Edgar Filing: ServiceNow, Inc.

NOW-2013.9.30-10Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q



x	Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2013



¨	Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 001-35580

SERVICENOW, INC.

(Exact name of registrant as specified in its charter)



Delaware		20-2056195
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

ServiceNow, Inc.

3260 Jay Street

Santa Clara, California 95054

(408) 501-8550

(Registrant's telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes x No ¨

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):



Large accelerated filer ¨	Accelerated filer ¨
Non-accelerated filer x (Do not check if a smaller reporting company)	Smaller reporting company ¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x

As of September 30, 2013, there were approximately 138.7 million shares of the Registrant’s Common Stock outstanding.

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TABLE OF CONTENTS



		Page
	PART I
Item 1.	Financial Statements	1
	Condensed Consolidated Balance Sheets as of September 30, 2013 (Unaudited) and December 31, 2012	1
	Condensed Consolidated Statements of Comprehensive Loss for the Three and Nine Months Ended September 30, 2013 and 2012 (Unaudited)	2
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2013 and 2012 (Unaudited)	3
	Notes to Condensed Consolidated Financial Statements (Unaudited)	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	33
Item 4.	Controls and Procedures	34

	PART II
Item 1.	Legal Proceedings	35
Item 1A.	Risk Factors	35
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	49
Item 3.	Defaults upon Senior Securities	50
Item 4.	Mine Safety Disclosures	50
Item 5.	Other Information	50
Item 6.	Exhibits	50
Signatures

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PART I

ITEM 1. FINANCIAL STATEMENTS

SERVICENOW, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)



	September 30, 2013			December 31, 2012
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	121,094		$	118,989
Short-term investments	99,044			195,702
Accounts receivable, net	84,527			78,163
Current portion of deferred commissions	24,835			14,979
Prepaid expenses and other current assets	12,919			14,256
Total current assets	342,419			422,089
Deferred commissions, less current portion	16,716			11,296
Long-term investments	132,619			—
Property and equipment, net	68,642			42,342
Intangible assets, net	6,189			596
Goodwill	8,526			—
Other assets	3,625			1,791
Total assets	$	578,736		$	478,114
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	7,930		$	9,604
Accrued expenses and other current liabilities	49,664			48,059
Current portion of deferred revenue	210,545			153,964
Total current liabilities	268,139			211,627
Deferred revenue, less current portion	15,256			16,397
Other long-term liabilities	7,745			6,685
Total liabilities	291,140			234,709
Stockholders’ equity:
Common stock	139			126
Additional paid-in capital	443,083			348,803
Accumulated other comprehensive loss	(662		)	(36		)
Accumulated deficit	(154,964		)	(105,488		)
Total stockholders’ equity	287,596			243,405
Total liabilities and stockholders’ equity	$	578,736		$	478,114

See accompanying notes to condensed consolidated financial statements

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SERVICENOW, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(Unaudited)

(in thousands, except share and per share data)



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
Revenues:
Subscription	$	92,992		$	55,279		$	244,926		$	141,640
Professional services and other	18,267			9,066			54,494			26,910
Total revenues	111,259			64,345			299,420			168,550
Cost of revenues⁽¹⁾:
Subscription	23,429			17,931			61,960			43,182
Professional services and other	18,146			9,643			47,921			28,519
Total cost of revenues	41,575			27,574			109,881			71,701
Gross profit	69,684			36,771			189,539			96,849
Operating expenses⁽¹⁾:
Sales and marketing	47,336			28,140			137,853			74,356
Research and development	20,819			10,783			54,809			26,098
General and administrative	16,179			11,195			43,783			24,441
Total operating expenses	84,334			50,118			236,445			124,895
Loss from operations	(14,650		)	(13,347		)	(46,906		)	(28,046		)
Interest and other income (expense), net	600			615			(604		)	1,148
Loss before provision for income taxes	(14,050		)	(12,732		)	(47,510		)	(26,898		)
Provision for income taxes	663			321			1,966			519
Net loss	$	(14,713	)	$	(13,053	)	$	(49,476	)	$	(27,417	)
Net loss attributable to common stockholders - basic and diluted	$	(14,713	)	$	(13,053	)	$	(49,476	)	$	(27,725	)
Net loss per share attributable to common stockholders - basic and diluted	$	(0.11	)	$	(0.11	)	$	(0.37	)	$	(0.49	)
Weighted-average shares used to compute net loss per share attributable to common stockholders - basic and diluted	137,456,531			117,698,005			134,036,466			57,089,411
Other comprehensive income (loss):
Foreign currency translation adjustments	$	758		$	57		$	(608	)	$	(479	)
Unrealized gain (loss) on investments	412			(17		)	(18		)	(34		)
Provision for income taxes	—			—			—			60
Other comprehensive income (loss), net of tax	1,170			40			(626		)	(573		)
Comprehensive loss	$	(13,543	)	$	(13,013	)	$	(50,102	)	$	(27,990	)


(1)	Includes stock-based compensation as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
Cost of revenues:
Subscription	$	2,190	$	1,276	$	5,980	$	2,514
Professional services and other	1,209		495		3,095		964
Sales and marketing	5,945		2,899		14,752		6,852
Research and development	4,176		1,919		11,005		4,121
General and administrative	4,331		1,624		9,893		4,137

See accompanying notes to condensed consolidated financial statements

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SERVICENOW, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)



	Nine Months Ended September 30,
	2013				2012
Cash flows from operating activities:
Net loss	$	(49,476	)		$	(27,417	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization	16,316				8,841
Amortization of premiums on investments, net	3,441				594
Amortization of deferred commissions	19,825				9,264
Stock-based compensation	44,725				18,588
Tax benefit from exercise of stock options	(1,817		)		(533		)
Bad debt expense	882				148
Lease abandonment costs	354				2,922
Changes in operating assets and liabilities:
Accounts receivable	(6,988		)		(11,065		)
Deferred commissions	(34,894		)		(20,525		)
Prepaid expenses and other current assets	2,827				4,242
Other assets	(1,750		)		(35		)
Accounts payable	(408		)		(106		)
Accrued expenses and other current liabilities	(2,646		)		4,189
Deferred revenue	54,332				43,081
Other long-term liabilities	756				(93		)
Net cash provided by operating activities	45,479				32,095
Cash flows from investing activities:
Purchases of property and equipment	(39,059		)		(32,156		)
Acquisition, net of cash acquired	(13,330		)		—
Purchases of investments	(233,444		)		(146,922		)
Sale of investments	50,403				1,025
Maturities of investments	142,456			(1)	5,800
Restricted cash	(174		)		8
Net cash used in investing activities	(93,148		)		(172,245		)
Cash flows from financing activities:
Net proceeds from initial public offering	—				169,799
Offering costs in connection with follow-on offering	(698		)		—
Proceeds from employee stock plans	47,833				2,349
Proceeds from early exercise of stock options	—				1,024
Tax benefit from exercise of stock options	1,817				533
Net proceeds from issuance of common stock	—				17,848
Purchases of common stock and restricted stock from stockholders	—				(1,960		)
Net cash provided by financing activities	48,952				189,593
Foreign currency effect on cash and cash equivalents	822				(555		)
Net increase in cash and cash equivalents	2,105				48,888
Cash and cash equivalents at beginning of period	118,989				68,088
Cash and cash equivalents at end of period	$	121,094			$	116,976
Supplemental disclosures of non-cash investing activities:
Property and equipment included in accounts payable and accrued expenses	$	5,360			$	3,768


(1)	Maturities of investments include the effect of the correction of an immaterial error of $3.0 million related to securities that were improperly classified as short-term investments instead of cash and cash equivalents as of December 31, 2012.

See accompanying notes to condensed consolidated financial statements

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SERVICENOW, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Unless the context requires otherwise, references in this report to “ServiceNow,” “we,” “us,” and “our” refer to ServiceNow, Inc. and its consolidated subsidiaries.

(1) Description of the Business

ServiceNow is a leading provider of cloud-based services to automate enterprise IT operations. We focus on transforming enterprise IT by automating and standardizing service relationships and consolidating IT across the global enterprise. Organizations deploy our service to create a single system of record for enterprise IT, lower operational costs and enhance efficiency. Additionally, our customers use our extensible platform to build custom applications both for IT and other functions across the enterprise, thereby facilitating the automation of activities unique to their business requirements.

(2) Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements and condensed footnotes have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring items) considered necessary for fair statement have been included. The results of operations for the three and nine months ended September 30, 2013 are not necessarily indicative of the results to be expected for the year ended December 31, 2013 or for other interim periods or for future years. The condensed consolidated balance sheet as of December 31, 2012 is derived from audited financial statements as of that date, however, does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s Form 10-K for the fiscal year ended December 31, 2012, which was filed with the Securities and Exchange Commission on March 8, 2013.

Principles of Consolidation

The condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles, or GAAP, and include our accounts and the accounts of our wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated upon consolidation.

Use of Estimates

The preparation of condensed consolidated financial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements, as well as reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Items subject to the use of estimates include revenue recognition, allowance for trade accounts receivable, accrual for service level credits, useful lives of fixed assets, certain accrued liabilities including our facility exit obligation, the determination of the provision for income taxes, the fair value of stock awards, loss contingencies and the fair value of assets acquired and liabilities assumed for business combinations.

Foreign Currency Translation

The functional currencies for our foreign subsidiaries are primarily their local currencies. Assets and liabilities of the wholly-owned foreign subsidiaries are translated into U.S. dollars at exchange rates in effect at each period end. Amounts classified in stockholders’ equity are translated at historical exchange rates. Revenues and expenses are translated at the average exchange rates during the period. The resulting translation adjustments are recorded in accumulated other comprehensive loss as a component of stockholders’ equity. Foreign currency transaction gains and losses are included in interest and other income (expense), net within the condensed consolidated statements of comprehensive loss.

Revenue Recognition

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We derive our revenues from two sources: (i) subscriptions and (ii) professional services and other. Subscription revenues are primarily comprised of subscription fees that give customers access to the ordered subscription service and related support and include updates to the subscribed service during the subscription term.

Our contracts typically do not give the customer the right to take possession of the software supporting the solution. Professional services and other revenues consist of fees associated with the implementation and configuration of our service. Professional services and other revenues also include customer training and attendance and sponsorship fees for Knowledge, our annual user conference.

We commence revenue recognition when all of the following conditions are met:


•	There is persuasive evidence of an arrangement;


•	The service has been provided to the customer;


•	The collection of related fees is reasonably assured; and


•	The amount of fees to be paid by the customer is fixed or determinable.

We use a signed contract together with either a signed order form or a purchase order, as evidence of an arrangement for a new customer. In subsequent transactions with an existing customer, including an upsell or a renewal, we consider the existing signed contract and either the new signed order form or new purchase order as evidence of an arrangement.

We recognize subscription revenues ratably over the contract term beginning on the commencement date of each contract, which is the date we make our service available to our customers. Once our service is available to customers, we record amounts due in accounts receivable and in deferred revenue. We price our professional services primarily on a time-and-materials basis. We recognize professional services and other revenues as the services are delivered using a proportional performance model. Such services are delivered over a short period of time. In instances where final acceptance of the services are required before revenues are recognized, we defer professional services revenues and the associated costs until all acceptance criteria have been met.

We assess collectibility based on a number of factors such as past collection history with the customer and creditworthiness of the customer. If we determine collectibility is not reasonably assured, we defer revenue recognition until collectibility becomes reasonably assured. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. Our arrangements do not include general rights of return.

We have multiple element arrangements comprised of subscription fees and professional services. We account for subscription and professional services revenues as separate units of accounting. To qualify as a separate unit of accounting, the delivered item must have value to the customer on a standalone basis. We have concluded that our subscription service has standalone value as it is routinely sold separately by us. In addition, the applications offered through this subscription service are fully functional without any additional development, modification or customization. We provide customers access to our subscription service at the beginning of the contract term. In determining whether professional services have standalone value, we considered the following factors for each professional services agreement: availability of the services from other vendors, the nature of the professional services, the timing of when the professional services contract was signed in comparison to the subscription service start date and the contractual dependence of the subscription service on the customer's satisfaction with the professional services work. Our professional services, including implementation and configuration services, are not so unique and complex that other vendors cannot provide them. In some instances, customers independently contract with third-party vendors to do the implementation and we regularly outsource implementation services to contracted third-party vendors. As a result, we concluded professional services, including implementation and configuration services, have standalone value.

We determine the selling price of each deliverable in the arrangement using the selling price hierarchy. Under the selling price hierarchy, the selling price for each deliverable is determined using vendor-specific objective evidence, or VSOE, of selling price or third-party evidence, or TPE, of selling price if VSOE does not exist. If neither VSOE nor TPE of selling price exists for a deliverable, the selling price is determined using the best estimate of selling price, or BESP. The selling price for each unit of account is based on the BESP since VSOE and TPE are not available for our subscription service or professional services and other. The BESP for each deliverable is determined primarily by considering the historical selling price of these deliverables in similar transactions as well as other factors, including, but not limited to, market competition, review of stand-alone sales and current pricing practices. In determining the appropriate pricing structure, we consider the extent of competitive pricing of similar products and marketing analyses. The total arrangement fee for these multiple element arrangements is then allocated to the separate units of account based on the relative selling price. We price our subscription service using a scaled model based on the duration of the subscription term and we frequently extend discounts to our customers based on the number of users.

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In limited circumstances, we grant certain customers the right to deploy our subscription service on the customers’ own servers without significant penalty. We have analyzed all of the elements in these particular multiple element arrangements and determined we do not have sufficient VSOE of fair value to allocate revenue to our subscription service and professional services. We defer all revenue under the arrangement until the last element in the transaction has been delivered or started to be delivered. Once the subscription service and the associated professional services have commenced, the entire fee from the arrangement is recognized ratably over the remaining period of the arrangement.

Deferred Revenue

Deferred revenue consists primarily of payments received in advance of revenue recognition for our subscriptions and professional services and other revenues and is recognized as the revenue recognition criteria are met. We generally invoice our customers in annual installments for our subscription service. Accordingly, the deferred revenue balance does not represent the total contract value of annual or multi-year subscription license agreements. Deferred revenue that will be recognized during the succeeding 12-month period is recorded as current portion of deferred revenue and the remaining portion is recorded as long-term.

Deferred Commissions

Deferred commissions are the incremental costs that are directly associated with our non-cancelable subscription contracts with customers and consist of sales commissions paid to our direct sales force and referral fees paid to independent third-parties. The majority of commissions and referral fees are deferred and amortized on a straight-line basis over the non-cancelable terms of the related customer contracts. Amortization of deferred commissions is included in sales and marketing expense in the condensed consolidated statements of comprehensive loss.

Fair Value Measurements

We apply fair value accounting for all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. We use a fair value hierarchy that is based on three levels of inputs, of which the first two are considered observable and the last unobservable. The three levels of the fair value hierarchy are as follows:

Level 1—Quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access;

Level 2—Inputs other than Level 1 that are directly or indirectly observable, such as quoted prices for identical or similar assets and liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities, such as interest rates, yield curves and foreign currency spot rates; and

Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets and liabilities.

Cash and Cash Equivalents

Cash and cash equivalents consist of highly liquid investments with original maturities of three months or less. Cash and cash equivalents are stated at fair value.

Investments

Investments consist of commercial paper, corporate notes and bonds and U.S. government agency securities. We classify investments as available-for-sale at the time of purchase and reevaluate such classification as of each balance sheet date. All investments are recorded at estimated fair value. Unrealized gains and losses for available-for-sale securities are in accumulated other comprehensive income (loss), a component of stockholders’ equity. We evaluate our investments to assess whether those with unrealized loss positions are other than temporarily impaired. We consider impairments to be other than temporary if they are related to deterioration in credit risk or if it is likely we will sell the securities before the recovery of their cost basis. Realized gains and losses and declines in value judged to be other than temporary are determined based on the specific identification method and are reported in interest and other income (expense), net in the condensed consolidated statements of comprehensive loss.

Accounts Receivable

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We record trade accounts receivable at the net invoice value and such receivables are non-interest bearing. We consider receivables past due based on the contractual payment terms. We review our exposure to accounts receivable and reserve for specific amounts if collectibility is no longer reasonably assured.

Property and Equipment

Property and equipment, net, are stated at cost, subject to review of impairment, and depreciated using the straight-line method over the estimated useful lives of the assets as follows:



Computer equipment and software		3—5 years
Furniture and fixtures		3—5 years
Leasehold improvements		shorter of the lease term or estimated useful life

When assets are sold, or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any gain or loss is included in operating expenses. Repairs and maintenance are charged to operations as incurred.

Capitalized Software Costs

Costs incurred to develop our internal administration, finance and accounting systems are capitalized during the application development stage and amortized over the software’s estimated useful life of three to five years.

Leases

Leases are reviewed and classified as capital or operating at their inception. For leases that contain rent escalations or periods during the lease term where rent is not required, we recognize rent expense based on allocating the total rent payable on a straight-line basis over the term of the lease excluding lease extension periods. The difference between rent payments and straight-line rent expense is recorded as deferred rent in the condensed consolidated balance sheets. Deferred rent that will be recognized during the succeeding 12-month period is recorded as the current portion of deferred rent and the remainder is recorded as long-term deferred rent.

Under certain leases, we also receive incentives for leasehold improvements, which are recognized as deferred rent, if we determine they are owned by us, and amortized on a straight-line basis over the shorter of the lease term or estimated useful life as a reduction to rent expense. The leasehold improvements are included in property and equipment, net.

Goodwill, Intangible Assets and Impairment Assessments

Goodwill represents the excess of the purchase price in a business combination over the fair value of net tangible and intangible assets acquired. We evaluate and test the recoverability of its goodwill for impairment at least annually, or more frequently if circumstances indicate that goodwill may not be recoverable.

Intangible assets are amortized over their useful lives. Each period we evaluate the estimated remaining useful life of purchased intangible assets to determine whether events or changes in circumstances warrant a revision to the remaining period of amortization.

The carrying amounts of these assets are periodically reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of these assets may not be recoverable. Recoverability of these assets is measured by comparison of the carrying amount of each asset to the future undiscounted cash flows the asset is expected to generate.

Stock-based Compensation

We recognize compensation expense related to stock options and restricted stock units, or RSUs, on a straight-line basis over the requisite service period, which is generally the vesting term of four years. We recognize compensation expense related to shares issued pursuant to the employee stock purchase plan, or ESPP, on a straight-line basis over the offering period. Compensation expense is recognized, net of forfeiture activity estimated to be 4% annually. We estimate the fair value of options using the Black-Scholes options pricing model and fair value of restricted stock unit awards using the value of our common stock on the date of grant. Refer to Note 11 for further information.

Net Income (Loss) Per Share Attributable to Common Stockholders

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We compute net income attributable to common stockholders using the two-class method required for participating securities. We consider our convertible preferred stock that was outstanding prior to the close of our initial public offering and shares of common stock subject to repurchase resulting from the early exercise of stock options to be participating securities since they contain non-forfeitable rights to dividends or dividend equivalents in the event we declare a dividend for common stock. In accordance with the two-class method, earnings allocated to these participating securities are subtracted from net income after deducting preferred stock dividends and accretion to the redemption value of the Series A, Series B and Series C to determine total undistributed earnings to be allocated to common stockholders. The holders of our convertible preferred stock did not have a contractual obligation to share in our net losses and such shares were excluded from the computation of basic earnings per share in periods of net loss.

Basic net income (loss) per share attributable to common stockholders is computed by dividing net income (loss) attributable to common stockholders by the weighted-average number of common shares outstanding during the period. All participating securities are excluded from basic weighted-average common shares outstanding. Diluted net income (loss) per share is computed by dividing net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period, adjusted for the effects of dilutive common shares, which are comprised of outstanding common stock options, RSUs, common stock subject to repurchase and ESPP obligations. The dilutive potential common shares are computed using the treasury stock method. The effects of outstanding common stock options, RSUs, common stock subject to repurchase and ESPP obligations are excluded from the computation of diluted net income (loss) per common share in periods in which the effect would be antidilutive.

Concentration of Credit Risk and Significant Customers

Financial instruments potentially exposing us to credit risk consist primarily of cash equivalents, investments and accounts receivable. We maintain cash, cash equivalents and investments at financial institutions that management believes to have good credit ratings and represent minimal risk of loss of principal. We invest in securities with a minimum rating of A by Standard & Poor's and A-2 by Moody's.

Credit risk arising from accounts receivable is mitigated due to our large number of customers and their dispersion across various industries and geographies. As of September 30, 2013 and December 31, 2012, there were no customers that represented more than 10% of our accounts receivable balance. During the three and nine months ended September 30, 2013 and 2012, there were no customers that individually exceeded 10% of our revenues.

We review the composition of the accounts receivable balance, historical write-off experience and the potential risk of loss associated with delinquent accounts to determine if an allowance for doubtful accounts is necessary. Individual accounts receivable are written off when we become aware of a specific customer’s inability to meet its financial obligation and all collection efforts are exhausted. As of September 30, 2013 and December 31, 2012, the allowance for doubtful accounts was $0.5 million and $0.7 million, respectively.

Warranties and Indemnification

Our cloud-based service to automate enterprise IT operations is typically warranted to perform in material conformance with specifications.

We include service level commitments to our customers that permit those customers to receive credits in the event we fail to meet those levels. We establish an accrual based on historical credits paid and an evaluation of the performance of our services including an assessment of the impact, if any, of any known service disruptions. As of September 30, 2013 and December 31, 2012, the service level credit accrual was $0.8 million and $1.2 million, respectively.

We have also agreed to indemnify our directors and executive officers for costs associated with any fees, expenses, judgments, fines and settlement amounts incurred by any of these persons in any action or proceeding to which any of those persons is, or is threatened to be, made a party by reason of the person’s service as a director or officer, including any action by us, arising out of that person’s services as a director or officer of our company or that person’s services provided to any other company or enterprise at our request. We maintain director and officer insurance coverage that may enable us to recover a portion of any future amounts paid. The fair values of these obligations are not material as of each balance sheet date.

Our arrangements include provisions indemnifying customers against intellectual property and other third-party claims. We have not incurred any costs as a result of such indemnifications and have not recorded any liabilities related to such obligations in the condensed consolidated financial statements.

Income Taxes

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We use the asset and liability method of accounting for income taxes in which deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the condensed consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be reversed. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date. A valuation allowance is established if it is more likely than not that all or a portion of the deferred tax asset will not be realized.

Recent Accounting Pronouncements

In July 2013, the FASB issued a new accounting standard update 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. The new guidance becomes effective for us on January 1, 2014 and it should be applied prospectively to unrecognized tax benefits that exist at the effective date with retrospective application permitted. We are currently assessing the impact of this new guidance.

(3) Investments

The following is a summary of our investments (in thousands):



	September 30, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
Available-for-sale securities:
Commercial paper	$	55,898	$	2	$	—		$	55,900
Corporate notes and bonds	215,199		43		(168		)	215,074
Total available-for-sale securities	$	271,097	$	45	$	(168	)	$	270,974



	December 31, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
Available-for-sale securities:
Commercial paper	$	72,850	$	—	$	(15	)	$	72,835
Corporate notes and bonds	158,038		8		(98		)	157,948
U.S. government agency securities	1,001		—		—			1,001
Total available-for-sale securities	$	231,889	$	8	$	(113	)	$	231,784

As of September 30, 2013, the contractual maturities of our investments did not exceed 24 months. The fair values of available-for-sale investments, by contractual maturity, are as follows:



	September 30, 2013
Due in 1 year or less	$	138,355
Due in 1 year through 3 years	132,619
Total	$	270,974

As of September 30, 2013 and December 31, 2012, we had certain available-for-sale securities in a gross unrealized loss position, all of which had been in such position for less than twelve months. There were no impairments considered other-than-temporary as it is more likely than not we will hold the securities until maturity or a recovery of the cost basis. The following table shows the fair values and the gross unrealized losses of these available-for-sale securities aggregated by investment types (in thousands):

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	September 30, 2013					December 31, 2012
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses
Commercial paper	$	—	$	—		$	36,753	$	(15	)
Corporate notes and bonds	164,230		(168		)	137,558		(98		)
Total	$	164,230	$	(168	)	$	174,311	$	(113	)

(4) Acquisition

On July 1, 2013, we acquired all the outstanding stock of Mirror42 Holding B.V., a cloud-based performance analytics company, for total cash consideration of $13.3 million. The acquisition accelerates our ability to deliver on enterprise requirements for advanced business intelligence.

The following table summarizes the allocation of the purchase price to the fair value of the tangible and intangible assets acquired and liabilities assumed as of the acquisition date:



	Purchase Price Allocation (in thousands)			Useful Lives (in years)
Net tangible liabilities acquired	$	(595	)
Intangible assets:
Developed technology	5,530			4
Contracts	297			1.5
Non-compete agreements	31			1.5
Goodwill	8,218
Net deferred tax liabilities	(139		)
Total purchase price	$	13,342

The excess of purchase consideration over the fair value of net tangible and identifiable intangible assets acquired was recorded as goodwill. Management believes that the goodwill represents the synergies expected from expanded market opportunities when integrating the Mirror42 Holding B.V.’s technologies with our offerings. The goodwill balance is not deductible for U.S. income tax purposes.

The results of operations of Mirror42 Holding B.V. described above have been included in our condensed consolidated financial statements from the date of purchase. Our business combination did not have a material impact on our condensed consolidated financial statements, and therefore pro forma disclosures have not been presented.

(5) Goodwill and Intangible Assets

Goodwill balance as of September 30, 2013 and December 31, 2012 is presented below (in thousands):



	Carrying Amount
Balance as of December 31, 2012	$	—
Goodwill acquired	8,218
Foreign currency translation adjustments	308
Balance as of September 30, 2013	$	8,526

Intangible assets consisted of the following as of September 30, 2013 and December 31, 2012 (in thousands):

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	September 30, 2013
	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Developed technology	$	5,737	$	(358	)	$	5,379
Contracts	308		(51		)	257
Non-compete agreements	32		(5		)	27
Acquisition-related intangible assets	6,077		(414		)	5,663
Other intangible assets	650		(124		)	526
Total intangible assets	$	6,727	$	(538	)	$	6,189



	December 31, 2012
	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Other intangible assets	$	650	$	(54	)	$	596
Total intangible assets	$	650	$	(54	)	$	596

Amortization expense for intangible assets for the three months ended September 30, 2013 and 2012 was approximately $439,000 and $23,000, respectively, and for the nine months ended September 30, 2013 and 2012 was approximately $484,000 and $31,000, respectively.

(6) Property and Equipment

Property and equipment, net consists of the following (in thousands):



	September 30,			December 31,
	2013			2012
Computer equipment and software	$	83,406		$	46,541
Furniture and fixtures	9,084			4,691
Leasehold improvements	4,924			2,649
Construction in progress	2,647			4,855
	100,061			58,736
Less: Accumulated depreciation	(31,419		)	(16,394		)
Total property and equipment, net	$	68,642		$	42,342

Construction in progress consists primarily of in-process software development costs. Depreciation expense for the three months ended September 30, 2013 and 2012 was $6.2 million and $3.9 million, respectively, and for the nine months ended September 30, 2013 and 2012 was $15.8 million and $8.8 million, respectively.

(7) Accrued Expenses and Other Current Liabilities

Accrued expenses and other current liabilities consist of the following (in thousands):



	September 30,		December 31,
	2013		2012
Bonuses and commissions	$	15,001	$	10,999
Accrued compensation	11,630		18,392
Other employee expenses	6,807		7,796
Current portion of facility exit obligation	1,252		1,515
Other	14,974		9,357
Total accrued expenses and other current liabilities	$	49,664	$	48,059

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(8) Accumulated Other Comprehensive Loss

The components of accumulated other comprehensive loss, net of tax, consist of the following (in thousands):



	September 30,			December 31,
	2013			2012
Foreign currency translation adjustment	$	(539	)	$	69
Net unrealized loss on investments	(123		)	(105		)
Accumulated other comprehensive loss, net of tax	$	(662	)	$	(36	)

Reclassification adjustments out of accumulated other comprehensive income into net loss were immaterial for all periods presented.

(9) Fair Value Measurements

The following table presents our fair value hierarchy for our assets and liabilities measured at fair value on a recurring basis at September 30, 2013 (in thousands):



	Level 1		Level 2		Level 3		Total
Cash and cash equivalents:
Cash	$	45,694	$	—	$	—	45,694
Money market funds	36,089		—		—		36,089
Commercial paper	—		39,311		—		39,311
Short-term investments:
Commercial paper	—		16,589		—		16,589
Corporate notes and bonds	—		82,455		—		82,455
Long-term investments:
Corporate notes and bonds	—		132,619		—		132,619
Total	$	81,783	$	270,974	$	—	$	352,757

The following table presents our fair value hierarchy for our assets and liabilities measured at fair value on a recurring basis at December 31, 2012 (in thousands):



	Level 1		Level 2		Level 3		Total
Cash and cash equivalents:
Cash	$	47,478	$	—	$	—	$	47,478
Money market funds	35,429		—		—		35,429
Commercial paper	—		36,082		—		36,082
Short-term investments:
Commercial paper	—		36,753		—		36,753
Corporate notes and bonds	—		157,948		—		157,948
U.S. government agency securities	—		1,001		—		1,001
Total	$	82,907	$	231,784	$	—	$	314,691

We determine the fair value of our security holdings based on pricing from our service provider. The service provider values the securities based on “consensus pricing,” using market prices from a variety of industry-standard independent data providers. Such market prices may be quoted prices in active markets for identical assets (Level 1 inputs) or pricing determined using inputs other than quoted prices that are observable either directly or indirectly (Level 2 inputs), such as yield curve, volatility factors, credit spreads, default rates, loss severity, current market and contractual prices for the underlying instruments or debt, broker and dealer quotes, as well as other relevant economic measures.

(10) Common Stock

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We are authorized to issue 600,000,000 shares of common stock as of September 30, 2013. Holders of our common stock are not entitled to receive dividends unless declared by our board of directors.

As of September 30, 2013, we had 138,736,768 shares of common stock outstanding and had reserved shares of common stock for future issuance as follows:



	September 30, 2013
Stock option plans:
Options outstanding	25,453,497
RSUs	4,755,522
Stock awards available for future grants:
2005 Stock Option Plan⁽¹⁾	—
2012 Equity Incentive Plan⁽¹⁾	13,405,017
2012 Employee Stock Purchase Plan⁽¹⁾	5,549,918
Total reserved shares of common stock for future issuance	49,163,954


(1)	Refer to Note 11 for a description of these plans.

(11) Stock Awards

We have a 2005 Stock Option Plan, or 2005 Plan, which provides for grants of stock awards, including options to purchase shares of common stock, stock purchase rights and RSUs to certain employees, officers, directors and consultants. As of September 30, 2013, there were 54,517,674 total shares of common stock authorized for issuance under the 2005 Plan, which includes shares already issued under such plan and shares reserved for issuance pursuant to outstanding options and RSUs.

Our 2012 Equity Incentive Plan, or 2012 Plan, provides for the grant of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock awards, RSUs, performance-based stock awards and other forms of equity compensation, or collectively, stock awards. In addition, the 2012 Plan provides for the grant of performance cash awards. Incentive stock options may be granted only to employees. All other awards may be granted to employees, including officers, as well as directors and consultants. The share reserve may increase to the extent that outstanding stock options under the 2005 Plan expire or terminate unexercised. The share reserve also automatically increases on January 1 of each year until January 1, 2022, by up to 5% of the total number of shares of the common stock outstanding on December 31 of the preceding calendar year as determined by the board of directors. As of September 30, 2013, there were 20,981,151 total shares of common stock authorized for issuance under the 2012 Plan.

Our 2012 Employee Stock Purchase Plan, or 2012 ESPP, authorizes the issuance of shares of common stock pursuant to purchase rights granted to our employees. The number of shares of common stock reserved for issuance automatically increases on January 1 of each calendar year until January 1, 2022, by up to 1% of the total number of shares of the common stock outstanding on December 31 of the preceding calendar year. The price at which common stock is purchased under the 2012 ESPP is equal to 85% of the fair market value of the common stock on the first or last day of the offering period, whichever is lower. Offering periods are six months long and begin on February 1 and August 1 of each year. As of September 30, 2013, we had 6,263,677 total shares of common stock reserved for issuance under the 2012 ESPP.

Stock Options

The stock options are exercisable at a price equal to the market value of the underlying shares of common stock on the date of the grant as determined by our board of directors or, for those stock options issued subsequent to our IPO, the closing price of our common stock as reported on the New York Stock Exchange on the date of grant. Stock options granted under our 2005 Plan and the 2012 Plan to new employees generally vest 25% one year from the date the requisite service period begins and continue to vest monthly for each month of continued employment over the remaining three years. Options granted generally are exercisable for a period of up to 10 years. Option holders under the 2005 Plan can exercise unvested options to acquire restricted stock. Upon termination of service, we have the right to repurchase at the original purchase price any unvested (but issued) shares of common stock.

A summary of the stock option activity for the nine months ended September 30, 2013 is as follows:



	Number of Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (Years)	Aggregate Intrinsic Value (in thousands)
Outstanding at December 31, 2012	36,115,460		$	5.05
Granted	1,936,206		35.21
Exercised	(11,388,760	)	3.00			$	371,796
Cancelled	(1,209,409	)	8.13
Outstanding at September 30, 2013	25,453,497		$	8.12	7.92	$	1,115,754
Vested and expected to vest as of September 30, 2013	24,857,489		$	7.96	7.87	$	1,093,387
Vested and exercisable as of September 30, 2013	8,989,834		$	4.25	7.29	$	428,779

Aggregate intrinsic value represents the difference between the estimated fair value of our common stock and the exercise price of outstanding, in-the-money options. The weighted-average grant date fair value per share of options granted and vested were $17.33 and $3.61, respectively, for the nine months ended September 30, 2013. The total fair value of shares vested was $26.1 million for the nine months ended September 30, 2013.

As of September 30, 2013, total unrecognized compensation cost, adjusted for estimated forfeitures, related to unvested stock options was approximately $77.3 million. The weighted-average remaining vesting period of unvested stock options at September 30, 2013 was 2.63 years.

Under our 2005 Plan, we issue shares of restricted stock as a result of the cash exercise of unvested stock options. The proceeds initially are recorded as a liability from the early exercise of stock options and reclassified to common stock as our repurchase right lapses. A summary of the restricted stock activity for the nine months ended September 30, 2013 is as follows:



	Shares Outstanding		Weighted-Average Grant Date Fair Value
Balance at December 31, 2012	235,066		$	1.49
Vested	(116,103	)	1.59
Balance at September 30, 2013	118,963		$	1.39

RSUs



	Number of Shares		Weighted- Average Grant Date Fair Value		Aggregate Intrinsic Value (in thousands)
Outstanding at December 31, 2012	1,457,870		$	16.89
Granted	3,719,856		34.95
Vested	(266,903	)	11.13		$	10,622
Forfeited	(155,301	)	33.92
Outstanding at September 30, 2013	4,755,522		$	30.60	$	247,049
Expected to vest as of September 30, 2013	4,396,974				$	228,423

RSUs granted under the 2005 Plan and the 2012 Plan to employees generally vest annually over a four-year period. As of September 30, 2013, total unrecognized compensation cost, adjusted for estimated forfeitures, related to unvested RSUs was approximately $118.1 million and the weighted-average remaining vesting period was 3.59 years.

(12) Stock-Based Compensation

We use the Black-Scholes options pricing model to estimate the fair value of our stock-based awards. This model incorporates various assumptions including expected volatility, expected term, risk-free interest rates and expected dividend yields. The following weighted-average assumptions were used for each respective period to calculate our stock-based compensation for each stock option grant:

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	Three Months Ended September 30,		Nine Months Ended September 30,
	2013	2012	2013	2012
Stock Options:
Expected volatility	51% - 52%	54%	51% - 52%	54% - 57%
Expected term (in years)	6.08	6.05	6.01	6.05
Risk-free interest rate	1.71% - 2.05%	0.87% - 0.93%	0.91% - 2.05%	0.87% - 1.18%
Dividend yield	—	—	—	—

The following weighted-average assumptions were used to calculate our stock-based compensation for each stock purchase right granted under the 2012 ESPP:



	Three Months Ended September 30,			Nine Months Ended September 30,
	2013	2012		2013	2012
ESPP:
Expected volatility	35% - 39%	42	%	35% - 42%	42	%
Expected term (in years)	0.50	0.58		0.50	0.58
Risk-free interest rate	0.08% - 0.11%	0.16	%	0.08% - 0.16%	0.16	%
Dividend yield	—	—		—	—

Expected volatility. We use the historic volatility of publicly traded peer companies as an estimate for expected volatility. In considering peer companies, characteristics such as industry, stage of development, size and financial leverage are considered. 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.

Expected term. We estimate the expected term using the simplified method due to the lack of historical exercise activity for our company. The simplified method calculates the expected term as the mid-point between the vesting date and the contractual expiration date of the award.

Risk-free interest rate. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for the expected term of the stock-based award.

Expected dividend yield. Our expected dividend yield is zero, as we have not and do not currently intend to declare dividends in the foreseeable future.

Expected forfeiture rate. We consider our pre-vesting forfeiture history to determine our expected forfeiture rate.

Fair value of common stock. Prior to our initial public offering in June 2012, the fair value of our common stock was determined by our board of directors, which intended all options granted to be exercisable at a price per share not less than the per share fair value of the common stock underlying those options on the date of grant. The valuations of our common stock were determined in accordance with the guidelines outlined in the American Institute of Certified Public Accountants Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. The assumptions used in the valuation model are based on future expectations combined with management judgment.

For stock options granted subsequent to our initial public offering, the fair value is based on the closing price of our common stock as reported on the New York Stock Exchange on the date of grant.

(13) Net Loss Per Share Attributable to Common Stockholders

The following tables present the calculation of basic and diluted net income (loss) per share attributable to common stockholders (in thousands, except share and per share data):

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	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
Numerator:
Net loss	$	(14,713	)	$	(13,053	)	$	(49,476	)	$	(27,417	)
Accretion of redeemable convertible preferred stock	—			—			—			(308		)
Net loss attributable to common stockholders—basic and diluted	$	(14,713	)	$	(13,053	)	$	(49,476	)	$	(27,725	)
Denominator:
Weighted-average shares outstanding—basic and diluted	137,456,531			117,698,005			134,036,466			57,089,411
Net loss per share attributable to common stockholders:
Basic	$	(0.11	)	$	(0.11	)	$	(0.37	)	$	(0.49	)
Diluted	$	(0.11	)	$	(0.11	)	$	(0.37	)	$	(0.49	)

Potentially dilutive securities that are not included in the calculation of diluted net loss per share because doing so would be antidilutive are as follows:



	September 30,
	2013	2012
Common stock options	25,453,497	37,279,442
Restricted stock units	4,755,522	1,134,851
Common stock subject to repurchase	118,963	349,165
ESPP obligations	236,006	468,704
Total potentially dilutive securities	30,563,988	39,232,162

(14) Income Taxes

We compute our provision for income taxes by applying the estimated annual effective tax rate to income from recurring operations and adjust the provision for discrete tax items recorded in the period. Our effective tax rate for the three and nine months ended September 30, 2013 was (5)% and (4)% respectively, which was lower than the federal statutory tax rate of 34%. The lower tax rate was primarily attributable to our loss from operations, a foreign tax rate differential and non-deductible expenses arising from stock-based compensation, partially offset by state income taxes.

Our effective tax rate for the three and nine months ended September 30, 2012 was (3)% and (2)%, respectively. The lower tax rate was primarily attributable to our loss from operations, a foreign tax rate differential and non-deductible expenses arising from stock-based compensation, partially offset by state income taxes and California tax credits.

We are currently under examination by the Internal Revenue Service for the year ended June 30, 2011 and six months ended December 31, 2011. There are differing interpretations of tax laws and regulations, and as a result, disputes may arise with these tax authorities involving issues of the timing and amount of deductions and allocations of income among various tax jurisdictions. We periodically evaluate our exposures associated with our tax filing positions.

We record liabilities related to uncertain tax positions in accordance with the income tax guidance which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements by prescribing a minimum recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. We believe we have provided adequate reserves for our income tax uncertainties in all open tax years.

(15) Commitments and Contingencies

Leases

We lease facilities for data center capacity and office space under non-cancelable operating lease agreements with various expiration dates. Annual future minimum payments under these operating leases as of September 30, 2013 (in thousands) are

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presented in the table below. Included in the table below are future minimum lease payments under non-cancelable subleases as of September 30, 2013 of $3.8 million.



	Data Centers		Office Leases		Total
Fiscal Period:
Remaining three months ended December 31, 2013	$	2,534	$	1,468	$	4,002
2014	12,110		10,473		22,583
2015	4,713		12,946		17,659
2016	1,193		13,303		14,496
2017	57		13,537		13,594
Thereafter	—		53,541		53,541
Total minimum lease payments	$	20,607	$	105,268	$	125,875

Lease commitments of $8.8 million related to the lease for our former San Diego office, which we exited in 2012, are included in the table above.

Legal Proceedings

From time to time, we are party to litigation and other legal proceedings in the ordinary course of business. While the results of any litigation or other legal proceedings are uncertain, management does not believe the ultimate resolution of any pending legal matters is likely to have a material adverse effect on our financial position, results of operations or cash flows, except for those matters for which we have recorded a loss contingency. We accrue for loss contingencies when it is both probable that we will incur the loss and when we can reasonably estimate the amount of the loss.

Generally, our subscription agreements require us to indemnify our customers for third-party intellectual property infringement claims. Any adverse determination related to intellectual property claims or litigation could prevent us from offering our service and adversely affect our financial condition and results of operations.

(16) Information about Geographic Areas

Revenues by geographic area, based on the billing location of the customer, were as follows for the periods presented (in thousands):



	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
Revenues by geography:
North America	$	76,851	$	45,509	$	208,851	$	120,124
EMEA ⁽¹⁾	27,621		16,133		72,403		42,027
Asia Pacific and other	6,787		2,703		18,166		6,399
Total revenues	$	111,259	$	64,345	$	299,420	$	168,550

(1) Europe, the Middle East and Africa, or EMEA

Long-lived assets by geographic area were as follows (in thousands):



	September 30,		December 31,
	2013		2012
Long-lived assets:
North America	$	47,086	$	30,209
EMEA	17,970		10,513
Asia Pacific and other	3,586		1,620
Total long-lived assets	$	68,642	$	42,342

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition, results of operations and cash flows should be read in conjunction with the (1) unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q, and (2) the audited consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the fiscal year ended December 31, 2012 included in the form 10-K dated as of, and filed with the Securities and Exchange Commission, or the SEC, on March 8, 2013 (File No. 001-35580). This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. These statements are often identified by the use of words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “estimate,” or “continue,” and similar expressions or variations. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified herein, and those discussed in the section titled “Risk Factors”, set forth in Part II, Item 1A of this Form 10-Q and in our other SEC filings. We disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.

Overview

We offer our service under a SaaS business model. Our subscription fees include access to the ordered subscription service and related support and include updates of the subscribed service during the subscription term. We provide a scaled pricing model based on the duration of the subscription term and we frequently extend discounts to our customers based on the number of users. We generate sales through our direct sales team and indirectly through channel partners and third-party referrals. We also generate revenues from professional services for implementation and training of customer personnel. We generally bill our customers annually in advance for subscription services and monthly in arrears for our professional services as the work is performed.

Many customers initially subscribe to our service to solve a specific and immediate problem. Once their problem is solved, many of our customers deploy additional applications as they become more familiar with our service and apply it to new IT processes. In addition, many customers either repurpose our IT applications or build custom applications that automate various processes for business uses outside of IT such as human resources, facilities and quality control management. A majority of our revenues come from large global enterprise customers.

To date, we have funded our business primarily with cash flows from operations. We continue to invest in the development of our service, infrastructure and sales and marketing to drive long-term growth. We increased our overall employee headcount to 1,654 as of September 30, 2013 from 963 as of September 30, 2012.

Key Factors Affecting Our Performance

Total customers. We believe our total customer count is a key indicator of our market penetration, growth and future revenues. We have aggressively invested in, and intend to continue to invest in, our direct sales force and additional partnerships within our indirect sales channel. We generally define a customer as an entity with an active service contract as of the measurement date. In situations where there is a single contract that applies to entities with multiple subsidiaries or divisions, universities, or governmental organizations, each entity that has contracted for a separate production instance of our service is counted as a separate customer. As of September 30, 2013 and 2012, our total customer count was 1,900 and 1,346, respectively.

Upsells. To grow our business it is important for us to generate additional sales from existing customers, which we refer to as our upsell rate. We calculate our upsell rate as the annual contract value of upsells signed during the period, net of any decreases in annual contract value of renewals during the period, divided by our total annual contract value signed during the period. The upsell rate was 29% and 20% for the three months ended September 30, 2013 and 2012, respectively, and 29% for both the nine months ended September 30, 2013 and 2012. Our upsells are primarily derived by an increase in the number of seat licenses purchased by our customers, but are also derived from the addition of other subscription services.

Renewal rate. We calculate our renewal rate by subtracting our attrition rate from 100%. Our attrition rate for a period is equal to the annual contract value from lost customers, divided by the total annual contract value from all customers that renewed

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during the period and from all lost customers. A lost customer is a customer that did not renew a contract expiring in the period and that, in our judgment, will not renew. Annual contract value is equal to the first twelve months of expected subscription revenues under a contract. Typically a customer that reduces its subscription upon renewal is not considered a lost customer. Rather, these decreases in annual contract value are netted against upsells. However, in instances where the subscription decrease represents the majority of the customer's annual contract value, we may deem the renewal as a lost customer. We believe our renewal rate is an important metric to measure the long-term value of customer agreements and our ability to retain our customers. Our renewal rate was 97% and 96% for the three months ended September 30, 2013 and 2012, respectively, and 96% for both the nine months ended September 30, 2013 and 2012.

Investment in growth. We have invested, and intend to continue to invest in, expanding our operations, including increasing our headcount, expanding our cloud-based infrastructure and developing technology to support our growth. We have recently, and may in the future, also enter into acquisition transactions. We expect our total operating expenses to increase in the foreseeable future in terms of dollars, however decline as a percent of total revenues.

Professional services model. We believe our professional services engagements by us or our partners facilitate the adoption of our subscription service. Beginning in December 2011, we began shifting our pricing model from a fixed-fee basis to a time-and-materials basis and improving the process by which we scope projects and manage resource utilization.

Expansion beyond IT. Our customers can purchase access to our application suite for use outside of the IT department. Customers may also purchase access to our services to develop custom applications. Although in the near term we expect our revenue growth to be primarily driven by adoption and penetration of our suite of applications for use within IT, we continue to enhance the development capabilities within the platform, allowing custom application development to expand within our customer base. We believe the extensibility and simplicity of our platform is resulting in an increased use of our application suite outside of the IT department as well as an increase in custom application development.

Components of Results of Operations

Revenues

Subscription revenues. Subscription revenues are primarily comprised of fees that give customers access to the ordered subscription service and related support and includes updates of the subscribed service during the subscription term. Pricing includes multiple instances, hosting and support services, data backup and disaster recovery services, as well as future upgrades offered during the subscription period. In addition, we offer three separately priced enabling technologies, Discovery, Orchestration and Performance Analytics. We typically invoice our customers for subscription fees in annual increments upon execution of the initial contract or subsequent renewal. Our average initial contract term was approximately 35 months and 33 months for the three and nine months ended September 30, 2013 and 31 months and 33 months for the three and nine months ended September 30, 2012. Our contracts are generally non-cancelable, though customers can terminate for breach if we materially fail to perform.

We generate sales directly through our sales team and, to a lesser extent, through our channel partners. Sales to our channel partners are made at a discount and revenues are recorded at the discounted price when all revenue recognition criteria are met. From time to time, our channel partners also provide us referrals for which we pay a referral fee. We pay referral fees to channel partners and other third parties typically ranging from 2% to 34% of the first year’s annual contract value. These fees are included in sales and marketing expense.

Professional services and other revenues. Professional services revenues consist of fees associated with the implementation and configuration of our subscription service. Other revenues include customer training and attendance and sponsorship fees for Knowledge, our annual user conference. Prior to 2012, our pricing for professional services was predominantly on a fixed-fee basis. Beginning in December 2011, we began shifting our pricing model to a time-and-materials basis. In 2013, the majority of our new business has been priced on a time-and-materials basis, a trend we expect to continue. In the three and nine months ended September 30, 2012, the average professional services engagement was four months and five months, respectively. The average professional services engagement completed during the three and nine months ended September 30, 2013 was five months. We invoice a majority of our fixed price professional services contracts upon execution of the contract. Our time-and-materials professional services are generally billed monthly in arrears based on actual hours and expenses incurred. Typical payment terms provide our customers pay us within 30 days of invoice.

Refer to “Critical Accounting Policies and Significant Judgments and Estimates” below for further discussion of our revenue recognition accounting policy.

Overhead Allocation

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Overhead associated with benefits, facilities and IT costs is allocated to cost of revenues and operating expenses based on headcount.

Cost of Revenues

Subscription cost of revenues. Cost of subscription revenues consists primarily of expenses related to hosting our service and providing support to our customers. These expenses are comprised of data center capacity costs; personnel and related costs directly associated with our cloud-based infrastructure and customer support, including salaries, benefits, bonuses and stock-based compensation; and allocated overhead.

Professional services and other cost of revenues. Cost of professional services and other revenues consists primarily of personnel and related costs directly associated with our professional services and training departments, including salaries, benefits, bonuses and stock-based compensation; the costs of contracted third-party vendors; and allocated overhead.

Professional services associated with the implementation and configuration of our subscription services are performed directly by our services team, as well as by contracted third-party vendors. Fees paid up-front to our third-party vendors are deferred and amortized to cost of revenues as the professional services are delivered. Fees owed to our third-party vendors are accrued over the same requisite service period. Internal payroll costs are similarly recognized as professional services are delivered. Cost of revenues associated with our professional services engagements contracted with third-party vendors was $3.5 million and $1.4 million in the three months ended September 30, 2013 and 2012, respectively, and $9.1 million and $7.4 million in the nine months ended September 30, 2013 and 2012, respectively.

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of personnel and related expenses directly associated with our sales and marketing staff, including salaries, benefits, bonuses, commissions and stock-based compensation. Sales and marketing expenses also includes third-party referral fees, marketing and promotional events, including our annual Knowledge user conference, online marketing, product marketing and allocated overhead.

Research and Development Expenses

Research and development expenses consist primarily of personnel and related expenses directly associated with our research and development staff, including salaries, benefits, bonuses and stock-based compensation, and allocated overhead.

General and Administrative Expenses

General and administrative expenses consists primarily of personnel and related expenses for our executive, finance, legal, human resources and administrative personnel, including salaries, benefits, bonuses and stock-based compensation; external legal, accounting and other professional services fees; other corporate expenses; and allocated overhead.

Provision for Income Taxes

Provision for income taxes consists of federal, state and foreign income taxes. Due to cumulative losses, we maintain a valuation allowance against our deferred tax assets as of September 30, 2013. We consider all available evidence, both positive and negative, in assessing the extent to which a valuation allowance should be applied against our deferred tax assets.

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Results of Operations

To enhance comparability, the following table sets forth our results of operations for the periods presented. The period-to-period comparison of financial results is not necessarily indicative of future results.



	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	(in thousands)
Revenues:
Subscription	$	92,992		$	55,279		$	244,926		$	141,640
Professional services and other	18,267			9,066			54,494			26,910
Total revenues	111,259			64,345			299,420			168,550
Cost of revenues⁽¹⁾:
Subscription	23,429			17,931			61,960			43,182
Professional services and other	18,146			9,643			47,921			28,519
Total cost of revenues	41,575			27,574			109,881			71,701
Gross profit	69,684			36,771			189,539			96,849
Operating expenses⁽¹⁾:
Sales and marketing	47,336			28,140			137,853			74,356
Research and development	20,819			10,783			54,809			26,098
General and administrative	16,179			11,195			43,783			24,441
Total operating expenses	84,334			50,118			236,445			124,895
Loss from operations	(14,650		)	(13,347		)	(46,906		)	(28,046		)
Interest and other income (expense), net	600			615			(604		)	1,148
Loss before provision for income taxes	(14,050		)	(12,732		)	(47,510		)	(26,898		)
Provision for income taxes	663			321			1,966			519
Net loss	$	(14,713	)	$	(13,053	)	$	(49,476	)	$	(27,417	)


(1)	Stock-based compensation included in the statements of operations above was as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
	(in thousands)
Cost of revenues:
Subscription	$	2,190	$	1,276	$	5,980	$	2,514
Professional services and other	1,209		495		3,095		964
Sales and marketing	5,945		2,899		14,752		6,852
Research and development	4,176		1,919		11,005		4,121
General and administrative	4,331		1,624		9,893		4,137

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	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
Revenues:
Subscription	84	%	86	%	82	%	84	%
Professional services and other	16		14		18		16
Total revenues	100		100		100		100
Cost of revenues:
Subscription	21		28		21		26
Professional services and other	16		15		16		17
Total cost of revenues	37		43		37		43
Gross profit	63		57		63		57
Operating expenses:
Sales and marketing	43		44		46		44
Research and development	19		17		18		15
General and administrative	15		17		15		15
Total operating expenses	77		78		79		74
Loss from operations	(14	)	(21	)	(16	)	(17	)
Interest and other income, net	1		1		—		1
Loss before provision for income taxes	(13	)	(20	)	(16	)	(16	)
Provision for income taxes	—		—		1		—
Net loss	(13	)%	(20	)%	(17	)%	(16	)%



	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
	(in thousands)
Revenues by geography
North America	$	76,851	$	45,509	$	208,851	$	120,124
EMEA ⁽¹⁾	27,621		16,133		72,403		42,027
Asia Pacific and other	6,787		2,703		18,166		6,399
Total revenues	$	111,259	$	64,345	$	299,420	$	168,550

(1) Europe, the Middle East and Africa, or EMEA



	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
Revenues by geography
North America	69	%	71	%	70	%	71	%
EMEA	25		25		24		25
Asia Pacific and other	6		4		6		4
Total revenues	100	%	100	%	100	%	100	%

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Comparison of the three months ended September 30, 2013 and 2012

Revenues



	Three Months Ended September 30,						% Change
	2013			2012			% Change
	(dollars in thousands)
Revenues:
Subscription	$	92,992		$	55,279		68	%
Professional services and other	18,267			9,066			101	%
Total revenues	$	111,259		$	64,345		73	%
Percentage of revenues:
Subscription	84		%	86		%
Professional services and other	16			14
Total	100		%	100		%

Revenues increased $46.9 million during the three months ended September 30, 2013 compared to the same period in the prior year, primarily due to an increase in subscription revenues of $37.7 million driven by an increase in our customer count, additional sales from existing customers, or upsells, and renewals. Total customer count at September 30, 2013 was 1,900 compared to 1,346 at September 30, 2012, an increase of 554 customers, or 41%. Our upsell rate and renewal rate for the trailing twelve months ending September 30, 2013 were 30% and 96%, respectively compared to 29% and 96%, respectively for the trailing twelve months ending September 30, 2012.

Professional services and other revenues increased $9.2 million during the three months ended September 30, 2013 compared to the same period in the prior year due to an increase in services provided to our growing customer base, increase in billable utilization and improvements in pricing of our professional services engagements.

Our average total revenue per customer, defined as trailing four quarters' revenues divided by the average number of customers during the trailing four quarters, increased to approximately $219,000 for the three months ended September 30, 2013 compared to approximately $181,000 for the three months ended September 30, 2012.

Cost of Revenues and Gross Profit Percentage



	Three Months Ended September 30,						% Change
	2013			2012			% Change
	(dollars in thousands)
Cost of revenues:
Subscription	$	23,429		$	17,931		31	%
Professional services and other	18,146			9,643			88	%
Total cost of revenues	$	41,575		$	27,574		51	%
Gross profit percentage:
Subscription	75		%	68		%
Professional services and other	1		%	(6		)%
Total gross profit percentage	63		%	57		%
Headcount (at period end)
Subscription	299			202			48	%
Professional services and other	278			159			75	%
Total headcount	577			361			60	%

Cost of subscription revenues increased $5.5 million during the three months ended September 30, 2013 compared to the same period in the prior year, primarily due to increased personnel-related expenses within our cloud-based infrastructure and support organizations and additional investments in our data centers, offset by a decrease in third party hosting expenses. Personnel-

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related expenses were $13.3 million during the three months ended September 30, 2013 compared to $8.5 million during the three months ended September 30, 2012, consisting primarily of increased employee compensation, benefits, travel and hiring expenses of $3.9 million and additional stock-based compensation of $0.9 million.

On December 31, 2012, we completed our migration from the managed services data centers to co-location data centers which decreased our third party hosting expenses by $0.5 million during the three months ended September 30, 2013. Depreciation expense related to our cloud-based infrastructure hardware increased $1.1 million primarily due to purchases of equipment in our co-location data centers partially offset by a decrease in depreciation expense associated with the termination of our managed service data centers.

Our subscription gross profit percentage was 75% for the three months ended September 30, 2013 compared to 68% for the three months ended September 30, 2012. We expect our subscription gross profit percentage to decline slightly for the remainder of the year, as we continue to invest in our cloud-based infrastructure and support personnel, grow our data center footprint and purchase new equipment to support our growing customer base.

Cost of professional services and other revenues increased $8.5 million during the three months ended September 30, 2013 as compared to the prior year, primarily due to increased personnel-related expenses. Personnel-related expenses were $12.6 million during the three months ended September 30, 2013 compared to $7.1 million during the three months ended September 30, 2012, consisting primarily of increased employee compensation, benefits, travel and hiring expenses of $4.7 million and additional stock-based compensation of $0.7 million, driven by headcount growth and an increase in our stock price. Outside service costs increased from $1.5 million during the three months ended September 30, 2012 to $3.6 million during the three months ended September 30, 2013 primarily due to growth in professional services and a corresponding growth in work sub-contracted to our partners.

Our professional services and other gross profit percentage improved to 1% during the three months ended September 30, 2013 compared to (6)% during the three months ended September 30, 2012 due to improvements in scoping and pricing projects and resource utilization. Due to the anticipated increase in headcount in the professional services organization for the remainder of the year, we expect our gross profit percentage from professional services and other to remain relatively flat.

Sales and Marketing



	Three Months Ended September 30,						% Change
	2013			2012			% Change
	(dollars in thousands)
Sales and marketing	$	47,336		$	28,140		68	%
Percentage of revenues	43		%	44		%
Headcount (at period end)	581			330			76	%

Sales and marketing expenses increased $19.2 million during the three months ended September 30, 2013 compared to the same period in the prior year, primarily driven by the expansion of our direct sales team and increases in marketing program expenses to address additional opportunities in new and existing markets. Excluding commissions, personnel-related expenses were $32.7 million during the three months ended September 30, 2013 compared to $18.6 million during the three months ended September 30, 2012, consisting primarily of increased employee compensation, benefits, travel and hiring expenses of $11.0 million and additional stock-based compensation of $3.0 million. Overhead expenses increased $1.1 million due to increased headcount. Commissions increased $4.6 million primarily due to growth in bookings in prior periods and current year changes made to our commission plans. Commissions and referral fees were 10% and 9% of subscription revenues for the three months ended September 30, 2013 and 2012, respectively.

Marketing program expenses, which include events, advertising and market data, increased $0.9 million during the three months ended September 30, 2013 compared to the same period in the prior year. We expect sales and marketing expenses to increase for the remainder of the year in terms of dollars and remain relatively flat as a percentage of total revenues as we continue to expand our direct sales force, increase our marketing activities, grow our international operations, build brand awareness and sponsor additional marketing events.

Research and Development

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	Three Months Ended September 30,						% Change
	2013			2012			% Change
	(dollars in thousands)
Research and development	$	20,819		$	10,783		93	%
Percentage of revenues	19		%	17		%
Headcount (at period end)	296			164			80	%

Research and development expenses increased $10.0 million during the three months ended September 30, 2013 compared to the same period in the prior year, driven by our continued investments in upgrading and extending our service offerings and the development of new technologies. Personnel-related expenses were $17.8 million during the three months ended September 30, 2013 compared to $9.7 million during the three months ended September 30, 2012, consisting primarily of increased employee compensation, benefits, travel and hiring expenses of $5.8 million and additional stock-based compensation of $2.3 million. Outside services increased $1.0 million primarily due to the increase in consultants used for product releases.

We expect research and development expenses to increase in terms of dollars, however remain relatively flat as a percent of total revenues for the remainder of the year as we continue to improve the existing functionality of our service, develop new applications to fill market needs and continue to enhance our core platform.

General and Administrative



	Three Months Ended September 30,						% Change
	2013			2012			% Change
	(dollars in thousands)
General and administrative	$	16,179		$	11,195		45	%
Percentage of revenues	15		%	17		%
Headcount (at period end)	200			108			85	%

General and administrative expenses increased $5.0 million during the three months ended September 30, 2013 compared to the same period in the prior year, primarily due to increased headcount and our international expansion, partially offset by a decrease in corporate expenses. Personnel-related expenses were $12.0 million during the three months ended September 30, 2013 compared to $5.5 million during the three months ended September 30, 2012, consisting primarily of increased employee compensation, benefits, travel and hiring expenses of $3.8 million and additional stock-based compensation of $2.7 million, as we added employees to support the growth of our business. Corporate expenses decreased by $2.2 million primarily due to the relocation of our San Diego, California office, for which we incurred $2.9 million in lease abandonment costs during the three months ended September 30, 2012.

We expect general and administrative expenses to increase in terms of dollars, however remain relatively flat as a percent of total revenues for the remainder of the year as we continue to grow. These expenses include higher legal, corporate insurance and accounting expenses, and the additional expenses of achieving and maintaining compliance with Section 404 of the Sarbanes-Oxley Act and related regulations.

Interest and Other Income (Expense), net



	Three Months Ended September 30,						% Change
	2013			2012			% Change
	(dollars in thousands)
Interest and other income (expense), net	$	600		$	615		(2	)%
Percentage of revenues	1		%	1		%

Interest and other income (expense), net, for the three months ended September 30, 2013 did not change significantly in total or by expense category compared to the same period in the prior year.

Provision for Income Taxes

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	Three Months Ended September 30,						% Change
	2013			2012			% Change
	(dollars in thousands)
Loss before income taxes	$	(14,050	)	$	(12,732	)	10	%
Provision for income taxes	663			321			107	%
Effective tax rate	(5		)%	(3		)%

Our effective tax rate changed to (5)% for the three months ended September 30, 2013 from (3)% for the three months ended September 30, 2012, due to a higher proportion of earnings in jurisdictions with higher statutory tax rates, a higher loss from U.S. operations, and the tax effect of integration of acquired companies for the three months ended September 30, 2013 compared to the same period in the prior year.

We continue to maintain a full valuation allowance on our federal and state deferred tax assets, and the significant components of the tax expense recorded are current cash taxes in various jurisdictions. The cash tax expenses are impacted by each jurisdiction’s individual tax rates, laws on timing of recognition of income and deductions and availability of net operating losses and tax credits. Given the full valuation allowance, sensitivity of current cash taxes to local rules and our foreign restructuring, we expect our effective tax rate could fluctuate significantly on a quarterly basis and could be adversely affected to the extent earnings are lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates. We consider the earnings of our foreign subsidiaries to be indefinitely reinvested outside of the United States.

Comparison of the nine months ended September 30, 2013 and 2012

Revenues



Nine Months Ended September 30,		% Change
2013	2012	% Change