third parties, restrictions on our ability to pay dividends or make distributions and a prohibition to engage in any business other than the businesses we are currently engaged in or reasonably related to our current businesses. As of January 31, 2014, we had no amounts outstanding under this facility. The debt agreement with TriplePoint allows TriplePoint to declare an event of default if, in the determination and explicit discretion of the lender, we experience a material adverse change to our business. Under this debt facility, a material adverse change means: a material adverse effect on our business, operations, properties, assets or financial condition; a material adverse effect on our ability to perform our obligations under the terms of the debt facility agreement; or a material adverse effect on the assets that we used to secure our obligations under the debt facility or TriplePoint's ability to enforce its security rights in those assets. In the event the lender declares an event of default, all amounts outstanding under this facility would become immediately due and payable and further advances under the facility would not be available. As of January 31, 2014, we were not in default on our debt facility with TriplePoint. As of January 31, 2014, we believe this facility was available to us. However, there can be no assurances that the funds will be available in the future or at the amount requested. Our line of credit with Comerica Bank has a term of two years, bears interest at the rate of prime plus 1.0% and is secured by our accounts receivable and collections thereof as well as our intellectual property. As of January 31, 2014, there were no amounts outstanding under the line of credit. While amounts are outstanding, we have agreed to certain operating covenants, including a requirement to obtain Comerica's consent to a merger or acquisition of us if our obligations to Comerica are not repaid in connection with such merger or acquisition, a requirement to obtain Comerica's consent before we acquire another company under certain circumstances, a prohibition on certain investments in third parties and restrictions on our ability to pay dividends or make distributions. We believe that our existing cash, cash equivalents, short-term investments and available lines of credit will be sufficient to meet our working capital and capital expenditure requirements for at least the next twelve months. The amount of IPO proceeds we use for our operations and expansion plans will depend on the amount 63 -------------------------------------------------------------------------------- Table of Contents of cash generated from our operations and any strategic decisions we may make that could alter our expansion plans and the amount of cash necessary to fund these plans. Although management believes existing cash, cash equivalents, short-term investments and available lines of credit will be sufficient to fund our operations and capital expenditures for at least the next twelve months, it may be necessary thereafter to finance our future operations and capital expenditures by raising additional capital. Ultimately, management intends to finance operations by achieving profitable operations. However, there can be no assurances that capital will be available on acceptable terms to us or at all, or that we will ever achieve profitable operations. If we are not able to raise additional capital or access our debt facilities in sufficient amounts to fund our operations in the future, it could have a negative impact on our business plans. Stock Split In September 2013, we completed a two-for-one reverse stock split of our common stock, with an automatic adjustment to the conversion ratio of the outstanding shares of convertible preferred stock to reflect the same reverse stock split ratio upon conversion of the convertible preferred stock into common stock. Based on the adjusted conversion ratio, two outstanding shares of convertible preferred stock converted into one share of common stock, except for Series D convertible preferred stock for which every two shares converted into 1.016998402 shares of common stock. All information related to common stock, stock options, RSUs and earnings per share for prior periods has been retroactively adjusted to give effect to the two-for-one reverse stock split. Off-Balance Sheet Arrangements During the periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purpose. Contractual Obligations The following summarizes our contractual obligations as of January 31, 2014 (in thousands): Less than 1 1 to 3 3 to 5 After 5 Total year years years years Operating lease obligations (1) $ 9,593 $ 2,196 $ 7,397 $ - $ - Purchase commitments (2) (3) (4) (5) 58,795 20,042 10,753 8,000 20,000 Total $ 68,388 $ 22,238 $ 18,150 $ 8,000 $ 20,000 (1) Operating lease obligations represent our obligations to make payments under the lease agreements for our facilities. (2) Purchase obligations include non-cancelable purchase orders for raw materials inventory and others. Purchase obligations under purchase orders or contracts that we can cancel without a significant penalty, such as routine purchases for operating expenses, are not included in the above table. (3) In June 2012, we entered into an agreement with the Forty Niners SC Stadium Company LLC, or the Team. As part of this agreement, from fiscal 2015 through fiscal 2024, we will receive advertising, branding in various locations throughout the stadium and the ability to meet with potential and existing partners and customers at sporting and other events at the stadium under construction in Santa Clara, California to be used by the Team. Because this stadium will be located in the heart of Silicon Valley, where many of our partners and customers operate, these advertising and meeting benefits are a key element of our marketing strategy to build awareness of our brand and our technology. We are committed to make payments to the Team of $4.0 million per year over the term of this agreement starting in fiscal 2015. Purchase obligations include all amounts we are obligated to pay under this agreement. 64 -------------------------------------------------------------------------------- Table of Contents (4) In July 2012, we entered into OEM agreement with a software vendor, which obligates us to pay an aggregate of $5.0 million in minimum royalty fees over a three-year period beginning after the first commercial shipment of the related product. During April 2013, we made our first commercial shipment under the agreement and began paying royalties. Purchase obligations include all remaining amounts we are obligated to pay under this agreement. (5) In July 2013, we entered into an OEM agreement with a software vendor, which obligates us to pay an aggregate of $6.0 million upon the software vendor meeting certain delivery milestones through December 2014. Purchase obligations include all remaining amounts we are obligated to pay under this agreement. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles, or GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. These estimates and assumptions are often based on judgments that we believe to be reasonable under the circumstances at the time made, but all such estimates and assumptions are inherently uncertain and unpredictable. Actual results may differ from those estimates and assumptions, and it is possible that others, applying their own judgment to the same facts and circumstances, could develop and support alternative estimates and assumptions that would result in material changes to our operating results and financial condition. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates. We believe that the assumptions and estimates associated with revenue recognition, stock-based compensation, inventory valuation, warranty liability, income taxes and investment in privately held companies have the greatest potential impact on our consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates. For further information on all of our significant accounting policies, see Note 1 of the accompanying notes to our consolidated financial statements. Revenue Recognition We derive our revenue from sales of products and related support services and enter into multiple-element arrangements in the normal course of business with our direct customers, resellers and systems vendors. In all of our arrangements, we do not recognize revenue until we can determine that persuasive evidence of an arrangement exists; delivery has occurred; the fee is fixed or determinable; and we deem collection to be reasonably assured. In making these judgments, we evaluate these criteria as follows: • Evidence of an Arrangement - We consider a non-cancelable agreement signed by a direct customer, reseller or systems vendor or purchase order generated by a customer, reseller or systems vendor to be persuasive evidence of an arrangement. • Delivery has Occurred - We consider delivery to have occurred when product has been delivered to the customer and no post-delivery obligations exist other than ongoing support obligations sold under separate support terms. In instances where customer acceptance is required, delivery is deemed to have occurred when customer acceptance has been achieved. • Fees are Fixed or Determinable - We consider the fee to be fixed or determinable unless the fee is subject to refund or adjustment or is not payable within normal payment terms. If the fee is subject to refund or adjustment, we recognize revenue net of estimated returns or if a reasonable estimate cannot be made, when the right to a refund or adjustment lapses. We currently do not provide price protection, rebates or other sales incentives to customers. We also do not allow a right of return to our customers, including resellers. • Collection is Reasonably Assured - We conduct a credit worthiness assessment on our customers, systems vendors and resellers. If we determine that collection is not reasonably assured, revenue is deferred and recognized upon the receipt of cash. 65 -------------------------------------------------------------------------------- Table of Contents Our multiple-element arrangements typically include two elements: hardware, which includes embedded software, and support services. Beginning in the second quarter of fiscal 2014, following introduction of the Violin Symphony Management Software Suite, our multiple-element arrangements also may include non essential software elements. We have determined that our hardware and the embedded software are considered a single unit of accounting, because the hardware and software function together to deliver the hardware's essential functionality and the hardware is never sold separately without the essential software. Support services are considered a separate unit of accounting as they are sold separately and have standalone value. When more than one element, such as hardware, software and services, are contained in a single arrangement, we first allocate arrangement consideration to the software deliverables as a group and non-software deliverables based on the relative selling price method. Our appliance products, embedded software and certain other services are considered to be non-software deliverables in our arrangements. We allocate revenue within the software group based upon fair value using vendor specific objective evidence, or VSOE, with the residual revenue allocated to the delivered element. If we cannot objectivity determine the VSOE of the fair value of any undelivered software element, we defer revenue until all elements are delivered and services have been performed, or until fair value can objectively be determined for any remaining undelivered elements. We allocate revenue within the non-software group to each element based upon their relative selling price in accordance with the selling price hierarchy, which includes: (1) VSOE, if available; (2) third-party evidence, or TPE, if VSOE is not available; and (3) best estimate of selling price, or BESP, if neither VSOE nor TPE are available. • VSOE - We determine VSOE based on our historical pricing and discounting practices for the specific product or support service when sold separately or as an optional stated renewal rate in the transaction. In determining VSOE, we require that a substantial majority of the selling prices for products or support services fall within a reasonably narrow pricing range. • TPE - When VSOE cannot be established for deliverables in multiple-element arrangements, we apply judgment with respect to whether we can establish selling price based on TPE. TPE is determined based on competitor prices for similar deliverables when sold separately. Generally, our products differ from those of our peers such that the comparable pricing of support services with similar functionality cannot be obtained. Furthermore, we are unable to reliably determine what similar competitor services' selling prices are on a stand-alone basis. As a result, we have not been able to establish selling price based on TPE. • BESP - When we are unable to establish selling price using VSOE or TPE, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the product or support service was sold on a stand-alone basis. We determine BESP for deliverables by considering multiple factors including, but not limited to, prices we charge for similar offerings, gross margin expectations, sales volume, geographies, market conditions, competitive landscape and pricing practices. We have historically priced our products within a narrow range and have used BESP to allocate the selling price of deliverables for product sales. Deferred revenue primarily represents customer billings in excess of revenue recognized, primarily for support services. Support services are typically billed in advance on an annual basis or at the inception of a multiple year support contract, and revenue is recognized ratably over the support period of generally one to three years. Stock-Based Compensation Overview We have granted stock options, restricted stock awards and RSUs to our employees, consultants and members of our board of directors. Stock options and restricted stock awards typically vest upon the satisfaction of a service condition, which, for the majority of these awards, is satisfied over three years. RSUs granted under the 2005 Stock Plan vest upon the satisfaction of both a service condition and a liquidity condition. The service 66-------------------------------------------------------------------------------- Table of Contents condition for the vesting of the RSUs is satisfied over three to four years. The liquidity condition is satisfied upon the occurrence of a qualifying event, defined as a change of control transaction or an initial public offering. Under the terms of our 2005 Stock Plan, the shares underlying RSUs are to be delivered to holders that satisfy both of these conditions, except in the case of the initial public offering, in which case settlement is to occur upon the earlier of 181 days following our initial public offering or March 15th of the year following the completion of our initial public offering. In March 2014, RSUs totaling 2.3 million shares were settled. Stock-Based Compensation Expense We account for stock-based employee compensation under the fair value recognition and measurement provisions in accordance with applicable accounting standards, which require all stock-based payments to employees, including grants of stock options, restricted stock awards and RSUs to be measured based on the grant date fair value of the awards. We record stock-based compensation expense for service-based equity awards, including RSUs, using the straight-line attribution method over the period during which the employee is required to perform service in exchange for the awards. We capitalize stock-based employee compensation when appropriate. Capitalized stock-based compensation expense was not material in the three years ended January 31, 2014. Prior to September 27, 2013, the date our common stock began trading on the New York Stock Exchange, the fair value of common stock had been determined by the board of directors at each grant date based on a variety of factors, including periodic valuations of our common stock, our financial position, historical financial performance, projected financial performance, valuations of publicly traded peer companies arm's-length sales of our common stock, and the illiquid nature of common stock. We performed our analyses in accordance with applicable elements of the practice aid issued by the American Certified Public Accountants entitled, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Since our IPO, we determine the fair value of our common stock based on the closing price of our common stock as quoted on the New York Stock Exchange on the stock option grant date. Determining the fair value of stock-based awards at the grant date requires judgment. We estimate the fair value of stock option awards using the Black-Scholes single option-valuation model, which requires assumption such as fair value of our common stock, expected term, expected volatility and risk-free interest rate, which are estimated as follows: • Expected Term - We determine the expected term of options granted using the "simplified" method. Under this approach, the expected term is presumed to be the average of the vesting term and the contractual term of the option. • Volatility - Because we do not have a trading history for our common stock, the expected stock price volatility for our common stock was estimated by taking the average historic price volatility for a group of companies we consider our peers based on a number of factors including, but not limited to, similarity to us with respect to industry, business model, stage of growth, financial risk or other factors, along with considering the future plans of our company to determine the appropriate volatility over the expected life of the option. We used the weekly closing price of these peers over a period equivalent to the expected term of the stock option grants. We did not rely on implied volatilities of traded options in our peers' common stock because the volume of activity was relatively low. Our group of comparable industry peer companies has changed from time to time. We removed certain companies that became financially distressed or for which public information was no longer available. Meanwhile, we added a new public company and other larger companies in our industry. 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. 67 -------------------------------------------------------------------------------- Table of Contents • Risk-free Interest Rate - The risk-free interest rate was determined by reference to the U.S. Treasury rates with the remaining term approximating the expected option life assumed at the date of grant. • Dividend Yield - We have never declared or paid any cash dividends and do not presently plan to pay cash dividends in the foreseeable future. Consequently, we used an expected dividend yield of zero. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those options, restricted stock awards and RSUs expected to vest. We estimate a forfeiture rate based on our historical experience. Further, to the extent our actual forfeiture rate is different from our estimate, stock-based compensation expense is adjusted accordingly. If any of the assumptions used in the Black-Scholes single option-valuation model change significantly, the fair value and stock-based compensation expense on future grants is impacted accordingly and stock-based compensation expense may differ materially in the future from that recorded in the current period. We have used and will continue to use judgment in evaluating the expected term, expected volatility and forfeiture rate related to our stock-based compensation expense on a prospective basis. As we continue to accumulate additional data related to our common stock, we may have refinements to the estimates of our expected volatility, expected terms and forfeiture rates, which could materially impact our future stock-based compensation expense. Inventory Valuation Inventory consists of raw materials and finished goods and is stated at the lower of cost or market. Our finished goods consist of manufactured finished goods. We assess the valuation of inventory, including raw materials and finished goods, on a periodic basis. Inventory carrying value adjustments are established to reduce the carrying amounts of our inventory to their net estimated realizable value. Carrying value adjustments are based on historical usage, expected demand and trial deployment conversion rates. Inherent in our estimates of market value in determining inventory valuation are estimates related to economic trends, future demand for our products and technological obsolescence of our products. For example, because our revenue often is comprised of large, concentrated sales to a limited number of customers, we may carry high levels of inventory prior to shipment. In addition, in circumstances where a supplier discontinues the production of a key raw material component, such as non-volatile memory components, we may be required to make significant "last-time" purchases in order to ensure supply continuity until the transition is made to products based on next generation components. If a significant order were cancelled after we had purchased the related inventory, or if estimates of "last-time" purchases exceed actual demand, we may be required to record additional inventory carrying value adjustments. Warranty Liability We provide our customers a limited product warranty of three years. Our standard warranties require us to repair or replace defective products during such warranty period at no cost to the customer. We estimate the costs that may be incurred under our basic limited warranty and record a liability in the amount of such costs at the time product sales are recognized. Factors that affect our warranty liability include the number of installed units, performance of equipment in our test and support labs, historical data and trends of product reliability and costs of repairing and replacing defective products. We assess the adequacy of our recorded warranty liability each period and make adjustments to the liability as necessary. Income Taxes Significant judgment is required in determining our provision for income taxes and evaluating our uncertain tax positions. We record income taxes using the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been 68 -------------------------------------------------------------------------------- Table of Contents recognized in our financial statements or tax returns. In estimating future tax consequences, generally all expected future events other than enactments or changes in the tax law or rates are considered. Valuation allowances are provided when necessary to reduce deferred tax assets to the amount expected to be realized. We provide reserves as necessary for uncertain tax positions taken on our tax filings. First, we determine if the weight of available evidence indicates that a tax position is more likely than not to be sustained upon audit, including resolution of related appeals or litigation processes, if any. Second, based on the largest amount of benefit, which is more likely than not to be realized on ultimate settlement, we recognize any such differences as a liability. Because of our full valuation allowance against the net deferred tax assets, any change in our uncertain tax positions would generally not impact our effective tax rate. In evaluating our ability to recover our deferred tax assets, in full or in part, we consider all available positive and negative evidence, including our past operating results, our forecast of future market growth, forecasted earnings, future taxable income and prudent and feasible tax planning strategies. The assumptions utilized in determining future taxable income require significant judgment and are consistent with the plans and estimates we are using to manage the underlying businesses. Due to the net losses incurred and the uncertainty of realizing the deferred tax assets, for all the periods presented, we have a full valuation allowance against our net deferred tax assets. As of January 31, 2014, we had federal and state net operating loss carryforwards of $150.5 million and $65.8 million, respectively, and federal and state research and development tax credit carryforwards of $6.4 million and $71.1 million, respectively. In the future, we intend to utilize any carryforwards available to us to reduce our tax payments. A substantial amount of these carryforwards may be subject to annual limitations that may result in their expiration before some portion, or all, of them has been fully utilized. Investment in Privately-held Companies We analyze equity investments in privately held companies to determine if they should be accounted for under the cost or equity method of accounting based on such factors as our percentage ownership of the voting stock outstanding and our ability to exert significant influence over these companies. For our cost method investments, we determine if a decline in fair value is considered to be an other-than-temporary impairment. If a decline in fair value is determined to be other-than-temporary, we would recognize an impairment at the lower of cost or fair value. Recent Accounting Pronouncements For information with respect to recent accounting pronouncements and the impact of these pronouncements on our consolidated financial statements, see Note 1 "Organization and Summary of Significant Accounting Policies - Recent Accounting Pronouncements" in the notes to consolidated financial statements. Segments Operating segments are defined in accounting standards as components of an enterprise about which separate financial information is available and is regularly evaluated by management, namely the chief operating decision maker of an organization, in order to make operating and resource allocation decisions. We have concluded that we operate in one business segment. Substantially all of our revenue for all periods presented in the accompanying consolidated statements of operations has been from sales of the Flash Memory Arrays and related customer support services. Certain Relationships and Related Party Transactions For a discussion of certain relationships and related party transactions, see Note 10 "Related Party Transactions" in the notes to consolidated financial statements. 69 -------------------------------------------------------------------------------- Table of Contents |