NOW-2014.6.30-10Q


 
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 June 30, 2014
OR
 ¨
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 x
Accelerated filer ¨
Non-accelerated filer ¨ (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 July 31, 2014, there were approximately 145.7 million shares of the Registrant’s Common Stock outstanding.
TABLE OF CONTENTS

 
 
 
Page
 
 
Item 1.
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
 
 
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
 
 
 
 
   
 
 



PART I

ITEM 1.     FINANCIAL STATEMENTS

SERVICENOW, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
 
June 30, 2014
 
December 31, 2013
 
(Unaudited)
 
 
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
329,275

 
$
366,303

Short-term investments
348,205

 
268,251

Accounts receivable, net
109,246

 
108,339

Current portion of deferred commissions
34,105

 
31,123

Prepaid expenses and other current assets
23,828

 
23,733

Total current assets
844,659

 
797,749

Deferred commissions, less current portion
22,484

 
21,318

Long-term investments
279,580

 
255,356

Property and equipment, net
96,483

 
75,560

Intangible assets, net
5,290

 
5,796

Goodwill
8,622

 
8,724

Other assets
5,125

 
3,973

Total assets
$
1,262,243

 
$
1,168,476

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
22,463

 
$
7,405

Accrued expenses and other current liabilities
64,297

 
68,130

Current portion of deferred revenue
316,287

 
252,553

Total current liabilities
403,047

 
328,088

Deferred revenue, less current portion
12,565

 
14,169

Convertible senior notes, net
429,025

 
414,777

Other long-term liabilities
19,489

 
17,183

Total liabilities
864,126

 
774,217

Stockholders’ equity:
 
 
 
Common stock
145

 
140

Additional paid-in capital
670,242

 
573,791

Accumulated other comprehensive income (loss)
600

 
(476
)
Accumulated deficit
(272,870
)
 
(179,196
)
Total stockholders’ equity
398,117

 
394,259

Total liabilities and stockholders’ equity
$
1,262,243

 
$
1,168,476

 
See accompanying notes to condensed consolidated financial statements

1


SERVICENOW, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(Unaudited)
(in thousands, except share and per share data)
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Revenues:
 
 
 
 
 
 
 
Subscription
$
132,724

 
$
80,376

 
$
250,099

 
$
151,934

Professional services and other
34,033

 
21,846

 
55,748

 
36,227

Total revenues
166,757

 
102,222

 
305,847

 
188,161

Cost of revenues(1):
 
 
 
 
 
 
 
Subscription
33,243

 
20,219

 
64,432

 
38,531

Professional services and other
25,695

 
15,779

 
47,620

 
29,775

Total cost of revenues
58,938

 
35,998

 
112,052

 
68,306

Gross profit
107,819

 
66,224

 
193,795

 
119,855

Operating expenses(1):
 
 
 
 
 
 
 
Sales and marketing
91,937

 
52,291

 
161,353

 
90,517

Research and development
35,439

 
17,951

 
66,549

 
33,990

General and administrative
24,914

 
15,325

 
46,545

 
27,604

Total operating expenses
152,290

 
85,567

 
274,447

 
152,111

Loss from operations
(44,471
)
 
(19,343
)
 
(80,652
)
 
(32,256
)
Interest and other income (expense), net
(5,231
)
 
(1,323
)
 
(11,194
)
 
(1,204
)
Loss before provision for income taxes
(49,702
)
 
(20,666
)
 
(91,846
)
 
(33,460
)
Provision for income taxes
661

 
739

 
1,828

 
1,303

Net loss
$
(50,363
)
 
$
(21,405
)
 
$
(93,674
)
 
$
(34,763
)
Net loss per share - basic and diluted
$
(0.35
)
 
$
(0.16
)
 
$
(0.65
)
 
$
(0.26
)
Weighted-average shares used to compute net loss per share - basic and diluted
144,456,675

 
134,454,085

 
143,267,181

 
132,298,095

Other comprehensive income (loss):
 
 
 
 
 
 
 
Foreign currency translation adjustments
$
511

 
$
(201
)
 
$
686

 
$
(1,367
)
Unrealized gain (loss) on investments
365

 
(475
)
 
390

 
(429
)
Other comprehensive income (loss), net of tax
876

 
(676
)
 
1,076

 
(1,796
)
Comprehensive loss
$
(49,487
)
 
$
(22,081
)
 
$
(92,598
)
 
$
(36,559
)
 
(1)
Includes stock-based compensation as follows:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Cost of revenues:
 
 
 
 
 
 
 
Subscription
$
3,825

 
$
1,996

 
$
6,901

 
$
3,790

Professional services and other
3,224

 
1,065

 
5,616

 
1,886

Sales and marketing
12,383

 
4,822

 
21,426

 
8,807

Research and development
10,452

 
3,715

 
18,291

 
6,829

General and administrative
7,720

 
3,230

 
14,599

 
5,562

 
See accompanying notes to condensed consolidated financial statements

2
Table of Contents
SERVICENOW, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)

 
Six Months Ended June 30,
 
2014
 
2013
Cash flows from operating activities:
 
 
 
Net loss
$
(93,674
)
 
$
(34,763
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization
16,630

 
9,703

Amortization of premiums on investments
3,859

 
2,233

Amortization of deferred commissions
23,635

 
11,997

Amortization of debt discount and issuance costs
14,283

 
—

Stock-based compensation
66,833

 
26,874

Tax benefit from exercise of stock options
(617
)
 
(2,571
)
Other
(1,590
)
 
913

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
(2,098
)
 
(15,891
)
Deferred commissions
(27,966
)
 
(20,780
)
Prepaid expenses and other assets
(1,101
)
 
5,595

Accounts payable
10,976

 
(125
)
Deferred revenue
63,312

 
40,574

Accrued expenses and other liabilities
(6,206
)
 
1,000

Net cash provided by operating activities
66,276

 
24,759

Cash flows from investing activities:
 
 
 
Purchases of property and equipment
(27,405
)
 
(22,235
)
Purchases of investments
(241,312
)
 
(184,763
)
Sale of investments
68,893

 
43,298

Maturities of investments
67,168

 
107,451

Restricted cash
(55
)
 
(163
)
Net cash used in investing activities
(132,711
)
 
(56,412
)
Cash flows from financing activities:
 
 
 
Offering costs paid in connection with follow-on offering
—

 
(698
)
Proceeds from employee stock plans
28,811

 
31,830

Tax benefit from exercise of stock options
617

 
2,571

Net cash provided by financing activities
29,428

 
33,703

Foreign currency effect on cash and cash equivalents
(21
)
 
(806
)
Net increase (decrease) in cash and cash equivalents
(37,028
)
 
1,244

Cash and cash equivalents at beginning of period
366,303

 
118,989

Cash and cash equivalents at end of period
$
329,275

 
$
120,233

Supplemental disclosures of non-cash investing activities:
 
 
 
Property and equipment included in accounts payable and accrued expenses
$
12,669

 
$
5,756



See accompanying notes to condensed consolidated financial statements

3


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 and manage IT service relationships across the global enterprise. Our services include a suite of IT service automation applications built on our proprietary platform that can be rapidly deployed and configured. Customers use our services to create a single system of record for enterprise IT, automate manual tasks, standardize processes and consolidate legacy systems. Using ServiceNow, enterprise IT departments can accelerate their shift from the management of IT infrastructure to the management of IT service relationships across the enterprise with greater transparency, accountability and auditability. Our proprietary platform enables our customers to create custom applications and evolve the IT service model to service domains inside and outside the enterprise.
 
(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 financial statement presentation have been included. The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the results to be expected for the year ended December 31, 2014 or for other interim periods or for future years. The condensed consolidated balance sheet as of December 31, 2013 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 year ended December 31, 2013, which was filed with the Securities and Exchange Commission on February 28, 2014.
 
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 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 consolidated financial statements, as well as reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
  
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 issued by financial-sector firms with a minimum rating of A by Standard & Poor's and A2 by Moody's and securities issued by non-financial sector firms with a minimum rating of BBB by Standard & Poor's and Baa1 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 June 30, 2014 and December 31, 2013, there were no customers that represented more than 10% of our accounts receivable balance. During the three and six months ended June 30, 2014 and 2013, there were no customers that individually exceeded 10% of our revenues.
 

4


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 June 30, 2014 and December 31, 2013, the allowance for doubtful accounts was $1.7 million and $1.1 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 of any known service disruptions. Service level credit accrual charges are recorded against revenue. As of June 30, 2014 and December 31, 2013, the service level credit accrual was $1.0 million and $0.6 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.

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.

Recent Accounting Pronouncement

In May 2014, the Financial Accounting Standards Board ("FASB") issued an update to ASC 606 Revenue from Contracts with Customers (“ASC 606”) that will supersede virtually all existing revenue guidance. Under this update, an entity is required to recognize revenue upon transfer of promised goods or services to customers, in an amount that reflects the expected consideration received in exchange for those goods or services. As such, an entity will need to use more judgment and make more estimates than under the current guidance. This update should be applied retrospectively either to each prior reporting period presented in the financial statements, or only to the most current reporting period presented in the financial statements with a cumulative effect adjustment recorded in the retained earnings. This guidance will become effective for us for our interim and annual reporting periods beginning January 1, 2017. We are currently evaluating the impact of this update on our consolidated financial statements.

(3)    Investments
 
The following is a summary of our investments (in thousands):
 
 
June 30, 2014
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
Available-for-sale securities:
 
 
 
 
 
 
 
Commercial paper
$
63,018

 
$
6

 
$
(6
)
 
$
63,018

Corporate notes, bonds and certificate of deposit
554,612

 
333

 
(187
)
 
554,758

U.S. government agency securities
10,007

 
2

 
—

 
10,009

Total available-for-sale securities
$
627,637

 
$
341

 
$
(193
)
 
$
627,785

 

5


 
December 31, 2013
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
Available-for-sale securities:
 
 
 
 
 
 
 
Commercial paper
$
124,330

 
$
10

 
$
(21
)
 
$
124,319

Corporate notes and bonds
399,519

 
129

 
(360
)
 
399,288

Total available-for-sale securities
$
523,849

 
$
139

 
$
(381
)
 
$
523,607


As of June 30, 2014, 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 (in thousands):
 
June 30, 2014
Due in 1 year or less
$
348,205

Due in 1 year through 3 years
279,580

Total
$
627,785

    
We had certain available-for-sale securities in a gross unrealized loss position, all of which had been in such position for less than 12 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):
 
 
June 30, 2014
 
December 31, 2013
 
Fair Value
 
Gross
Unrealized
Losses
 
Fair Value
 
Gross
Unrealized
Losses
Commercial paper
$
31,027

 
$
(6
)
 
$
81,467

 
$
(21
)
Corporate notes, bonds and certificate of deposit
257,839

 
(187
)
 
293,642

 
(360
)
Total
$
288,866

 
$
(193
)
 
$
375,109

 
$
(381
)
  
(4)    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 June 30, 2014 (in thousands): 
 
Level 1
 
Level 2
 
Level 3
 
Total
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash
$
95,678

 
$
—

 
$
—

 
$
95,678

Money market funds
103,413

 
—

 
—

 
103,413

Commercial paper
—

 
130,184

 
—

 
130,184

Short-term investments:
 
 
 
 
 
 
 
Commercial paper
—

 
63,018

 
—

 
63,018

Corporate notes, bonds and certificate of deposit
—

 
285,187

 
—

 
285,187

Long-term investments:
 
 
 
 
 
 
 
Corporate notes and bonds
—

 
269,570

 
—

 
269,570

U.S. government agency securities
—

 
10,010

 
—

 
10,010

Total
$
199,091

 
$
757,969

 
$
—

 
$
957,060

 
The following table presents our fair value hierarchy for our assets and liabilities measured at fair value on a recurring basis at December 31, 2013 (in thousands): 

6


 
Level 1
 
Level 2
 
Level 3
 
Total
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash
$
69,333

 
$
—

 
$
—

 
$
69,333

Money market funds
35,248

 
—

 
—

 
35,248

Commercial paper
—

 
261,722

 
—

 
261,722

Short-term investments:
 
 
 
 
 
 
 
Commercial paper
—

 
124,319

 
—

 
124,319

Corporate notes and bonds
—

 
143,932

 
—

 
143,932

Long-term investments:
 
 
 
 
 
 
 
Corporate notes and bonds
—

 
255,356

 
—

 
255,356

Total
$
104,581

 
$
785,329

 
$
—

 
$
889,910


We determine the fair value of our security holdings based on pricing from our service provider and market prices from 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.

(5) Goodwill and Intangible Assets
Goodwill balances are presented below (in thousands):
 
Carrying Amount
Balance as of December 31, 2013
$
8,724

Foreign currency translation adjustments
(102
)
Balance as of June 30, 2014
$
8,622


Intangible assets consist of the following (in thousands):
 
June 30, 2014
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
Developed technology
$
5,759

 
$
(1,440
)
 
$
4,319

Contracts
312

 
(207
)
 
105

Non-compete agreements
33

 
(22
)
 
11

     Acquisition-related intangible assets
6,104

 
(1,669
)
 
4,435

Other intangible assets
1,075

 
(220
)
 
855

Total intangible assets
$
7,179

 
$
(1,889
)
 
$
5,290


 
December 31, 2013
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
Developed technology
$
5,783

 
$
(723
)
 
$
5,060

Contracts
315

 
(104
)
 
211

Non-compete agreements
33

 
(11
)
 
22

     Acquisition-related intangible assets
6,131

 
(838
)
 
5,293

Other intangible assets
650

 
(147
)
 
503

Total intangible assets
$
6,781

 
$
(985
)
 
$
5,796



7


Amortization expense for intangible assets for the three months ended June 30, 2014 and 2013 was approximately $468,000 and $23,000, respectively, and for the six months ended June 30, 2014 and 2013 was approximately $908,000 and $46,000, respectively.

(6)    Property and Equipment
 
Property and equipment, net consists of the following (in thousands):
 
 
June 30,
 
December 31,
 
2014
 
2013
Computer equipment and software
$
116,926

 
$
90,617

Furniture and fixtures
15,674

 
13,751

Leasehold improvements
14,151

 
8,371

Construction in progress
1,340

 
928

 
148,091

 
113,667

Less: Accumulated depreciation
(51,608
)
 
(38,107
)
Total property and equipment, net
$
96,483

 
$
75,560

 
Construction in progress consists primarily of in-process software development costs and leasehold improvements. Depreciation expense for the three months ended June 30, 2014 and 2013 was $8.2 million and $5.3 million, respectively, and for the six months ended June 30, 2014 and 2013 was $15.7 million and $9.7 million, respectively.

(7)    Accrued Expenses and Other Current Liabilities
 
Accrued expenses and other current liabilities consist of the following (in thousands):
 
 
June 30,
 
December 31,
 
2014
 
2013
Taxes payable
$
3,711

 
$
4,187

Bonuses and commissions
19,754

 
22,322

Accrued compensation
13,629

 
16,610

Other employee expenses
14,201

 
11,926

Other
13,002

 
13,085

Total accrued expenses and other current liabilities
$
64,297

 
$
68,130

 
(8)    Convertible Senior Notes
In November 2013, we issued 0% convertible senior notes due November 1, 2018 with aggregate principal amount of $575 million (the "Notes"). The Notes will not bear interest. The Notes mature on November 1, 2018 unless converted or repurchased in accordance with their terms prior to such date. We cannot redeem the Notes prior to maturity.
The Notes are unsecured obligations and do not contain any financial covenants or restrictions on the payments of dividends, the incurrence of indebtedness or the issuance or repurchase of securities by us or any of our subsidiaries.
Upon conversion, we may choose to pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock. We intend to settle the principal amount of the Notes with cash.
The Notes are convertible up to 7.8 million shares of our common stock at an initial conversion rate of approximately 13.54 shares of common stock per $1,000 principal amount, which is equal to an initial conversion price of approximately $73.88 per share of common stock, subject to adjustment. Holders of the Notes may convert their Notes at their option at any time prior to the close of business on the business day immediately preceding July 1, 2018, only under the following circumstances:

•
during any calendar quarter commencing after the calendar quarter ending on March 31, 2014 (and only during such calendar quarter), if the last reported sale price of the common stock for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;

8


•
during the five business day period after any five consecutive trading day period (the “measurement period”) in which the trading price per $1,000 principal amount of notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such trading day; or
•
upon the occurrence of specified corporate events.

On or after July 1, 2018, a holder may convert all or any portion of its notes at any time prior to the close of business on the second scheduled trading day immediately preceding the maturity date regardless of the foregoing conditions. Upon conversion, we will pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock, at our election.

The conversion price will be subject to adjustment in some events. Holders of the Notes who convert their notes in connection with certain corporate events that constitute a “make-whole fundamental change” are, under certain circumstances, entitled to an increase in the conversion rate. Additionally, in the event of a corporate event that constitutes a “fundamental change,” holders of the Notes may require us to purchase with cash all or a portion of the Notes upon the occurrence of a fundamental change, at a purchase price equal to 100% of the principal amount of the Notes plus any accrued and unpaid interest.

In accounting for the issuance of the Notes, we separated the Notes into liability and equity components. The carrying cost of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the par value of the Notes. The difference between the principal amount of the Notes and the proceeds allocated to the liability component (“debt discount”) is amortized to interest expense using the effective interest method over the term of the Note. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.

In accounting for the transaction costs related to the issuance of the Notes, we allocated the total amount incurred to the liability and equity components based on their relative fair values. Transaction costs attributable to the liability component are being amortized to interest expense over the term of the Notes, and transaction costs attributable to the equity component were netted with the equity component of the Notes in stockholders’ equity. The Notes consisted of the following (in thousands):
 
June 30, 2014
 
December 31, 2013
Liability:
 
 
 
Principal
$
575,000

 
$
575,000

Less: debt discount, net of amortization
(145,975
)
 
(160,223
)
Net carrying amount
$
429,025

 
$
414,777


We consider the fair value of the Notes at June 30, 2014 and December 31, 2013 to be a Level 2 measurement. The fair value of the Notes is primarily affected by the trading price of our common stock and interest rate. Based on the closing price of our common stock of $61.96 and $56.01 on June 30, 2014 and December 31, 2013, respectively, the if-converted value of the Notes was less than its principal amount.

As of June 30, 2014, the remaining life of the Notes is 52 months. The following table sets forth total interest expense recognized related to the Notes (in thousands):
 
Three months ended June 30, 2014
 
Six months ended June 30, 2014
Amortization of debt issuance cost
$
386

 
$
766

Amortization of debt discount
6,816

 
13,517

Total
$
7,202

 
$
14,283

Effective interest rate of the liability component
6.5%

No interest expense related to the Notes were recognized for the three and six months ended June 30, 2013.

Note Hedge


9


To minimize the impact of potential economic dilution upon conversion of the Notes, we entered into convertible note hedge transactions (the "Note Hedge") with respect to our common stock concurrent with the issuance of the Notes. The Note Hedge covers approximately 7.8 million shares of our common stock at a strike price per share that corresponds to the initial conversion price of the Notes, subject to adjustment, and is exercisable upon conversion of the Notes. We paid an aggregate amount of $135.8 million for the Note Hedge. The Note Hedge will expire upon maturity of the Notes. The Note Hedge is intended to reduce the potential economic dilution upon conversion of the Notes in the event that the fair value per share of our common stock at the time of exercise is greater than the conversion price of the Notes. The Note Hedge is a separate transaction and is not part of the terms of the Notes. The Note Hedge does not impact earnings per share, as it was entered into to offset any dilution from the Notes.

Warrants

Separately, we entered into warrant transactions (the “Warrants”) whereby we sold warrants to acquire up to 7.8 million shares of our common stock, at a strike price of $107.46 per share, subject to adjustment. We received aggregate proceeds of $84.5 million from the sale of the Warrants. If the average market value per share of our common stock for the reporting period, as measured under the Warrants, exceeds the strike price of the Warrants, the Warrants will have a dilutive effect on our earnings per share. The Warrants are separate transactions and are not remeasured through earnings each reporting period. The Warrants are not part of the Notes or the Note Hedge, and have been accounted for as part of additional paid-in capital.

(9)    Accumulated Other Comprehensive Income (Loss)

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

 
June 30,
 
December 31,
 
2014
 
2013
Foreign currency translation adjustment
$
452

 
$
(234
)
Net unrealized gain (loss) on investments
148

 
(242
)
        Accumulated other comprehensive income (loss), net of tax
$
600

 
$
(476
)

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

(10)    Stockholders' Equity
 
We were authorized to issue 600,000,000 shares of common stock as of June 30, 2014. Holders of our common stock are not entitled to receive dividends unless declared by our board of directors. As of June 30, 2014, we had 145,174,006 shares of common stock outstanding and had reserved shares of common stock for future issuance as follows: 
 
June 30, 2014
Stock option plans:
 
Options outstanding
19,375,640

RSUs
8,353,408

Stock awards available for future grants:
 
2005 Stock Option Plan(1)
—

2012 Equity Incentive Plan(1)
16,691,038

2012 Employee Stock Purchase Plan(1)
6,727,906

Total reserved shares of common stock for future issuance
51,147,992

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

During the six months ended June 30, 2014 and 2013, we issued a total of 4,825,594 shares and 9,817,230 shares, respectively, from stock option exercises, vesting of restricted stock units, or RSUs, and purchases from the employee stock purchase plan, or ESPP.

(11)    Stock Awards
 

10

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.
 
Our 2012 Equity Incentive Plan, or 2012 Plan, provides for the grant of incentive stock options, nonqualified stock options, stock appreciation rights, 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 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 common stock outstanding on December 31 of the preceding year as determined by the board of directors. On January 1, 2014, 7,017,730 shares of common stock were automatically added to the 2012 Plan pursuant to the provision described in the preceding sentence.

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 year until January 1, 2022, by up to 1% of the total number of shares of common stock outstanding on December 31 of the preceding year as determined by the board of directors. 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. On January 1, 2014, 1,403,546 shares of common stock were automatically added to the 2012 ESPP pursuant to the provision described in the preceding sentence.

Stock Options
 
A summary of the stock option activity for the six months ended June 30, 2014 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, 2013
23,399,374

 
$
9.07

 
 
 
 
Granted
232,048

 
64.82

 
 
 
 
Exercised
(3,792,101
)
 
5.35

 
 
 
$
209,315

Canceled
(463,681
)
 
24.47

 
 
 
 
Outstanding at June 30, 2014
19,375,640

 
$
10.05

 
7.27
 
$
1,006,664

Vested and expected to vest as of June 30, 2014
19,089,638

 
$
9.85

 
7.26
 
$
994,766

Vested and exercisable as of June 30, 2014
9,616,984

 
$
6.35

 
6.89
 
$
534,804

 
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 was $31.48 for the six months ended June 30, 2014. The total fair value of shares vested was $21.3 million for the six months ended June 30, 2014.
 
As of June 30, 2014, total unrecognized compensation cost, adjusted for estimated forfeitures, related to unvested stock options was approximately $59.1 million. The weighted-average remaining vesting period of unvested stock options at June 30, 2014 was 2.38 years.
 
 RSUs

 Activity with respect to outstanding RSUs for the six months ended June 30, 2014 was as follows:

11

 
Number of
Shares
 
Weighted Average Grant Date Fair Value
(Per Share)
 
Aggregate
Fair Value
(in thousands)
Outstanding at December 31, 2013
5,427,509

 
$
34.02

 
 
Granted
4,083,379

 
62.11

 
 
Vested
(807,935
)
 
25.16

 
$
45,691

Forfeited
(349,545
)
 
40.76

 
 
Non-vested and outstanding at June 30, 2014
8,353,408

 
$
48.32

 
$
517,577

Expected to vest as of June 30, 2014
7,806,579

 
 
 
$
483,696


RSUs granted under the 2005 Plan and the 2012 Plan to employees generally vest annually over a four-year period. As of June 30, 2014, total unrecognized compensation cost, adjusted for estimated forfeitures, related to unvested RSUs was approximately $332.4 million and the weighted-average remaining vesting period was 3.36 years.

In the six months ended June 30, 2014, we issued restricted stock units with both service and performance-based vesting criteria to certain executives. These restricted stock units will be eligible to vest based on our attainment of the 2014 financial performance goal as well as each executive's continued employment through the vesting date. In order to earn the restricted stock units, the low end of the predetermined goal must be met. The number of restricted stock units to be earned will range from 0% to 200% of the target awards based on the actual level of achievement of the financial performance goal. Shares earned will vest in four quarterly increments from February 2016 contingent on the continuous employment of each executive. We recognize stock-based compensation expense associated with these awards on a graded vesting basis over the vesting period, after assessing the probability of achieving the 2014 financial performance goal. As of June 30, 2014, we estimated 122.9% of target awards will be earned. As actual results are achieved, the probability assessment is updated and stock-based compensation expense is adjusted accordingly.

(12)    Net Loss Per Share
 
The following tables present the calculation of basic and diluted net loss per share (in thousands, except share and per share data): 

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Numerator:
 
 
 
 
 
 
 
Net loss
$
(50,363
)
 
$
(21,405
)
 
$
(93,674
)
 
$
(34,763
)
Denominator:
 
 
 
 
 
 
 
Weighted-average shares outstanding—basic and diluted
144,456,675

 
134,454,085

 
143,267,181

 
132,298,095

Net loss per share:
 
 
 
 
 
 
 
Basic
$
(0.35
)
 
$
(0.16
)
 
$
(0.65
)
 
$
(0.26
)
Diluted
$
(0.35
)
 
$
(0.16
)
 
$
(0.65
)
 
$
(0.26
)
 
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:

12


 
 
June 30,
 
2014
 
2013
Common stock options
19,375,640

 
27,534,924

Restricted stock units
8,353,408

 
3,861,621

Common stock subject to repurchase
45,879

 
150,522

ESPP obligations
187,649

 
268,910

Convertible senior notes
7,783,023

 
—

Warrants related to the issuance of convertible senior notes
7,783,023

 
—

Total potentially dilutive securities
43,528,622

 
31,815,977

 
(13)    Income Taxes

We compute our provision for income taxes by applying the estimated annual effective tax rate to year-to-date loss from recurring operations and adjust the provision for discrete tax items recorded in the period.

Our effective tax rate for the three and six months ended June 30, 2014 was (1)% and (2)%, respectively, which was lower than the U.S. federal statutory tax rate of 34%. The lower tax rate was primarily attributable to our loss from U.S. operations, a foreign tax rate differential, and non-deductible expenses arising from stock-based compensation.

Our effective tax rate for the three and six months ended June 30, 2013 was (4)%, 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.

We are subject to taxation in the United States and foreign jurisdictions.  As of June 30, 2014, our tax years 2005 to 2013 remain subject to examination in most jurisdictions. 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 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 believe that adequate amounts have been reserved for any adjustments that may ultimately result from these examinations, and we do not anticipate a significant impact to our gross unrecognized tax benefits within the next 12 months related to these years. Although the timing of the resolution, settlement, and closure of any audit is highly uncertain, it is reasonably possible that the balance of gross unrecognized tax benefits could significantly change in the next 12 months. However, given the number of years that remain subject to examination, we are unable to estimate the full range of possible adjustments to the balance of gross unrecognized tax benefits.

(14)    Commitments and Contingencies
 
Leases
 
We lease facilities for data center capacity and office space under non-cancelable operating lease agreements with various expiration dates. There have been no material changes in our commitments under contractual obligations, as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2013.
 
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 as discussed below and 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 and other claims. Any adverse determination related to intellectual property claims or other litigation could prevent us from offering our services and adversely affect our financial condition and results of operations.


13


On February 6, 2014, Hewlett-Packard Company filed a lawsuit against us in the U.S. District Court for the Northern District of California that alleges that some of our services infringe the claims of eight of Hewlett-Packard's patents. Hewlett-Packard is seeking unspecified damages and an injunction. We intend to vigorously defend this lawsuit. We cannot make a reasonable estimate of the potential loss or range of loss, if any, arising from this matter.

(15)    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 June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Revenues by geography:
 
 
 
 
 
 
 
North America (1)
$
114,261

 
$
71,855

 
$
209,225

 
$
132,001

EMEA (2)
42,194

 
24,478

 
78,500

 
45,741

Asia Pacific and other
10,302

 
5,889

 
18,122

 
10,419

Total revenues
$
166,757

 
$
102,222

 
$
305,847

 
$
188,161

 
Long-lived assets by geographic area were as follows (in thousands):
 
June 30,
 
December 31,
 
2014
 
2013
Long-lived assets:
 
 
 
North America
$
61,774

 
$
52,937

EMEA(2)
22,373

 
18,017

Asia Pacific and other
12,336

 
4,606

Total long-lived assets
$
96,483

 
$
75,560


(1) Revenues attributed to the United States were approximately 94% of North America revenues for the three months ended June 30, 2014 and 2013 and the six months ended June 30, 2014 and 2013.

(2) Europe, the Middle East and Africa
 
(16) Subsequent Event

On July 11, 2014, we completed the acquisition of a privately-held company, Neebula Systems Ltd. ("Neebula"), by acquiring all issued and outstanding common shares of Neebula for approximately $100 million in an all-cash transaction. Neebula’s flagship product, ServiceWatch, automates the discovery, mapping, and monitoring of IT-enabled enterprise services. The acquisition will expand the overall capabilities of our IT offerings. The following table summarizes the preliminary allocation of the purchase price to the fair value of the tangible and intangible assets acquired and liabilities assumed as of the acquisition date (in thousands):
 
Purchase Price Allocation
(in thousands)
 
 Useful Life
(in years)
Net tangible asset acquired
$
118

 
 
Intangible assets:
 
 
 
Developed technology
56,200

 
5.5
Order backlog
600

 
1.5
Trade names
300

 
1.5
Goodwill
54,564

 
 
Net deferred tax liabilities
(11,319
)
 
 
Total purchase price
$
100,463

 
 

The excess of purchase consideration over the fair value of net tangible and identifiable intangible assets acquired was recorded as goodwill. Management believes the goodwill represents the synergies expected from expanded market opportunities when integrating Neebula technologies with our offerings. The preliminary estimated fair values of assets acquired and liabilities

14


assumed, including current and noncurrent income taxes payable and deferred taxes, and identifiable intangible assets may be subject to change as additional information is received. Thus the provisional measurements of fair value set forth above are subject to change. We expect to finalize the valuation as soon as practicable.

The results of operations of Neebula will be included in our consolidated financial statements from the date of purchase.

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 year ended December 31, 2013 included in the form 10-K dated as of, and filed with the Securities and Exchange Commission, or the SEC, on February 28, 2014 (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 Quarterly Report on 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
 
ServiceNow is a leading provider of cloud-based services to automate and manage IT service relationships across the global enterprise. Our services include a suite of IT service automation applications built on our proprietary platform that can be rapidly deployed and configured. Customers use our services to create a single system of record for enterprise IT, automate manual tasks, standardize processes and consolidate legacy systems. Using ServiceNow, enterprise IT departments can accelerate their shift from the management of IT infrastructure to the management of IT service relationships across the enterprise with greater transparency, accountability and auditability. Our proprietary platform enables our customers to create custom applications and evolve the IT service model to service domains inside and outside the enterprise.
 
We offer our services 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 services to solve a specific and immediate problem. Once that problem is solved, many of our customers deploy additional applications as they become more familiar with our services and apply them 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. We continue to invest in the development of our services, infrastructure and sales and marketing to drive long-term growth. We increased our overall employee headcount to 2,328 as of June 30, 2014 from 1,443 as of June 30, 2013.

Key Factors Affecting Our Performance
 
Upsell rate. 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. Annual contract value is equal to the first 12 months of expected subscription revenues under a contract. The upsell rate was 33% and 25% for the three months ended June 30, 2014 and 2013, respectively, and 34% and 28% for the six months ended June 30, 2014 and 2013, respectively. Our upsells are primarily derived by an increase in the number of seat licenses purchased by our customers and are also derived from the addition of other subscription services.
  

15


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 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. In certain instances, when a customer informs us of their intent not to renew in a period prior to the expiration of their contract, we record the customer as lost immediately in our renewal rate calculation. Typically a customer that reduces its subscription upon renewal is not considered a lost customer. 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 98% and 94% for the three months ended June 30, 2014 and 2013, respectively, and 97% and 95% for the six months ended June 30, 2014 and 2013, respectively.
 
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 with 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 services is counted as a separate customer. As of June 30, 2014 and 2013, our total customer count was 2,364 and 1,778, respectively. Our customer count excludes customers of our recently developed product offering for mid-sized IT departments.

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, increasing access for our partners to utilize our tools and resources, and developing technology to support our growth. We have recently, and may in the future, also enter into acquisition transactions.

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 using our platform. 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 our 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 customer 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, related support and updates to 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, when and if available, 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 32 months and 34 months for the three and six months ended June 30, 2014, respectively, and 32 months for the three and six months ended June 30, 2013. 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 5% to 20% 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. Our pricing for professional services are primarily on a time-and-materials basis. We generally invoice our professional services monthly in arrears based on actual hours and expenses incurred. Other revenues include primarily fees from customer training delivered on-site or publicly available classes, royalties from licensing training materials, attendance and sponsorship fees for our annual Knowledge user conference and other customer forums. Typical payment terms require our customers to pay us within 30 days of invoice.

Allocation of Overhead Costs
 

16


Overhead costs associated with facilities, IT and certain depreciation related to noncloud-based infrastructure are allocated to cost of revenues and operating expenses based on headcount. Depreciation related to our cloud-based infrastructure hardware equipment is classified as cost of subscription revenues.
 
Cost of Revenues
 
Cost of subscription revenues. Cost of subscription revenues consists primarily of expenses related to hosting our services and providing support to our customers. These expenses are comprised of data center capacity costs; personnel related costs directly associated with our cloud-based infrastructure and customer support, including salaries, benefits, bonuses and stock-based compensation; and allocated overhead.

Cost of professional services and other revenues. Cost of professional services and other revenues consists primarily of personnel 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 to third-party vendors are primarily recognized as cost of revenues as the professional services are delivered. Cost of revenues associated with our professional services engagements contracted with third-party vendors as a percentage of professional services and other revenues was 13% and 14% in the three months ended June 30, 2014 and 2013, respectively, and 14% and 15% in the six months ended June 30, 2014 and 2013, respectively.

Sales and Marketing Expenses
 
Sales and marketing expenses consist primarily of personnel 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 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 consist primarily of personnel 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 U.S. deferred tax assets as of June 30, 2014 and 2013. We consider all available evidence, both positive and negative, including but not limited to, earnings history, projected future outcomes, industry and market trends and the nature of each of the deferred tax assets in assessing the extent to which a valuation allowance should be applied against our U.S. deferred tax assets.

Recent Accounting Pronouncement

In May 2014, the Financial Accounting Standards Board ("FASB") issued an update to ASC 606 Revenue from Contracts with Customers (“ASC 606”) that will supersede virtually all existing revenue guidance. Under this update, an entity is required to recognize revenue upon transfer of promised goods or services to customers, in an amount that reflects the expected consideration received in exchange for those goods or services. As such, an entity will need to use more judgment and make more estimates than under the current guidance. This update should be applied retrospectively either to each prior reporting period presented in the financial statements, or only to the most current reporting period presented in the financial statements with a cumulative effect adjustment recorded in the retained earnings. This guidance will become effective for us for our interim and annual reporting periods beginning January 1, 2017. We are currently evaluating the impact of this update on our consolidated financial statements.


17


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 June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
 
 
 
 
Revenues:



 
 
 
 
Subscription
$
132,724

 
$
80,376

 
$
250,099

 
$
151,934

Professional services and other
34,033

 
21,846

 
55,748

 
36,227

Total revenues
166,757

 
102,222

 
305,847

 
188,161

Cost of revenues(1):
 
 
 
 
 
 
 
Subscription
33,243

 
20,219

 
64,432

 
38,531

Professional services and other
25,695

 
15,779

 
47,620

 
29,775

Total cost of revenues
58,938

 
35,998

 
112,052

 
68,306

Gross profit
107,819

 
66,224

 
193,795

 
119,855

Operating expenses(1):
 
 
 
 
 
 
 
Sales and marketing
91,937

 
52,291

 
161,353

 
90,517

Research and development
35,439

 
17,951

 
66,549

 
33,990

General and administrative
24,914

 
15,325

 
46,545

 
27,604

Total operating expenses
152,290

 
85,567

 
274,447

 
152,111

Loss from operations
(44,471
)
 
(19,343
)
 
(80,652
)
 
(32,256
)
Interest and other income (expense), net
(5,231
)
 
(1,323
)
 
(11,194
)
 
(1,204
)
Loss before provision for income taxes
(49,702
)
 
(20,666
)
 
(91,846
)
 
(33,460
)
Provision for income taxes
661

 
739

 
1,828

 
1,303

Net loss
$
(50,363
)
 
$
(21,405
)
 
$
(93,674
)
 
$
(34,763
)
 
(1)
Stock-based compensation included in the statements of operations above was as follows:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
 
 
 
 
Cost of revenues:
 
 
 
 
 
 
 
Subscription
$
3,825

 
$
1,996

 
$
6,901

 
$
3,790

Professional services and other
3,224

 
1,065

 
5,616

 
1,886

Sales and marketing
12,383

 
4,822

 
21,426

 
8,807

Research and development
10,452

 
3,715

 
18,291

 
6,829

General and administrative
7,720

 
3,230

 
14,599

 
5,562





18


 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
Revenues:
 
 
 
 
 
 
 
Subscription
80
 %
 
79
 %
 
82
 %
 
81
 %
Professional services and other
20

 
21

 
18

 
19

Total revenues
100

 
100

 
100

 
100

Cost of revenues:

 

 
 
 
 
Subscription
20

 
20

 
21

 
20

Professional services and other
15

 
15

 
16

 
16

Total cost of revenues
35

 
35

 
37

 
36

Gross profit
65

 
65

 
63

 
64

Operating expenses:

 

 
 
 
 
Sales and marketing
55

 
51

 
53

 
48

Research and development
21

 
18

 
22

 
18

General and administrative
15

 
15

 
15

 
15

Total operating expenses
91

 
84

 
90

 
81

Loss from operations
(26
)
 
(19
)
 
(26
)
 
(17
)
Interest and other income, net
(3
)
 
(1
)
 
(4
)
 
(1
)
Loss before provision for income taxes
(29
)
 
(20
)
 
(30
)
 
(18
)
Provision for income taxes
—

 
1

 
1

 
1

Net loss
(29
)%
 
(21
)%
 
(31
)%
 
(19
)%
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
 
 
 
 
Revenues by geography
 
 
 
 
 
 
 
North America
$
114,261

 
$
71,855

 
$
209,225

 
$
132,001

EMEA (1)
42,194

 
24,478

 
78,500

 
45,741

Asia Pacific and other
10,302

 
5,889

 
18,122

 
10,419

Total revenues
$
166,757

 
$
102,222

 
$
305,847

 
$
188,161

 
(1) Europe, the Middle East and Africa


19


Comparison of the three months ended June 30, 2014 and 2013
 
Revenues 

 
Three Months Ended June 30,
 
% Change    
 
2014
 
2013
 
 
(dollars in thousands)
 
 
Revenues:
 
 
 
 
 
Subscription
$
132,724

 
$
80,376

 
65
%
Professional services and other
34,033

 
21,846

 
56
%
Total revenues
$
166,757

 
$
102,222

 
63
%
Percentage of revenues:
 
 
 
 
 
Subscription
80
%
 
79
%
 
 
Professional services and other
20

 
21

 
 
Total
100
%
 
100
%
 
 
 
Subscription revenues increased $52.3 million during the three months ended June 30, 2014, compared to the same period in the prior year, driven by our upsells, renewals and an increase in our customer count. Our upsell rate and renewal rate for the trailing twelve months ending June 30, 2014 was 33% and 97%, respectively, compared to 28% and 96%, respectively for the trailing 12 months ending June 30, 2013. Total customer count at June 30, 2014 was 2,364 compared to 1,778 at June 30, 2013, an increase of 33%. Revenues from our direct sales organization and channel partners represented 86% and 14%, respectively, for the three months ended June 30, 2014, and 89% and 11% for the three months ended June 30, 2013, respectively.

Professional services and other revenues increased $12.2 million during the three months ended June 30, 2014, compared to the same period in the prior year, due to an increase in the services provided to our growing customer base and improvements in pricing of our professional services engagements.  In addition, revenues from our annual Knowledge user conference increased from $5.0 million for the three months ended June 30, 2013 to $8.2 million for the three months ended June 30, 2014 due to increased sponsorship and paid registration in the current year. This event is held once each year in the second quarter, and all revenues and costs associated with this event are recognized in the quarter in which the event is held. We believe excluding Knowledge revenues facilitates a more meaningful comparison between comparative periods for our professional services and other revenue and gross profit. We expect professional services and other revenues to increase at a slower rate than subscription revenues as we continue to focus on strengthening and supporting our network of professional services partners.
Our average total annual revenues per customer increased to approximately $262,000 for the three months ended June 30, 2014, compared to approximately $217,000 for the three months ended June 30, 2013. Our average total annual revenues per customer is the sum of average quarterly revenues for the trailing four quarters. We calculate average quarterly revenues per customer by dividing the quarter’s revenues by the average number of customers in the quarter.  In the second quarter 2014, we made a change to our calculation to improve the accuracy of our average revenues per customer.  We used this changed calculation for both the three months ended June 30, 2014, and the three months ended June 30, 2013.  The change in methodology increased the average annual revenues per customer that we had disclosed in a prior period for the three months ended June 30, 2013, by 4%.

20


Cost of Revenues and Gross Profit Percentage
 
 
Three Months Ended June 30,
 
% Change    
 
2014
 
2013
 
 
(dollars in thousands)
 
 
Cost of revenues:
 
 
 
 
 
Subscription
$
33,243

 
$
20,219

 
64
%
Professional services and other
25,695

 
15,779

 
63
%
Total cost of revenues
$
58,938

 
$
35,998

 
64
%
Gross profit/(loss) percentage:
 
 
 
 
 
Subscription
75
%
 
75
%
 
 
Professional services and other
24
%
 
28
%
 
 
Total gross profit percentage
65
%
 
65
%
 
 
Gross Profit
$
107,819

 
$
66,224

 
 
Headcount (at period end)
 
 
 
 
 
Subscription
405


266

 
52
%
Professional services and other
370


239

 
55
%
Total headcount
775

 
505

 
53
%
 
Cost of subscription revenues increased $13.0 million during the three months ended June 30, 2014, compared to the same period in the prior year, primarily due to increased headcount resulting in an increase of $5.8 million in personnel related costs excluding stock-based compensation, an increase of $1.8 million in stock-based compensation, an increase of $1.4 million in other overhead expenses and an increase of $1.3 million in depreciation expense primarily due to purchases of cloud-based infrastructure hardware equipment for our data centers. Hosting expenses increased $1.6 million primarily due to the expansion of our data centers.

Our subscription gross profit percentage was 75% for the three months ended June 30, 2014 and 2013. We expect our subscription gross profit percentage to range between 74% and 75% for the remainder of the year as we continue to leverage the investments we have made in our existing data center infrastructure, offset by additional amortization expense we will begin to incur in July 2014 related to developed technology from the acquisition of Neebula Systems Ltd. ("Neebula").

Cost of professional services and other revenues increased $9.9 million during the three months ended June 30, 2014 as compared to the same period in the prior year, primarily due to increased headcount resulting in an increase of $5.5 million in personnel related costs excluding stock-based compensation, an increase of $2.2 million in stock-based compensation, an increase of $1.1 million in outside services costs and an increase of $0.8 million in overhead expenses.

Our professional services and other gross profit percentage decreased to 24% during the three months ended June 30, 2014 compared to 28% for the three months ended June 30, 2013 primarily due to increased stock-based compensation. The decrease in gross profit percentage was partially offset by the increase in revenues from our annual Knowledge user conference. Costs associated with Knowledge are included in sales and marketing expense. Knowledge contributed $8.2 million in revenue, or 24 percentage points to the professional services and other gross profit percentage for the three months ended June 30, 2014. During the three months ended June 30, 2013, Knowledge contributed $5.0 million in revenue, or 22 percentage points to the professional services and other gross profit percentage. We expect a decrease in our professional services and other gross profit percentage for the remainder of the year primarily driven by increasing stock-based compensation and additional investment in our professional services organization.
 
Sales and Marketing
 

21


 
Three Months Ended June 30,
 
% Change    
 
2014
 
2013
 
 
(dollars in thousands)
 
 
Sales and marketing
$
91,937

 
$
52,291

 
76
%
Percentage of revenues
55
%
 
51
%
 
 
Headcount (at period end)
806

 
512

 
57
%
 
Sales and marketing expenses increased $39.6 million during the three months ended June 30, 2014 compared to the same period in the prior year, primarily due to increased headcount that resulted in an increase of $16.1 million in personnel related costs excluding stock-based compensation, an increase of $7.6 million in stock-based compensation, an increase of $1.9 million in overhead expenses and an increase of $6.3 million in commissions expense. Commissions increased primarily due to an increase in bookings. Commissions and referral fees amounted to 11% and 10% of subscription revenues for three months ended June 30, 2014 and 2013, respectively.

In addition, expenses related to our annual Knowledge user conference increased $7.0 million, from $8.3 million for the three months ended June 30, 2013 to $15.3 million for the three months ended June 30, 2014, due to attendance increasing more than 50% year-over-year.

Excluding the charges related to Knowledge, we expect sales and marketing expenses to increase for the remainder of the year, in absolute dollar terms, but to 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. Additionally, the Neebula acquisition added 10 employees to our sales and marketing organizations. We will begin to incur expenses for these employees in July 2014. Excluding the charges from Knowledge makes it easier to compare our sales and marketing expenses in the three months ended June 30, 2014 with our sales and marketing expenses in other quarters.

Research and Development
 
 
Three Months Ended June 30,
 
% Change    
 
2014
 
2013
 
 
(dollars in thousands)
 
 
Research and development
$
35,439

 
$
17,951

 
97
%
Percentage of revenues
21
%
 
18
%
 
 
Headcount (at period end)
470

 
251

 
87
%
 
Research and development expenses increased $17.5 million during the three months ended June 30, 2014 compared to the same period in the prior year, primarily due to increased headcount, which resulted in an increase of $8.5 million in personnel related costs excluding stock-based compensation, an increase of $6.7 million in stock-based compensation and an increase of $1.7 million in overhead expenses.
 
We expect research and development expenses to increase for the remainder of the year, in absolute dollar terms and to increase slightly as a percentage of total revenues as we continue to improve the existing functionality of our services, develop new applications to fill market needs and continue to enhance our core platform. Additionally, the Neebula acquisition added 14 employees to our research and development organization. We will begin to incur expenses for these employees in July 2014.

General and Administrative
 
 
Three Months Ended June 30,
 
% Change    
 
2014
 
2013
 
 
(dollars in thousands)
 
 
General and administrative
$
24,914

 
$
15,325

 
63
%
Percentage of revenues
15
%
 
15
%
 
 
Headcount (at period end)
277

 
175

 
58
%
 
General and administrative expenses increased $9.6 million during the three months ended June 30, 2014 compared to the same period in the prior year, primarily due to increased headcount which resulted in an increase of $3.1 million in personnel

22


related costs excluding stock-based compensation, an increase of $4.5 million in stock-based compensation and an increase of $1.0 million in overhead expenses.

We expect general and administrative expenses to remain relatively flat for the remainder of the year, in absolute dollar terms, but to decrease as a percentage of total revenues. We also expect to incur approximately $0.5M in acquisition related expenses related to Neebula in the three months ended September 31, 2014.
 
Interest and Other Income (Expense), net
 
 
Three Months Ended June 30,
 
% Change    
 
2014
 
2013
 
 
(dollars in thousands)
 
 
Interest and other income (expense), net
$
(5,231
)
 
$
(1,323
)
 
295
%
Percentage of revenues
(3
)%
 
(1
)%
 



Interest and other income (expense), net, decreased $3.9 million during the three months ended June 30, 2014 compared to the same period in the prior year, primarily due to $7.2 million in amortization expense of debt discount and issuance costs related to our convertible senior notes (the "Notes") issued in November 2013, partially offset by a gain from foreign currency transactions and increased interest income. We had a foreign currency transaction gain of $1.2 million for the three months ended June 30, 2014 compared to a loss of $1.6 million for the three months ended June 30, 2013, primarily due to the weakening of the Euro against other major currencies. Interest income increased $0.5 million due to the higher investment balances during the three months ended June 30, 2014 compared to the same period in the prior year.

Our expanding international operations will continue to increase our exposure to currency risks, though we cannot presently predict the impact of this exposure on our consolidated financial statements. While we have not engaged in the hedging of our foreign currency transactions to date, we are conducting an ongoing evaluation of the costs and benefits of initiating such a program and may hedge selected significant transactions denominated in currencies other than the U.S. dollar in the future.

Provision for Income Taxes
 
 
Three Months Ended June 30,
 
% Change    
 
2014
 
2013
 
 
(dollars in thousands)
 
 
Loss before income taxes
$
(49,702
)
 
$
(20,666
)
 
141
 %
Provision for income taxes
661

 
739

 
(11
)%
Effective tax rate
(1
)%
 
(4
)%
 
 
 
Our effective tax rate changed to (1)% for the three months ended June 30, 2014 compared to (4)% for the three months ended June 30, 2013 due to a higher loss from U.S. and foreign operations and an increase in non-deductible stock-based compensation expense.
 
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 operations, we expect that 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.


23


Comparison of the six months ended June 30, 2014 and 2013
 
Revenues 
 
Six Months Ended June 30,
 
% Change    
 
2014
 
2013
 
 
(dollars in thousands)
 
 
Revenues:
 
 
 
 
 
Subscription
$
250,099

 
$
151,934

 
65
%
Professional services and other
55,748

 
36,227

 
54
%
Total revenues
$
305,847

 
$
188,161

 
63
%
Percentage of revenues:
 
 
 
 
 
Subscription
82
%
 
81
%
 
 
Professional services and other
18

 
19

 
 
Total
100
%
 
100
%
 
 
 
Subscription revenues increased $98.2 million during the six months ended June 30, 2014, compared to the same period in the prior year, driven by our upsells, renewals and an increase in our customer count. Revenues from our direct sales organization and channel partners represented 87% and 13%, respectively, for the six months ended June 30, 2014 and 88% and 12% for the six months ended June 30, 2013, respectively.

Professional services and other revenues increased $19.5 million during the six months ended June 30, 2014, compared to the same period in the prior year, due to an increase in the services provided to our growing customer base and improvements in pricing of our professional services engagements. In addition, revenues from our Knowledge conference increased from $5.0 million for the three months ended June 30, 2013 to $8.2 million for the three months ended June 30, 2014 due to increased sponsorship and paid registration in the current year.
 
Cost of Revenues and Gross Profit Percentage
 
 
Six Months Ended June 30,
 
% Change    
 
2014
 
2013
 
 
(dollars in thousands)
 
 
Cost of revenues:
 
 
 
 
 
Subscription
$
64,432

 
$
38,531

 
67
%
Professional services and other
47,620

 
29,775

 
60
%
Total cost of revenues
$
112,052

 
$
68,306

 
64
%
Gross profit/(loss) percentage:
 
 
 
 
 
Subscription
74
%
 
75
%
 
 
Professional services and other
15
%
 
18
%
 
 
Total gross profit percentage
63
%
 
64
%
 
 
Gross Profit
$
193,795

 
$
119,855

 
 
Headcount (at period end)
 
 
 
 
 
Subscription
405

 
266

 
52
%
Professional services and other
370

 
239

 
55
%
Total headcount
775

 
505

 
53
%
 
Cost of subscription revenues increased $25.9 million during the six months ended June 30, 2014, compared to the same period in the prior year, primarily due to increased headcount resulting in an increase of $12.0 million in personnel related costs excluding stock-based compensation, an increase of $3.1 million in stock-based compensation, an increase of $3.0 million in depreciation expense primarily due to purchases of cloud-based infrastructure hardware equipment for our data centers and an increase of $2.4 million in other overhead expenses. Hosting expenses increased $3.1 million primarily due to the expansion of our data centers.


24


Our subscription gross profit percentage was 74% for the six months ended June 30, 2014 compared to 75% for the six months ended June 30, 2013.

Cost of professional services and other revenues increased $17.8 million during the six months ended June 30, 2014 as compared to the same period in the prior year, primarily due to increased headcount resulting in an increase of $10.8 million in personnel related costs excluding stock-based compensation, an increase of $3.7 million in stock-based compensation, an increase of $1.6 million in overhead expenses, and an increase of $1.6 million in outside services costs.

Our professional services and other gross profit percentage decreased to 15% during the six months ended June 30, 2014 compared to 18% for the six months ended June 30, 2013 primarily due to increased stock-based compensation. The decrease in gross profit percentage was partially offset by the increase in revenues from our annual Knowledge user conference. Costs associated with Knowledge are included in sales and marketing expense. Knowledge contributed $8.2 million in revenue, or 15 percentage points to the professional services and other gross profit percentage for the six months ended June 30, 2014. During the six months ended June 30, 2013, Knowledge contributed $5.0 million in revenue, or 13 percentage points to the professional services and other gross profit percentage.
 
Sales and Marketing
 
 
Six Months Ended June 30,
 
% Change    
 
2014
 
2013
 
 
(dollars in thousands)
 
 
Sales and marketing
$
161,353

 
$
90,517

 
78
%
Percentage of revenues
53
%
 
48
%
 
 
Headcount (at period end)
806

 
512

 
57
%
 
Sales and marketing expenses increased $70.8 million during the six months ended June 30, 2014 compared to the same period in the prior year, primarily due to increased headcount that resulted in an increase of $30.8 million in personnel related costs excluding stock-based compensation, an increase of $12.6 million in stock-based compensation, an increase of $4.1 million in overhead expenses and an increase of $13.1 million in commissions expense. Commissions increased primarily due to an increase in bookings. Commissions and referral fees amounted to 11% and 9% of subscription revenues for six months ended June 30, 2014 and 2013, respectively.

In addition, expenses related to our annual Knowledge user conference increased $7.0 million, from $8.3 million for the six months ended June 30, 2013 to $15.3 million for the six months ended June 30, 2014, due to an increase in attendance of more than 50% year-over-year. All other marketing program expenses, which include events, advertising and market data, increased $2.6 million during the six months ended June 30, 2014 compared to the same period in the prior year.

Research and Development
 
 
Six Months Ended June 30,
 
% Change    
 
2014
 
2013
 
 
(dollars in thousands)
 
 
Research and development
$
66,549

 
$
33,990

 
96
%
Percentage of revenues
22
%
 
18
%
 
 
Headcount (at period end)
470

 
251

 
87
%
 
Research and development expenses increased $32.6 million during the six months ended