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FIVE9, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion in conjunction with the condensed consolidated financial statements and notes thereto included elsewhere in this report and our prospectus (dated April 3, 2014) filed with the SEC pursuant to Rule 424(b) under the Securities Act of 1933 on April 4, 2014. In addition to historical information, this discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that involve risks and uncertainties that could cause our actual results to differ materially from our expectations. Factors that could cause such differences include, but are not limited to, those described in the section titled "Risk Factors" and elsewhere in this report. Overview We are a pioneer and leading provider of cloud software for contact centers, facilitating over three billion interactions between our more than 2,000 clients and their customers per year. We believe we achieved this leadership position through our expertise and technology, which has empowered us to help organizations of all sizes transition from legacy on-premise contact center systems to our cloud solution. Our solution, which is comprised of our Virtual Contact Center ("VCC") cloud platform and applications, allows simultaneous management and optimization of customer interactions across voice, chat, email, web, social media and mobile channels, either directly or through our application programming interfaces. Our VCC cloud platform routes each customer interaction to an appropriate agent resource, and delivers relevant customer data to the agent in real-time to optimize the customer experience. Unlike legacy on-premise contact center systems, our solution requires minimal up-front investment and can be rapidly deployed and adjusted depending on our client's requirements. Since founding our business in 2001, we have focused exclusively on delivering cloud contact center software. We initially targeted smaller contact center opportunities with our telesales team and, over time, invested in expanding the breadth and depth of the functionality of our cloud platform to meet the evolving requirements of our clients. In 2009, we made a strategic decision to expand our market opportunity to include larger contact centers. This decision drove further investments in research and development and the establishment of our field sales team to meet the requirements of these larger contact centers. We believe this shift has helped us diversify our client base while significantly enhancing our opportunity for future revenue growth. To complement these efforts, we have also focused on building client awareness and driving adoption of our solution through marketing activities, which include internet advertising, digital marketing campaigns, social marketing, trade shows, industry events and telemarketing. In June 2014, we introduced our Summer Release 2014 that includes new native multichannel applications that support social, mobile, chat and email interactions. The new multichannel capabilities are powered by Five9 Connect, a unique intelligent technology layer that helps contact centers evaluate, prioritize and route requests. Additional major enhancements provide more mobility for supervisors and the enablement of customized monitoring and reporting. We provide our solution through a SaaS business model with recurring subscriptions. We offer a comprehensive suite of applications delivered on our VCC cloud platform that are designed to enable our clients to manage and optimize interactions across inbound and outbound contact centers. We primarily generate revenue by selling subscriptions and related usage of our VCC cloud platform. We charge our clients monthly subscription fees for access to our solution, primarily based on the number of agent seats, as well as the specific functionalities and applications our clients deploy. We define agent seats as the maximum number of named agents allowed to concurrently access our solution. Our clients typically have more named agents than agent seats, and multiple named agents may use an agent seat, though not simultaneously. Substantially all of our clients purchase both subscriptions and related usage from us. A small percentage of our clients subscribe to our platform but purchase telephony usage directly from a wholesale telecommunications service provider. We do not sell telephony usage on a stand-alone basis to any client. The related usage fees are based on the volume of minutes for inbound and outbound interactions. We also offer bundled plans, generally for smaller deployments, whereby the client is charged a single monthly fixed fee per agent seat that includes both subscription and unlimited usage in the contiguous 48 states and, in some cases, Canada. We offer both annual and monthly contracts to our clients, with 30 days' notice required for changes in the number of agent seats. Our clients can use this notice period to rapidly adjust the number of agent seats used to meet their changing contact center volume needs, including to reduce the number of agent seats to zero. As a general matter, this means that a client can effectively terminate its agreement with us upon 30 days' notice. Our larger clients typically choose annual contracts, which generally include an implementation and ramp period of several months. Fixed subscription fees (including bundled plans) are generally billed monthly in advance, while related usage fees are billed in arrears. For the three and nine months ended September 30, 2014, subscription and 24-------------------------------------------------------------------------------- Table of Contents related usage fees accounted for 97% of our revenue. For the three and nine months ended September 30, 2013, subscription and related usage fees accounted for 98% of our revenue. The remainder is comprised of professional services revenue from the implementation and optimization of our solution. Our revenue increased to $25.9 million and $74.8 million for the three and nine months ended September 30, 2014, from $21.1 million and $60.5 million for the three and nine months ended September 30, 2013, respectively. Revenue growth has primarily been driven by new clients choosing to use our solution and to a lesser extent, existing clients gradually increasing the number of agent seats under subscription. For each of the three and nine months ended September 30, 2014 and 2013, no single client accounted for more than 10% of our total revenue. As of September 30, 2014, we had over 2,000 clients across multiple industries, with subscriptions ranging in size from fewer than 10 agent seats to approximately 900 agent seats. On March 20, 2014, we experienced an extended interruption in service due to an issue with third-party equipment that affected our Santa Clara, California colocation facility. Many of our larger clients utilize our geographic-redundancy option and were successfully switched over to our Atlanta, Georgia colocation facility. However, our clients that remained in our Santa Clara, California colocation facility experienced an extended interruption in service. We had refunded a portion of the affected month's subscription revenue in the form of service credits to certain of these affected clients. The total credits refunded relating to this interruption in service did not have a material impact on our revenue for the nine months ended September 30, 2014, and it did not impact revenue for the three months ended September 30, 2014 or revenue previously reported for any period prior to 2014. In April 2014, we consummated our initial public offering, or IPO, in which we sold 11,500,000 shares of common stock (inclusive of 1,500,000 shares of common stock from the exercise of the option granted to the underwriters). The public offering price of the shares sold in the IPO was $7.00 per share. We received aggregate proceeds of $74.9 million from the IPO after deducting underwriters' discounts and commissions of $5.6 million, but before deduction of offering expenses of approximately $4.2 million, of which $0.8 million had been paid by us prior to 2014 and the remaining $3.4 million had been paid in the first two quarters of 2014. We have continued to make significant expenditures and investments, including in research and development, sales and marketing and infrastructure. We primarily evaluate the success of our business based on revenue growth and the efficiency and effectiveness of our investments. The growth of our business and our future success depend on many factors, including our ability to continue to expand our client base to include larger opportunities, grow revenue from our existing client base, innovate and expand internationally. While these areas represent significant opportunities for us, they also pose risks and challenges that we must successfully address in order to sustain the growth of our business and improve our operating results. In order to pursue these opportunities, we anticipate that we will expand our operations and headcount in the near term. The expected addition of new employees and the investments that we anticipate will be necessary to manage our anticipated growth will make it more difficult for us to generate earnings. As we grow our business, we expect our cost of revenue and operating expenses to increase in future periods. For example, (i) sales and marketing expenses are expected to increase in absolute dollars as we continue to expand our sales and marketing teams, increase our marketing activities and grow our international operations; (ii) research and development expenses are expected to increase in absolute dollars to support the enhancement of our existing solution and development of additional industry-leading contact center features and applications; and (iii) general and administrative expenses are expected to increase in absolute dollars as a result of both our growth and the infrastructure required to be a public company. In order to support future client growth, we also intend to invest in maintaining a high level of client service and support and in our data center infrastructure and services capabilities. Due to our continuing investments to scale our business, increase our sales and marketing efforts, pursue new opportunities, enhance our solution and build our technology, we will continue to incur significant expenses in the future. Key Operating and Financial Performance Metrics In addition to measures of financial performance presented in our condensed consolidated financial statements, we monitor the key metrics set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies. 25-------------------------------------------------------------------------------- Table of Contents Dollar-Based Retention Rate We believe that our Dollar-Based Retention Rate provides insight into our ability to retain and grow revenue from our clients, and is a measure of the long-term value of our client relationships. Our Dollar-Based Retention Rate is calculated by dividing our Retained Net Invoicing by our Retention Base Net Invoicing on a monthly basis, which we then average using the rates for the trailing twelve months for the period being presented. We define Retention Base Net Invoicing as recurring net invoicing from all clients in the comparable prior year period, and we define Retained Net Invoicing as recurring net invoicing from that same group of clients in the current period. We define recurring net invoicing as subscription and related usage revenue excluding the impact of service credits, reserves and deferrals. Historically, recurring net invoicing has been within 10% of our subscription and related usage revenue. The following table shows our Dollar-Based Retention Rate for the periods presented: Twelve Months Ended September 30, 2014 September 30, 2013 Dollar-Based Retention Rate 97% 102% Our Dollar-Based Retention Rate declined year over year primarily due to a reduction in usage revenue during the period from one current client due to the competitive pricing environment on international calling, and our termination of one large client in 2013 based on financial difficulties experienced by this client and its failure to comply with the terms of its contract. Adjusted EBITDA We monitor Adjusted EBITDA, a non-GAAP financial measure, to analyze our financial results and believe that it is useful to investors, as a supplement to U.S. GAAP measures, in evaluating our ongoing operational performance and enhancing an overall understanding of our past financial performance. We believe that Adjusted EBITDA helps illustrate underlying trends in our business that could otherwise be masked by the effect of the income or expenses that we exclude from Adjusted EBITDA. Furthermore, we use this measure to establish budgets and operational goals for managing our business and evaluating our performance. We also believe that Adjusted EBITDA provides an additional tool for investors to use in comparing our recurring core business operating results over multiple periods with other companies in our industry. Adjusted EBITDA should not be considered in isolation from, or as a substitute for, financial information prepared in accordance with U.S. GAAP and our calculation of Adjusted EBITDA may differ from that of other companies in our industry. We compensate for the inherent limitations associated with using Adjusted EBITDA through disclosure of these limitations, presentation of our financial statements in accordance with U.S. GAAP and reconciliation of Adjusted EBITDA to the most directly comparable U.S. GAAP measure, net loss. We calculated Adjusted EBITDA as net loss before (1) depreciation and amortization, (2) stock-based compensation, (3) change in fair value of convertible preferred and common stock warrants, (4) interest expense, (5) interest income and other, (6) provision for income taxes, (7) a credit recorded in the three months ended June 30, 2014 to release a contingent sales tax liability that was accrued progressively on a quarterly basis from 2011 through the first quarter of 2014 following a favorable ruling from a state revenue authority, and (8) an FCC settlement charge recorded in the three months ended September 30, 2014. 26-------------------------------------------------------------------------------- Table of Contents The following table shows a reconciliation from net loss to Adjusted EBITDA for the periods presented (in thousands): Three Months Ended Nine Months Ended September 30, 2014 September 30, 2013 September 30, 2014 September 30, 2013 Net loss $ (11,435 ) $ (7,735 ) $ (28,414 ) $ (22,682 ) Non-GAAP adjustments: Depreciation and amortization (1) 1,567 1,063 4,858 2,902 Stock-based compensation (2) 1,877 458 4,796 1,026 Interest expense 1,116 273 2,986 666 Interest income and other (95 ) 15 (99 ) (19 ) Provision for income taxes 13 45 52 69 Change in fair value of convertible preferred and common stock warrant liabilities - 622 (1,745 ) 1,177 Reversal of contingent sales tax liability (3) - - (2,766 ) - Accrued FCC charge (4) 2,000 - 2,000 - Adjusted EBITDA $ (4,957 ) $ (5,259 ) $ (18,332 ) $ (16,861 ) (1) Depreciation and amortization expenses included in our results of operations are as follows (in thousands): Three Months Ended Nine Months Ended September 30, 2014 September 30, 2013 September 30, 2014 September 30, 2013 Cost of revenue $ 1,272 $ 900 $ 3,847 $ 2,509 Research and development 58 57 154 155 Sales and marketing 50 17 146 42 General and administrative 187 89 711 196 Total depreciation and amortization $ 1,567 $ 1,063 $ 4,858 $ 2,902 (2) See Note 7 of the notes to the condensed consolidated financial statements for stock-based compensation expense included in our results of operations for the periods presented. (3) Included in general and administrative. See Note 10 of the notes to the condensed consolidated financial statements. (4) Included in general and administrative. See Note 12 of the notes to the condensed consolidated financial statements. Key Components of Our Results of Operations Revenue Our revenue consists of subscription and related usage as well as professional services. We consider our subscription and related usage to be recurring. This recurring revenue includes fixed subscription fees for the delivery and support of our VCC cloud platform as well as related usage fees. The related usage fees are based on the volume of minutes for inbound and outbound client interactions. We also offer bundled plans, generally for smaller deployments, whereby the client is charged a single monthly fixed fee per agent seat that includes both subscription and unlimited usage in the contiguous 48 states and, in some cases, Canada. We offer both annual and monthly contracts for our clients, with 30 days' notice required for changes in the number of agent seats. Our clients can use this notice period to rapidly adjust the number of agent seats used to meet their changing contact center volume needs, including to reduce the number of agent seats to zero. As a general matter, this means that a client can effectively terminate its agreement with us upon 30 days' notice. 27-------------------------------------------------------------------------------- Table of Contents Fixed subscription fees, including plans with bundled usage, are generally billed monthly in advance, while variable usage fees are billed in arrears. Fixed subscription fees are recognized on a straight-line basis over the applicable term, predominantly the monthly contractual billing period. Support activities include technical assistance for our solution and upgrades and enhancements on a when and if available basis, which are not billed separately. Variable subscription related usage fees for non-bundled plans are billed in arrears based on client specific per minute rate plans and are recognized as actual usage occurs. We generally require advance deposits from clients based on estimated usage. All fees, except usage deposits, are non-refundable. In addition, we generate professional services revenue from assisting clients in implementing our solution and optimizing use. These services include application configuration, system integration and education and training services. Professional services are primarily billed on a fixed-fee basis and are typically performed by us directly. In limited cases, our clients may choose to perform these services themselves or engage their own third-party service providers to perform such services. Professional services are recognized as the services are performed using the proportional performance method, with performance measured based on hours of work performed provided all other criteria for revenue recognition are met. Cost of Revenue Our cost of revenue consists primarily of fees that we pay to telecommunications providers for usage, personnel costs (including stock-based compensation), costs to build out and maintain colocation data centers, depreciation and related expenses of the servers and equipment, and taxes due to federal and state agencies on usage fees. Personnel costs included as part of cost of revenue include those associated with support of our solution, clients and data center operations, as well as providing professional services. Cost of revenue can fluctuate based on a number of factors, including the fees we pay to telecommunications providers, which vary depending on our clients' usage of our VCC cloud platform, the timing of capital expenditures and related depreciation charges and changes in headcount. We expect to continue investing in our network infrastructure and operations and client support function to maintain high quality and availability of service. As our business grows, we expect to realize economies of scale in network infrastructure, personnel and client support. Operating Expenses We classify our operating expenses as research and development, sales and marketing and general and administrative expenses. Research and Development. Our research and development expenses consist primarily of salary and related expenses (including stock-based compensation) for personnel related to the development of improvements and expanded features for our services, as well as quality assurance, testing, product management and allocated overhead. We expense research and development expenses as they are incurred. We believe that continued investment in our solution is important for our future growth, and we expect research and development expenses to increase in absolute dollars in the foreseeable future as we continue to hire additional personnel to update and enhance our solution, although these expenses may fluctuate as a percentage of our revenue from period to period. Sales and Marketing. Sales and marketing expenses consist primarily of salaries and related expenses (including stock-based compensation) for employees in sales and marketing, including commissions and bonuses, as well as advertising, marketing, corporate communications, travel costs and allocated overhead. We expense the costs of sales commissions associated with the acquisition or renewal of client contracts as incurred in the period the contract is acquired or the renewal occurs. We believe it is important to continue investing in sales and marketing to continue to generate revenue growth. Accordingly, we expect sales and marketing expenses to increase in absolute dollars as we continue to support our growth initiatives, although these expenses may fluctuate as a percentage of our revenue from period to period. General and Administrative. General and administrative expenses consist primarily of salary and related expenses (including stock-based compensation) for management, finance and accounting, legal, information systems and human resources personnel, professional fees, compliance costs, other corporate expenses and allocated overhead. Excluding a $2.8 million credit recorded in the second quarter of 2014 following a favorable ruling from a state's revenue authority (see Note 10 of the notes to our condensed consolidated financial statements) and a $2.0 million charge recorded in the third quarter of 2014 due to a potential settlement with the FCC Enforcement Bureau (see Note 12 of the notes to our condensed consolidated financial statements), we expect that general and administrative expenses will generally increase in absolute dollars but decline as a percentage of revenue. 28-------------------------------------------------------------------------------- Table of Contents Other Income (Expense), Net Other income (expense), net consists primarily of interest expense associated with our notes payable, capital leases, and revolving line of credit. In October 2013, we borrowed a $5.0 million term loan to acquire SoCoCare. In December 2013, we drew down $12.5 million under our revolving line of credit. In February 2014, we borrowed a $20.0 million term loan under the 2014 Loan and Security Agreement. See Note 6 of the notes to the condensed consolidated financial statements. Change in Fair Value of Convertible Preferred and Common Stock Warrant Liabilities. Prior to our IPO, we had outstanding warrants to purchase shares of our convertible preferred stock and common stock which were classified as liabilities. These warrants were subject to re-measurement at each balance sheet date, and any change in fair value was recognized as a component of other income (expense), net. In connection with our IPO in April 2014, these liability-classified warrants became equity-classified and accordingly the associated liability was reclassified to additional paid-in capital. After the IPO, we are no longer required to re-measure the fair value of the warrant liability, therefore, beginning with the three months ended June 30, 2014, no further charges or credits related to such warrants have been or will be made to other income (expense), net. Provision for Income Taxes Our provision for income taxes consists primarily of corporate income taxes resulting from profits generated in foreign jurisdictions by our wholly-owned subsidiaries, along with state income taxes payable in the United States. Results of Operations for the Three and Nine Months Ended September 30, 2014 and 2013 Based on the condensed consolidated statements of operations and comprehensive loss set forth in this quarterly report, the following table sets forth our operating results as a percentage of revenue for the periods indicated: Three Months Ended Nine Months Ended September 30, 2014 September 30, 2013 September 30, 2014 September 30, 2013 Revenue 100 % 100 % 100 % 100 % Cost of revenue 52 % 58 % 54 % 60 % Gross profit 48 % 42 % 46 % 40 % Operating expenses: Research and development 21 % 21 % 22 % 21 % Sales and marketing 36 % 33 % 37 % 33 % General and administrative 31 % 20 % 23 % 20 % Total operating expenses 88 % 74 % 82 % 74 % Loss from operations (40 )% (32 )% (36 )% (34 )% Other income (expense), net: Change in fair value of convertible preferred and common stock warrant liabilities - % (3 )% 2 % (2 )% Interest expense (5 )% (1 )% (4 )% (1 )% Interest income and other 1 % - % - % - % Total other income (expense), net (4 )% (4 )% (2 )% (3 )% Loss before provision for income taxes (44 )% (36 )% (38 )% (37 )% Provision for income taxes - % 1 % - % - % Net loss (44 )% (37 )% (38 )% (37 )% 29-------------------------------------------------------------------------------- Table of Contents Revenue Three Months Ended Nine Months Ended $ % $ % September 30, 2014 September 30, 2013 Change Change September 30, 2014 September 30, 2013 Change Change (in thousands, except percentages) Revenue $25,869 $21,091 $4,778 23% $74,828 $60,489 $14,339 24% For the three and nine months ended September 30, 2014, approximately $4.5 million, or 93%, and $9.0 million, or 63%, respectively, of the increase in revenue was attributable to revenue from new clients acquired since October 1, 2013, which was primarily driven by an increase in sales and marketing activities in the twelve months ended September 30, 2014. For the three and nine months ended September 30, 2014, approximately $0.3 million, or 7%, and $5.3 million, or 37%, respectively, of the increase in revenue was attributable to revenue from existing clients as of September 30, 2013. Our average pricing remained relatively consistent between these periods. Cost of Revenue Three Months Ended Nine Months Ended $ % $ % September 30, 2014 September 30, 2013 Change Change September 30, 2014 September 30, 2013 Change Change (in thousands, except percentages) Cost of revenue $13,504 $12,265 $1,239 10% $40,121 $36,161 $3,960 11% % of Revenue 52% 58% 54% 60% The increase in cost of revenue for the three and nine months ended September 30, 2014 compared to the same periods of 2013, respectively, was primarily due to a $0.6 million and a $1.8 million increase in personnel costs driven by increased headcount, a $0.3 million and a $0.8 million increase in facility-related costs due to expanded office space and increased headcount, a $0.3 million and a $1.1 million increase in depreciation expenses for servers and equipment due to additional investments in technical infrastructure to support current and expected future client growth, and a $0.2 million and a $0.3 million increase in business travel and related expenses, respectively. In addition, the increase for the nine months ended September 30, 2014 was also attributable to a $0.3 million increase in amortization of intangible asset related to developed technology that was acquired in connection with our acquisition of SoCoCare in October 2013, and a $0.2 million increase in stock-based compensation expense due to headcount additions, as well as the increased fair value of employee equity awards granted from period to period. These increases for the three and nine months ended September 30, 2014 were offset in part by a $0.2 million and a $0.8 million decrease, respectively, in telecommunication carrier costs relating to our clients' long distance call usage due to improved usage efficiencies. The remainder of the increases were primarily due to our business growth and system implementations. Gross Profit Three Months Ended Nine Months Ended $ % $ % September 30, 2014 September 30, 2013 Change Change September 30, 2014 September 30, 2013 Change Change (in thousands, except percentages) Gross profit $12,365 $8,826 $3,539 40% $34,707 $24,328 $10,379 43% % of Revenue 48% 42% 46% 40% For the three and nine months ended September 30, 2014, the increase in gross margin was primarily due to improved usage efficiencies and continued benefit from economies of scale. 30-------------------------------------------------------------------------------- Table of Contents Operating Expenses Research and Development Three Months Ended Nine Months Ended $ % $ % September 30, 2014 September 30, 2013 Change Change September 30, 2014 September 30, 2013 Change Change (in thousands, except percentages) Research and development $5,503 $4,419 $1,084 25% $16,282 $12,679 $3,603 28% % of Revenue 21% 21% 22% 21% The increase in research and development expenses for the three and nine months ended September 30, 2014 compared to the same periods of 2013, was primarily due to a $0.7 million and a $2.6 million increase in personnel-related costs driven by an increase in average employee and related costs as we had more senior level employees during 2014 as compared with 2013 as part of our investment in future growth, and a $0.4 million and a $1.2 million increase in stock-based compensation expense due to an increase in the fair value of employee equity awards granted from period to period, respectively. Sales and Marketing Three Months Ended Nine Months Ended $ % $ % September 30, 2014 September 30, 2013 Change Change September 30, 2014 September 30, 2013 Change Change (in thousands, except percentages) Sales and marketing $9,296 $6,964 $2,332 33% $27,992 $20,338 $7,654 38% % of Revenue 36% 33% 37% 33% The increase in sales and marketing expenses for the three and nine months ended September 30, 2014 compared to the same periods of 2013, respectively, was primarily due to a $0.9 million and a $3.2 million increase in personnel costs resulting from headcount additions, a $0.5 million and a $1.1 million increase in commissions paid to sales personnel driven by the growth in sales of our solution, a $0.3 million and a $1.3 million increase in marketing-related expenses, a $0.2 million and a $0.6 million increase in business travel and related expenses, a $0.2 million and a $0.6 million increase in facility and office-related costs due to expanded office space to support increased headcount, and a $0.2 million and a $0.6 million increase in stock-based compensation expense due to headcount additions, as well as the increased fair value of employee equity awards granted from period to period. The increases in headcount and other expense categories described above supported our growth strategy to acquire new clients, increase the number of agent seats within our existing client base and establish brand awareness. We increased marketing efforts to raise brand awareness and lead generation efforts, which led to increased marketing, travel and related expenses. Sales and marketing expenses increased as a percentage of revenue, primarily as a result of expenses incurred in expanding our marketing organization and continuing to increase our field sales personnel. General and Administrative Three Months Ended Nine Months Ended $ % $ % September 30, 2014 September 30, 2013 Change Change September 30, 2014 September 30, 2013 Change Change (in thousands, except percentages) General and administrative $7,967 $4,223 $3,744 89% $17,653 $12,100 $5,553 46% % of Revenue 31% 20% 23% 20% The increase in general and administrative expenses for the three and nine months ended September 30, 2014 compared to the same periods of 2013, was primarily due to a $2.0 million charge for a potential settlement with the FCC Enforcement Bureau (see Note 12 of the notes to our condensed consolidated financial statements), a $1.2 million and a $3.5 million increase in personnel costs due to headcount additions as we prepared to become a public company, a $0.7 million and a $1.7 million increase in stock-based compensation expense due to headcount 31-------------------------------------------------------------------------------- Table of Contents additions as well as the increased fair value of employee equity awards granted from period to period, a $0.1 million and $0.5 million increase in depreciation expense primarily for computer equipment and software due to additional headcount and investments in infrastructure in preparation for future growth, a $0.1 million and $0.5 million increase in subscription fees to third-party SaaS providers due primarily to upgrading subscriptions to existing software and adding subscriptions to new software to support our growth, and a $0.2 million and a $0.2 million increase in facility and office-related costs due to expanded office space, respectively. These increases for the three and nine months ended September 30, 2014 compared to the same periods of 2013 were offset in part by a $0.5 million and a $3.2 million decrease, respectively, in contingent state and local taxes and surcharges on usage-based fees because we commenced collecting state and local taxes and surcharges from our clients for applicable states in June 2014 and we recorded a $2.8 million credit in the second quarter of 2014 as a result of a favorable ruling from a specific state's revenue authority (see Note 10 of the notes to our condensed consolidated financial statements). Excluding the credit of $2.8 million recorded in the second quarter of 2014 and the charge of $2.0 million for the potential FCC settlement recorded in the third quarter of 2014, general and administrative expenses as a percentage of revenue increased to 23% and 25% during the three and nine months ended September 30, 2014 from 20% and 20% for the same periods of 2013, primarily as a result of increased headcount to support our growth and operate as a public company. Other Income (Expense), Net Three Months Ended Nine Months Ended $ % $ % September 30, 2014 September 30, 2013 Change Change September 30, 2014 September 30, 2013 Change Change (in thousands, except percentages) Change in fair value of convertible preferred and common stock warrant liabilities $ - $ (622 ) $ 622 (100 )% $ 1,745 $ (1,177 ) $ 2,922 (248 )% Interest expense (1,116 ) (273 ) (843 ) 309 % (2,986 ) (666 ) (2,320 ) 348 % Interest income and other 95 (15 ) 110 (733 )% 99 19 80 421 % Total other income (expense), net $ (1,021 ) $ (910 ) $ (111 ) 12 % $ (1,142 ) $ (1,824 ) $ 682 (37 )% % of Revenue (4)% (4)% (2)% (3)% For the three and nine months ended September 30, 2014, interest expense increased as a result of a higher average balance of outstanding debt (see "Liquidity and Capital Resources" and Note 6 of the notes to our condensed consolidated financial statements). Liquidity and Capital Resources To date, we have financed our operations primarily through sales of our solution, net proceeds from the issuance of our convertible preferred stock, lease facilities and, more recently, net proceeds raised from our initial public offering and debt financings. As of September 30, 2014, we had cash and available-for-sale short-term investments totaling $83.5 million. In April 2014, we consummated our IPO and received aggregate proceeds of $74.9 million from the IPO after deducting underwriters' discounts and commissions of $5.6 million, but before deduction of offering expenses of approximately $4.2 million, of which $0.8 million had been paid by us prior to 2014 and the remaining $3.4 million had been paid in the first two quarters of 2014. In March 2013, we entered into the Loan and Security Agreement with a lender for a revolving line of credit for up to $12.5 million. In December 2013, we drew the full available amount of our revolving line of credit of $12.5 million, all of which remained outstanding as of September 30, 2014. The revolving line of credit bears monthly interest at a variable annual rate of prime plus 1.25%, and matures in March 2015. Interest is due and payable on the last business day of each month during the term of the loan, and all amounts outstanding under the revolving line of credit are due and payable in March 2015. In October 2013, the Loan and Security Agreement was amended to provide for an additional $5.0 million term loan in connection with our acquisition of SoCoCare. Interest-only payments are due on the term loan in equal monthly installments through September 2014, at which 32-------------------------------------------------------------------------------- Table of Contents point principal and interest payments are due in equal monthly installments through the maturity of the term loan in March 2017. The term loan carries a variable annual interest rate of prime plus 1.50%. The Loan and Security Agreement, as amended, contains certain covenants, including the requirement that we maintain $5.5 million of cash deposited with the lender for the term of the agreement. The Loan and Security Agreement includes the occurrence of a material adverse effect, as defined in the agreement and determined by the lender, as an event of default. In February 2014, we entered into the 2014 Loan and Security Agreement for a term loan of up to $30.0 million. At closing, we borrowed $20.0 million of the term loan and incurred $0.4 million in debt issuance costs. The remaining $10.0 million is available to be borrowed until February 2015. The term loan bears interest at a variable per annum rate equal to the greater of 10% or LIBOR plus 9%. Interest is due and payable on the last business day of each month during the term of the loan. Monthly principal payments will be due beginning in February 2016 based on 1/60th of the outstanding balance at that time and continue until all remaining principal outstanding under the term loan is due and payable in February 2019. The 2014 Loan and Security Agreement includes the occurrence of a material adverse event, as defined in the agreement and determined by the lender, as an event of default. We believe our existing cash, available-for-sale short-term investments and the amount available for borrowing under our 2014 Loan and Security Agreement will be sufficient to meet our working capital and capital expenditure needs at least through September 30, 2015. Our future capital requirements will depend on many factors including our growth rate, continuing market acceptance of our solution, client retention, ability to gain new clients, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities and the introduction of new and enhanced offerings. We may also acquire or invest in complementary businesses, technologies and intellectual property rights, which may increase our future capital requirements, both to pay acquisition costs and to support our combined operations. We may be required to seek additional equity or debt financing. In the event that additional financing is required, we may not be able to raise it on terms acceptable to us or at all. If we are unable to raise additional capital when desired, our business, operating results, and financial condition would be harmed. In addition, if our operating performance during the next twelve months is below our expectations, our liquidity and ability to operate our business could be harmed. If we raise additional funds by issuing equity or equity-linked securities, the ownership of our existing stockholders will be diluted. If we raise additional funds by the incurrence of indebtedness, we will be subject to increased debt service obligations and could also be subject to restrictive covenants, such as limitations on our ability to incur additional debt, and other operating restrictions that could harm our ability to conduct our business. Cash Flows The following table summarizes our cash flows for the periods presented (in thousands): Nine Months Ended September 30, 2014 September 30, 2013 $ Change % Change Net cash used in operating activities $ (20,759 ) $ (15,422 ) $ (5,337 ) 35 % Net cash provided by (used in) investing activities (30,496 ) 2,189 (32,685 ) (1,493 )% Net cash provided by financing activities 86,996 17,382 69,614 400 % Net increase in cash and cash equivalents $ 35,741 $ 4,149 $ 31,592 761 % Cash Flows from Operating Activities Cash used in operating activities is significantly influenced by the amount of cash we invest in personnel and infrastructure to support the anticipated growth of our business and the amount and timing of client payments. For the periods presented, we have continued to increase our investments in personnel and infrastructure faster than our growth in revenue, resulting in an increase in our net losses. As we continue to invest in personnel and infrastructure to support the anticipated growth of our business, we expect net uses of cash by operations to continue. Our largest source of operating cash inflows is cash collections from our clients for subscription and related usage services. Payments from clients for these services are typically received monthly. For the three months ended September 30, 2014 and 2013, our days-sales-outstanding were 25 and 20 days, respectively. During the nine months ended September 30, 2014, net cash used in operating activities increased by $5.3 million compared to the same period of 2013 primarily due to a $2.7 million increase in net loss after adjusting for 33-------------------------------------------------------------------------------- Table of Contents non-cash expenses and a $2.6 million increase in net cash outflows resulting from changes in operating assets and liabilities. During the nine months ended September 30, 2014, cash outflows from changes in operating assets and liabilities included primarily a $1.0 million increase in prepaid expenses and other current assets primarily related to long-term maintenance contracts and annual subscription fees on third-party licensed technology and insurance policies, a $1.0 million decrease in accounts payable related to timing of liabilities and payments, a $0.7 million increase in accounts receivable due to increased sales, and a $0.8 million decrease in accrued federal fees and sales tax liability primarily due to releasing a contingent state tax liability of $2.8 million in the second quarter of 2014 as a result of a favorable ruling from a specific state's revenue authority (see Note 10 of the notes to our condensed consolidated financial statements), which was offset by a $2.0 million accrual for a potential settlement with the FCC Enforcement Bureau (see Note 12 of the notes to our condensed consolidated financial statements). Cash inflows from changes in operating assets and liabilities included a $2.6 million increase in accrued and other liabilities primarily for ESPP withholdings for employees which started in April 2014, personnel costs due to increase in employee headcount and commissions paid to sales personnel driven by the growth in sales of our solution, and a $0.7 million increase in deferred revenue primarily attributable to increased billings. During the nine months ended September 30, 2013, cash outflows from changes in operating assets and liabilities included a $0.5 million increase in prepaid expenses and other current assets related primarily to long-term maintenance contracts and marketing contracts, and a $0.3 million decrease in accounts payable primarily related to timing of liabilities and payments. Cash inflows from changes in operating assets and liabilities included a $1.6 million increase in accrued federal fees and sales tax liability, a $1.0 million increase in accrued and other liabilities primarily for personnel costs due to increase in employee headcount and commissions paid to sales personnel driven by the growth in sales of our solution, and a $0.3 million increase in deferred revenue primarily attributable to increased billings. Cash Flows from Investing Activities Net cash used in investing activities in the nine months ended September 30, 2014 was primarily for purchase of short-term investments of $30.0 million and purchase of property and equipment of $0.5 million. Net cash provided by investing activities in the nine months ended September 30, 2013 was due to proceeds from the sale of certificates of deposit of $2.5 million, which was offset in part by $0.3 million cash used for purchase of property and equipment. Cash Flows from Financing Activities During the nine months ended September 30, 2014, cash provided by financing activities of $87.0 million was attributable to proceeds of $71.5 million from the IPO net of $3.4 million of payments for offering costs made in the first two quarters of 2014, net proceeds of $19.6 million from a term loan under our 2014 Loan and Security Agreement, and cash received from stock option and warrants exercises of $0.8 million. These cash inflows were partially offset by $4.8 million in repayments on our capital lease and notes payable obligations. During the nine months ended September 30, 2013, cash provided by financing activities of $17.4 million was primarily attributable to net proceeds of $21.8 million from issuance of convertible preferred stock, proceeds from our revolving line of credit of $6.0 million, and cash received from stock option exercises of $0.2 million, which was offset in part by $6.0 million in repayments on revolving line of credit, $3.8 million in repayments on our capital lease and notes payable obligations, and $0.8 million of payments for deferred offering costs in connection with our IPO. Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions. We believe our critical accounting policies involve the greatest degree of judgment and complexity and have the greatest potential impact on our consolidated financial statements. Our critical accounting policies are disclosed in our prospectus (dated April 3, 2014) filed with the SEC pursuant to Rule 424(b) under the Securities Act of 1933 34-------------------------------------------------------------------------------- Table of Contents on April 4, 2014. During the nine months ended September 30, 2014, our critical accounting policies did not materially change. Recent Accounting Pronouncements On August 27, 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern. The new guidance requires management of public and private companies to evaluate whether there is substantial doubt about the entity's ability to continue as a going concern and, if so, disclose that fact. Management will also be required to evaluate and disclose whether its plans alleviate that doubt. The standard will be effective for our annual period ending December 31, 2016 and interim and annual periods thereafter. Early adoption is permitted. We do not expect that the requirement will have an impact on our financial position, results of operations or cash flows. On May 28, 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard is effective for our annual and interim reporting periods beginning January 1, 2017. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. We are evaluating the effect that ASU 2014-09 will have on our consolidated financial statements and related disclosures. We have not yet selected a transition method nor have we determined the effect of the standard on our ongoing financial reporting. In July 2013, the FASB issued ASU No. 2013-11 on the financial statement presentation of unrecognized tax benefits. The new guidance provides that a liability related to an unrecognized tax benefit would be presented as a reduction of a deferred tax asset for a net operating loss carryforward, a similar tax loss or a tax credit carryforward if such settlement is required or expected in the event the uncertain tax position is disallowed. We adopted the guidance prospectively in the quarter ended March 31, 2014, and such adoption did not have a material impact on the Company's condensed consolidated financial statements. Off Balance Sheet Arrangements We did not have any off balance sheet arrangements as of September 30, 2014 or December 31, 2013. Contractual Obligations Our principal contractual obligations consist of obligations under operating leases for office space, research and development, and sales and marketing facilities in the United States, capital leases to finance data centers and other computer and networking equipment, short-term and long-term debt, and agreements with third parties to provide colocation hosting and telecommunication usage services. These contractual obligations as of December 31, 2013 are disclosed in our prospectus (dated April 3, 2014) filed with the SEC pursuant to Rule 424(b) under the Securities Act of 1933 on April 4, 2014, and have not changed materially during the nine months ended September 30, 2014 except for the following agreements entered into in 2014. In January 2014, we modified our corporate office lease to expand our existing space for an additional commitment of $0.6 million over the term of the original lease. In February 2014, we entered into the 2014 Loan and Security Agreement with two lenders in a syndicate for a term loan of up to $30.0 million. At closing, we borrowed $20.0 million of the term loan and incurred $0.4 million in debt issuance costs. The remaining $10.0 million is available to be borrowed until February 2015. The term loan bears interest that is payable monthly during the term of the loan. Monthly principal payments will be due beginning in February 2016 and through February 2019. The term loan is secured by substantially all assets of the Company and is subordinate to our Loan and Security Agreement. See Note 6 of the notes to our condensed consolidated financial statements for a detailed discussion of this loan. In June 2014, we entered into an agreement for colocation hosting services in the U.K. for a term of 36 months commencing in July 2014. This agreement requires us to make monthly payments over the service term in exchange for certain guaranteed network availability. Our total minimum future payment commitments under this agreement are $0.6 million. 35-------------------------------------------------------------------------------- Table of Contents During the nine months ended September 30, 2014, we purchased data center and network equipment and software under multiple capital leases. As of September 30, 2014, total minimum future payment commitments under these capital leases were approximately $4.6 million, of which $0.4 million is due in the fourth quarter of 2014, with the remainder due over approximately three years thereafter. ITEM 3. Quantitative and Qualitative Disclosure about Market Risk We are exposed to market risk in the ordinary course of our business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in interest rates, and to a lesser extent, foreign currency exchange rates. We do not hold or issue financial instruments for trading purposes. Interest Rate Sensitivity As of September 30, 2014, we had cash of $53.5 million and short-term investments of $30.0 million. We hold our cash and short-term investments for working capital purposes. Declines in interest rates would reduce future interest income. For the three and nine months ended September 30, 2014, the effect of a hypothetical 10% increase or decrease in overall interest rates would not have had a material impact on our interest income. The carrying amount of our short-term investments reasonably approximates fair value. We do not enter into investments for trading or speculative purposes. Our investments are exposed to market risk due to a fluctuation in interest rates, which may affect the fair market value of our investments. Due to the short-term nature of our investment portfolio, we believe only dramatic fluctuations in interest rates would have a material effect on our investments. As of September 30, 2014, we had a total of $37.5 million outstanding under our variable interest rate debt or financing agreements. See Note 6 of the notes to our condensed consolidated financial statements for a detailed discussion of our indebtedness. For each of the three and nine months ended September 30, 2014, a hypothetical 10% increase in the interest rates under these agreements would have increased our interest expense by approximately $0.1 million and $0.2 million, respectively. Foreign Currency Risk The functional currency of our foreign subsidiaries is the U.S. dollar. All of our sales are denominated in U.S. dollars, and therefore our net revenue is not currently subject to foreign currency risk. Our operating expenses are denominated in the currencies of the countries in which our operations are located, which are primarily in the U.S., the Philippines, Russia, and the U.K. Our consolidated results of operations and cash flows are, therefore, subject to fluctuations due to changes in foreign currency exchange rates and may be adversely affected in the future due to changes in foreign exchange rates. To date, we have not entered into any hedging arrangements with respect to foreign currency risk or other derivative financial instruments. During the three and nine months ended September 30, 2014, the effect of a hypothetical 10% change in foreign currency exchange rates applicable to our business would have had a maximum impact of approximately $0.2 million and $0.7 million on our operating results, respectively. ITEM 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of September 30, 2014. Based on management's evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2014, our disclosure controls and procedures are designed, and are effective, to provide assurance at a reasonable level that the information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management as appropriate to allow timely decisions regarding required disclosures. In designing and evaluating our disclosure controls and procedures, management recognizes that any disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures 36-------------------------------------------------------------------------------- Table of Contents must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs. Changes in Internal Control over Financial Reporting There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 37-------------------------------------------------------------------------------- Table of Contents |