SREV - 9.30.2013 - 10Q
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 FORM 10-Q 
(Mark One)
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
OR
 
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission file number 001-35108
 SERVICESOURCE INTERNATIONAL, INC.
(Exact name of registrant as specified in our charter)
Delaware
No. 81-0578975
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
 
 
634 Second Street
San Francisco, California
94107
(Address of Principal Executive Offices)
(Zip Code)
(415) 901-6030
(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 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
x
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 Exchange Act).    Yes  ¨    No  x
Indicate number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date:
 
Class
Outstanding as of October 31, 2013
Common Stock
81,095,945



Table of Contents

SERVICESOURCE INTERNATIONAL, INC.
Form 10-Q
INDEX
 
 
Page
No.
 
 
 
Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2013 and 2012

Condensed Consolidated Statements of Comprehensive Loss for the three and nine months ended September 30, 2013 and 2012

Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

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PART I FINANCIAL INFORMATION
 
Item 1.
Financial Statements
SERVICESOURCE INTERNATIONAL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)
 
 
September 30,
2013
 
December 31,
2012
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
174,674

 
$
76,568

Short-term investments
103,604

 
32,874

Accounts receivable, net
63,889

 
65,238

Deferred income taxes
286

 
389

Prepaid expenses and other
5,245

 
5,178

Total current assets
347,698

 
180,247

Property and equipment, net
28,150

 
34,513

Deferred debt issuance costs, net
3,535

 
71

Deferred income taxes, net of current portion
1,921

 
2,321

Other assets, net
761

 
986

Goodwill
6,334

 
6,334

Total assets
$
388,399

 
$
224,472

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
5,698

 
$
3,293

Accrued taxes
2,168

 
1,056

Accrued compensation and benefits
16,988

 
15,738

Accrued liabilities and other
12,932

 
10,403

Obligations under capital leases
333

 
326

Total current liabilities
38,119

 
30,816

Convertible notes, net
112,302

 

Obligations under capital leases, net of current portion
398

 
638

Other long-term liabilities
4,692

 
6,091

Total liabilities
155,511

 
37,545

Commitments and contingencies (Note 7)


 


Stockholders’ equity:
 
 
 
Common stock; $0.0001 par value; 1,000,000 shares authorized; 81,072 shares issued and 80,951 shares outstanding as of September 30, 2013; 75,758 shares issued and 75,637 shares outstanding as of December 31, 2012
8

 
8

Treasury stock
(441
)
 
(441
)
Additional paid-in capital
277,309

 
210,650

Accumulated deficit
(44,261
)
 
(23,398
)
Accumulated other comprehensive income
273

 
108

Total stockholders’ equity
232,888

 
186,927

Total liabilities and stockholders’ equity
$
388,399

 
$
224,472

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

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SERVICESOURCE INTERNATIONAL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Net revenue
$
66,482

 
$
59,090

 
$
195,300

 
$
176,358

Cost of revenue
39,730

 
34,544

 
116,848

 
101,002

Gross profit
26,752

 
24,546

 
78,452

 
75,356

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
13,731

 
13,512

 
43,906

 
41,158

Research and development
5,500

 
4,416

 
18,542

 
13,295

General and administrative
11,177

 
10,000

 
33,182

 
30,639

Total operating expenses
30,408

 
27,928

 
95,630

 
85,092

Loss from operations
(3,656
)
 
(3,382
)
 
(17,178
)
 
(9,736
)
Other income (expense):
 
 
 
 
 
 
 
Interest expense
(1,272
)
 
(70
)
 
(1,376
)
 
(180
)
Other, net
179

 
190

 
(119
)
 
(124
)
Loss before income taxes
(4,749
)
 
(3,262
)
 
(18,673
)
 
(10,040
)
Income tax provision
753

 
322

 
2,190

 
31,589

Net loss
$
(5,502
)
 
$
(3,584
)
 
$
(20,863
)
 
$
(41,629
)
Net loss per share, basic and diluted
$
(0.07
)
 
$
(0.05
)
 
$
(0.27
)
 
$
(0.56
)
Weighted average common shares outstanding, basic and diluted
79,740

 
74,667

 
77,557

 
73,994

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

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SERVICESOURCE INTERNATIONAL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands)
(Unaudited)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Net loss
$
(5,502
)
 
$
(3,584
)
 
$
(20,863
)
 
$
(41,629
)
Other comprehensive income, net of tax:
 
 
 
 
 
 
 
Foreign currency translation adjustments
(180
)
 
(119
)
 
32

 
(192
)
Unrealized gain on short-term investments, net of tax
254

 
(36
)
 
134

 
(10
)
Other comprehensive income, net of tax
74

 
(155
)
 
166

 
(202
)
Total comprehensive loss, net of tax
$
(5,428
)
 
$
(3,739
)
 
$
(20,697
)
 
$
(41,831
)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

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SERVICESOURCE INTERNATIONAL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
 
Nine Months Ended
September 30,
 
2013
 
2012
Cash flows from operating activities
 
 
 
Net loss
$
(20,863
)
 
$
(41,629
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization
9,010

 
7,092

Amortization of debt discount and issuance costs

960

 
135

Accretion of premium on short-term investments
569

 
577

Deferred income taxes
504

 
32,534

Stock-based compensation
17,301

 
15,260

Income tax charge (benefit) from stock-based compensation
249

 
(266
)
Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net
1,527

 
(4,237
)
Prepaid expenses and other
(174
)
 
734

Accounts payable
2,581

 
(1,087
)
Accrued taxes
1,110

 
85

Accrued compensation and benefits
1,227

 
(5,094
)
Accrued liabilities and other
763

 
5,050

Net cash provided by operating activities
14,764

 
9,154

Cash flows from investing activities
 
 
 
Acquisition of property and equipment
(3,108
)
 
(17,049
)
Purchases of short-term investments
(78,502
)
 
(31,100
)
Sales of short-term investments
5,336

 
52,050

Maturities of short-term investments
2,000

 
21,415

Net cash used in (provided by) investing activities
(74,274
)
 
25,316

Cash flows from financing activities
 
 
 
Proceeds from issuance of convertible notes
150,000

 

Issuance costs related to the issuance of convertible senior notes
(4,350
)
 

Payments of convertible note hedges
(31,408
)
 

Proceeds from the issuance of warrants
21,763

 

Repayment on capital leases obligations
(245
)
 
(234
)
Proceeds from common stock issuances
21,969

 
10,279

Income tax charge (benefit) from stock-based compensation
(249
)
 
266

Net cash provided by financing activities
157,480

 
10,311

Net increase in cash and cash equivalents
97,970

 
44,781

Effect of exchange rate changes on cash and cash equivalents
136

 
(487
)
Cash and cash equivalents at beginning of period
76,568

 
65,983

Cash and cash equivalents at end of period
$
174,674

 
$
110,277

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

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SERVICESOURCE INTERNATIONAL, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Note 1 — Description of Business and Basis of Presentation
ServiceSource International, Inc. (together with its subsidiaries, the “Company”) is a global leader in recurring revenue management, partnering with technology and technology-enabled companies to optimize maintenance, support and subscription revenue streams, while also improving customer relationships and loyalty. The Company delivers these results via a cloud-based solution, with dedicated service teams, leveraging benchmarks and best practices derived from their rich database of service and renewal behavior. By integrating software, managed services and data, the Company provides end-to-end management and optimization of the service-contract renewals process, including data management, quoting, selling and recurring revenue business intelligence. The Company receives commissions from its customers based on renewal sales that the Company generates on their behalf under a pay-for-performance model. In addition, the Company recently began to offer a purpose-built Software-As-A-Service (SaaS) application to maximize the renewal of subscriptions, maintenance and support contracts. The Company’s corporate headquarters are located in San Francisco, California. The Company has offices in Colorado, Tennessee, the United Kingdom, Ireland, Malaysia and Singapore.
The accompanying unaudited interim condensed consolidated financial statements (“condensed consolidated financial statements”) include the accounts of ServiceSource International Inc. and its subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation.
These condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“U.S. GAAP” or “GAAP”) for interim financial information, rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial statements, and accounting policies, consistent in all material respects with those applied in preparing our audited annual consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2012. These condensed consolidated financial statements and accompanying notes should be read in conjunction with our annual consolidated financial statements and the notes thereto for the year ended December 31, 2012, included in our Annual Report on Form 10-K. In the opinion of management, these condensed consolidated financial statements reflect all adjustments, including normal recurring adjustments, management considers necessary for a fair statement of our financial position, operating results, and cash flows for the interim periods presented. The results for the interim periods are not necessarily indicative of results for the entire year.
The December 31, 2012 condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. These unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes for the year ended December 31, 2012 included in the Company’s Annual Report on Form 10-K.
Recent Accounting Pronouncements
In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2013-2 “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” ASU No. 2013-2 requires an entity to disaggregate the total change of each component of other comprehensive income either on the face of the income statement or as a separate disclosure in the notes. The new guidance became effective for the Company’s interim period ended March 31, 2013. The Company adopted this guidance and the adoption did not have any impact on its financial position, results of operations or cash flows as the amounts reclassified out of accumulated other comprehensive income is not material.

In June 2013, the FASB determined that an unrecognized tax benefit should be presented as a reduction of a deferred tax asset for a net operating loss (“NOL”) carryforward or other tax credit carryforward when settlement in this manner is available under applicable tax law. This guidance is effective for the Company’s interim and annual periods beginning January 1, 2014. The Company does not believe the adoption of this guidance will have a material impact on its consolidated financial statements.
Note 2 — Cash, cash equivalents and short-term investments
Cash equivalents consist of highly liquid fixed-income investments with original maturities of three months or less at the time of purchase, including money market funds. Short-term investments consist of readily marketable securities with a remaining maturity of more than three months from time of purchase. The Company classifies all of its cash equivalents and short-term investments as “available for sale,” as these investments are free of trading restrictions. These marketable securities are carried at fair value, with the unrealized gains and losses, net of tax, reported as accumulated other comprehensive income and included as a separate component of stockholders’ equity. Gains and losses are recognized when realized. When the Company determines that an other-than-temporary decline in fair value has occurred, the amount of the decline that is related to

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a credit loss is recognized in earnings. Gains and losses are determined using the specific identification method. The Company’s realized gains and losses in the three and nine months ended September 30, 2013 and 2012 were insignificant.
Cash and cash equivalents and short-term investments consisted of the following as of September 30, 2013 and December 31, 2012 (in thousands):

September 30, 2013
 
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Estimated
Fair Value
Cash
$
31,706

 
$

 
$

 
$
31,706

Cash equivalents:
 
 
 
 
 
 
 
Money market mutual funds
142,968

 

 

 
142,968

Total cash and cash equivalents
174,674

 

 

 
174,674

Short-term investments:
 
 
 
 
 
 
 
Corporate bonds
39,518

 
57

 
(20
)
 
39,555

U.S. agency securities
32,235

 
45

 
(6
)
 
32,274

Asset-backed securities
13,968

 
9

 
(20
)
 
13,957

U.S. Treasury securities
17,760

 
58

 

 
17,818

Total short-term investments
103,481

 
169

 
(46
)
 
103,604

Cash, cash equivalents and short-term investments
$
278,155

 
$
169

 
$
(46
)
 
$
278,278

December 31, 2012
 
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Estimated
Fair Value
Cash
$
59,568

 
$

 
$

 
$
59,568

Cash equivalents:
 
 
 
 
 
 
 
Money market mutual funds
17,000

 

 

 
17,000

Total cash and cash equivalents
76,568

 

 

 
76,568

Short-term investments:
 
 
 
 
 
 
 
Corporate bonds
13,389

 
2

 
(14
)
 
13,377

U.S. agency securities
11,280

 
4

 
(1
)
 
11,283

Asset-backed securities
4,670

 
1

 
(5
)
 
4,666

U.S. Treasury securities
3,546

 
2

 

 
3,548

Total short-term investments
32,885

 
9

 
(20
)
 
32,874

Cash, cash equivalents and short-term investments
$
109,453

 
$
9

 
$
(20
)
 
$
109,442

The following table summarizes the cost and estimated fair value of short-term fixed income securities classified as short-term investments based on stated maturities as of September 30, 2013:
 
 
Amortized
Cost
 
Estimated
Fair Value
Less than 1 year
$
8,828

 
$
8,834

Due in 1 to 5 years
94,653

 
94,770

Total
$
103,481

 
$
103,604

As of September 30, 2013, the Company did not consider any of its investments to be other-than-temporarily impaired.
Note 3 — Fair value of financial instruments

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The Company measures certain financial instruments at fair value on a recurring basis. The Company uses a three-tier fair value hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value:
Level 1 valuations are based on quoted prices in active markets for identical assets or liabilities.

Level 2 valuations are based on inputs that are observable, either directly or indirectly, other than quoted prices included within Level 1. Such inputs used in determining fair value for Level 2 valuations include quoted prices in active markets for similar assets or liabilities, quoted prices for identical or similar assets or liabilities 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.
Level 3 valuations are based on information that is unobservable and significant to the overall fair value measurement.
All of the Company’s cash equivalents and short-term investments are classified within Level 1 or Level 2.
The following table presents information about the Company’s financial instruments that are measured at fair value as of September 30, 2013 and indicates the fair value hierarchy of the valuation (in thousands):
 
 
Total
 
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
Description
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
Money market mutual funds
$
142,968

 
$
142,968

 
$

Total cash equivalents
142,968

 
142,968

 

Short-term investments:
 
 
 
 
 
Corporate bonds
39,555

 

 
39,555

U.S. agency securities
32,274

 

 
32,274

Asset-backed securities
13,957

 

 
13,957

U.S. Treasury securities
17,818

 

 
17,818

Total short-term investments
103,604

 

 
103,604

Cash equivalents and short-term investments
$
246,572

 
$
142,968

 
$
103,604

The following table presents information about the Company’s financial instruments that are measured at fair value as of December 31, 2012 and indicates the fair value hierarchy of the valuation (in thousands):
 
 
Total
 
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
Description
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
Money market mutual funds
$
17,000

 
$
17,000

 
$

Total cash equivalents
17,000

 
17,000

 

Short-term investments:
 
 
 
 
 
Corporate bonds
13,377

 

 
13,377

U.S. agency securities
11,283

 

 
11,283

Asset-backed securities
4,666

 

 
4,666

U.S. Treasury securities
3,548

 

 
3,548

Total short-term investments
32,874

 

 
32,874

Cash equivalents and short-term investments
$
49,874

 
$
17,000

 
$
32,874


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The convertible notes issued by the Company in August 2013 are shown in the accompanying consolidated balance sheets at their original issuance value, net of unamortized discount, and are not marked to market each period. The fair value of the convertible notes approximates the notes carrying value as of September 30, 2013. The fair value of the convertible notes was determined using quoted market prices for similar securities, which, due to limited trading activity, are considered Level 2 in the fair value hierarchy.

The Company did not have any financial liabilities measured at fair value as of December 31, 2012.


Note 4 — Property and Equipment, Net
Property and equipment balances were comprised of the following (in thousands):
 
 
September 30,
2013
 
December 31,
2012
Computers and equipment
$
16,672

 
$
14,733

Software
33,603

 
32,982

Furniture and fixtures
8,670

 
8,555

Leasehold improvements
10,911

 
10,801

 
69,856

 
67,071

Less: accumulated depreciation and amortization
(41,706
)
 
(32,558
)
Property and equipment – net
$
28,150

 
$
34,513


Depreciation and amortization expense during the three and nine months ended September 30, 2013 and the three and nine months ended September 30, 2012, was $3.0 million, $9.0 million, $2.5 million and $7.1 million respectively.
Total property and equipment assets under capital lease at September 30, 2013 and December 31, 2012, was $3.2 million and $3.2 million, respectively. Accumulated depreciation related to assets under capital lease as of these dates were $2.5 million and $2.1 million, respectively.
The Company capitalized internal-use software development costs of $0 and $1.5 million during the three months ended September 30, 2013 and 2012, respectively and $0 and $6.6 million during the nine months ended September 30, 2013 and 2012, respectively. As of September 30, 2013 and December 31, 2012, the net value of capitalized costs related to internal-use software, net of accumulated amortization, was $9.8 million and $13.6 million, respectively. Amortization of capitalized costs related to internal-use software for the three months ended September 30, 2013 and 2012 was $1.3 million and $0.8 million, respectively, and for the nine months ended September 30, 2013 and 2012 was $3.8 million and $2.1 million, respectively.
Note 5 — Accrued Liabilities and Other
Accrued liabilities and other balances were comprised of the following (in thousands):
 
 
September 30,
2013
 
December 31,
2012
Deferred revenue
$
4,519

 
$
2,295

Accrued operating expenses
3,128

 
3,664

Deferred rent obligations
861

 
986

Other employee related
482

 
323

Accrued other (includes ESPP contributions of $330 and $1,059 at September 30, 2013 and December 31, 2012, respectively)
3,942

 
3,135

 
$
12,932

 
$
10,403

Note 6 — Credit Facility and Capital Leases
Revolving Credit Facility
On July 5, 2012, the Company, entered into a three-year credit agreement which provides for a secured revolving line of credit based on eligible accounts receivable of up to $25.0 million on and before July 5, 2013 and up to $30.0 million

10

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thereafter, in each case with a $2.0 million letter of credit sublimit. On June 18, 2013, the Company elected to maintain the revolving commitment at $25.0 million rather than have it increase to $30.0 million on July 5, 2013. Proceeds available under the credit agreement may be used for working capital and other general corporate purposes. The Company may prepay borrowing under the agreement in whole or in part at any time without premium or penalty. The Company may terminate the commitments under the credit agreement in whole at any time, and may reduce the commitments by up to $10.0 million between July 1, 2013 and June 30, 2014. On June 30, 2013, the Company amended the credit agreement to reduce the quarterly commitment fee, payable in arrears, based on the available commitments from the existing 0.45% rate to 0.30%.

On August 6, 2013, the Company entered into a second amendment ("Amendment No. 2") to the credit agreement. Amendment No. 2, among other things, allowed the Company to issue certain unsecured convertible notes and enter into related agreements. 
Amounts outstanding on the facility at September 30, 2013 consisted of a letter of credit for $575,000 required under an operating lease agreement for office space at the Company’s San Francisco headquarters. The loans bear interest, at the Company’s option, at a base rate determined in accordance with the credit agreement, minus 0.5%, or at a LIBOR rate plus 2.0%. Principal, together with all accrued and unpaid interest, is due and payable on July 5, 2015, the maturity date. The Company is also obligated to pay a quarterly commitment fee, payable in arrears, based on the available commitments at a rate of 0.30%. At September 30, 2013, the interest rate for borrowings under the facility was 2.2%.
The credit agreement contains customary affirmative and negative covenants, as well as financial covenants. Affirmative covenants include, among others, delivery of financial statements, compliance certificates and notices of specified events, maintenance of properties and insurance, preservation of existence, and compliance with applicable laws and regulations. Negative covenants include, among others, limitations on the ability of the Company to grant liens, incur indebtedness, engage in mergers, consolidations, sales of assets and affiliate transactions. The credit agreement requires the Company to maintain a maximum leverage ratio and a minimum liquidity amount, each as defined in the credit agreement.
The credit agreement also contains customary events of default including, among other things, payment defaults, breaches of covenants or representations and warranties, cross-defaults with certain other indebtedness, bankruptcy and insolvency events and a change in control of the Company, subject to grace periods in certain instances. Upon an event of default, the lender may declare the outstanding obligations of the Company under the credit agreement to be immediately due and payable and exercise other rights and remedies provided for under the credit agreement.
The Company’s obligations under the credit agreement are guaranteed by its subsidiary, ServiceSource Delaware, Inc. (the “Guarantor”) and are collateralized by substantially all of the assets of the Company and the Guarantor.
Effective June 29, 2012, the Company terminated a $20.0 million credit facility. At the time of the termination, no borrowings were outstanding other than a letter of credit in the face amount of $850,000.
Capital Leases
The Company has capital lease agreements that are collateralized by the underlying property and equipment and expire through September 2019. The weighted-average imputed interest rates for the capital lease agreements were 2.6% and 3.8% at September 30, 2013 and 2012, respectively.
Future minimum annual payments under capital lease obligations as of September 30, 2013 were as follows (in thousands):
 
 
September 30,
2013
Years Ending
 
2013 (remaining three months)
$
82

2014
269

2015
76

2016
78

2017
80

Thereafter
146

Total
$
731

Note 7 — Debt

11


Senior Convertible Notes
In August 2013, the Company issued senior convertible notes (the "Notes") raising gross proceeds of $150 million.
The Notes are governed by an Indenture, dated August 13, 2013 (the "Indenture"), between the Company and Wells Fargo Bank, National Association, as trustee. The Notes will mature on August 1, 2018, unless earlier repurchased or converted, and bear interest at a rate of 1.50% per year payable semi-annually in arrears on February 1 and August 1 of each year, commencing February 1, 2014.
The Notes are convertible at an initial conversion rate of 61.6770 of common stock per $1,000 principal amount of Notes, which represents an initial conversion price of approximately $16.21 per share of common stock, subject to anti-dilution adjustments upon certain specified events, including in certain circumstances, upon a make-whole fundamental change (as defined in the Indenture). Upon conversion, the Notes will be settled in cash, shares of the Company’s common stock, or any combination thereof, at the Company’s option.
Prior to February 1, 2018, the Notes are convertible only upon the following circumstances:
during any calendar quarter commencing after December 31, 2013, (and only during such calendar quarter), if 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, the last reported sale price of common stock on such trading day is greater than or equal to 130% of the applicable conversion price on such trading day.
during the five business day period after any five consecutive trading day period in which the trading price per $1,000 principal amount of the Notes for each trading day of that five consecutive trading day period was less than 98% of the product of the last reported sale price of common stock and the applicable conversion rate on each such trading day; or
upon the occurrence of specified corporate events described in the Indenture.
Holders of the Notes may convert their Notes at anytime on or after February 1, 2018, until the close of business on the second schedule trading day immediately preceding the maturity date, regardless of the foregoing circumstances.
The holders of the Notes may require the Company to repurchase all or a portion of their Notes at a cash repurchase price equal to 100% of the principal amount of the Notes being repurchased, plus accrued and unpaid interest, if any, upon a fundamental change (as defined in the Indenture). In addition, upon certain events of default (as defined in the Indenture), the trustee by notice to the Company, or the holders of at least 25% in principal amount of the outstanding Notes by notice to the Company and the trustee, may, and the trustee at the request of such holders shall, declare 100% of the principal amount of the Notes, plus accrued and unpaid interest, if any, on all the Notes to be due and payable. In case of certain events of bankruptcy, insolvency or reorganization involving the Company, 100% of the principal of and accrued and unpaid interest on the Notes will automatically become due and payable.
To account for the Notes at issuance, the Company separated the Notes into debt and equity components pursuant to the accounting standards for convertible debt instruments that may be fully or partially settled in cash upon conversion. The fair value of debt component was estimated using an interest rate for nonconvertible debt, with terms similar to the Notes, excluding the conversion feature. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The excess of the principal amount of the Notes over the fair value of the debt component was recorded as a debt discount and a corresponding increase in additional paid-in capital. The debt discount is accreted to interest expense over the term of the Notes using the interest method. The amount recorded to additional paid-in capital is not to be remeasured as long as it continues to meet the conditions of equity classification. Upon issuance of the $150.0 million of Notes, the Company recorded $111.5 million to debt and $38.5 million to additional paid-in capital.
The Company incurred transaction costs of approximately $4.9 million related to the issuance of the Notes. In accounting for these costs, the Company allocated the costs to the debt and equity components in proportion to the allocation of proceeds from the issuance of the Notes to such components. Transaction costs allocated to the debt component of $3.6 million are deferred as an asset and amortized to interest expense over the term of the Notes. The transaction costs allocated to the equity component of $1.3 million were recorded to additional paid-in capital. The transactions costs allocated to the debt component were recorded as deferred offering costs in other non-current assets.
The net carrying amount of the liability component of the Notes as of September 30, 2013 consists of the following (in thousands):
Principal amount
$
150,000

Unamortized debt discount
(37,698
)
Net carrying amount
$
112,302


12


The following table presents the interest expense recognized related to the Notes for the three months ended September 30, 2013 (in thousands):
Contractual interest expense at 1.5% per annum
$
296

Amortization of debt issuance costs
79

Accretion of debt discount
845

Total
$
1,220

The net proceeds from the Notes were approximately $145.1 million after payment of the initial purchasers' offering expense. The Company used approximately $31.4 million of the net proceeds from the Notes to pay the cost of the Note Hedges described below, which was partially offset by $21.8 million of the proceeds from the Company's sale of the Warrants also described below.
Note Hedges
Concurrent with the issuance of the Notes, the Company entered into note hedges ("Note Hedges") with certain bank counterparties, with respect to its common stock. The Company paid $31.4 million for the Note Hedges. The Note Hedges cover approximately 9.25 million shares of the Company's common stock at a strike price of $16.21 per share. The Note Hedges will expire upon the maturity of the Notes. The Note Hedges are intended to reduce the potential dilution to the Company's common stock upon conversion of the Notes and/or offset the cash payment in excess of the principal amount of the Notes the Company is required to make in the event that the market value per share of the Company's common stock at the time of exercise is greater than the conversion price of the Notes.
Warrants
Separately, the Company entered into warrant transactions, whereby it sold warrants to the same bank counterparties as the Note Hedges to acquire approximately 9.25 million shares of the Company's common stock at an initial strike price of $21.02 per share ("Warrants"), subject to anti-dilution adjustments. The Company received proceeds of approximately $21.8 million from the sale of the Warrants. If the fair value per share of the Company's common stock exceeds the strike price of the Warrants, the Warrants will have a dilutive effect on earnings per share, unless the Company elects, subject to certain conditions, to settle the Warrants in cash.
The amounts paid and received for the Note Hedges and the Warrants have been recorded in additional paid-in capital. The fair value of the Note Hedges and the Warrants are not remeasured through earnings each reporting period.

Note 8 — Commitments and Contingencies
Operating Leases
The Company leases its office space and certain equipment under noncancelable operating lease agreements with various expiration dates through September 30, 2022. Rent expense for the three months ended September 30, 2013 and 2012 was $2.0 million and $2.1 million, respectively, and for the nine months ended September 30, 2013 and 2012 was $6.4 million and $6.4 million, respectively. The Company recognizes rent expense on a straight-line basis over the lease period and accrues for rent expense incurred but not paid.
Future annual minimum lease payments under all noncancelable operating leases as of September 30, 2013 were as follows (in thousands):
 
 
September 30, 2013
Years Ending December 31,
 
2013 (remaining three months).
$
2,301

2014
8,188

2015
6,183

2016
4,374

2017
4,093

Thereafter
12,526

Total
$
37,665



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Other Contractual Obligations
In August 2013, the Company issued the Notes raising gross proceeds of $150.0 million. The Notes will mature on August 1, 2018, earlier repurchased or converted, and bear interest at a rate of 1.50% per year payable semi-annually in arrears on February 1 and August 1 of each year, commencing February 1, 2014.

Litigation
The Company may be subject to litigation or other claims in the normal course of business. In the opinion of management, the Company’s ultimate liability, if any, related to any currently pending or threatened litigation or claims would not materially affect its consolidated financial position, results of operations or cash flows.
Note 9 — Stockholders’ Equity
Stock Option Plans
The Company maintains the following stock plans: the 2011 Equity Incentive Plan (the “2011 Plan”), and the 2011 Employee Stock Purchase Plan. The Company’s board of directors and, as delegated to its compensation committee, administers the 2011 Plan and has authority to determine the directors, officers, employees and consultants to whom options or restricted stock may be granted, the option price or restricted stock purchase price, the timing of when each share is exercisable and the duration of the exercise period and the nature of any restrictions or vesting periods applicable to an option or restricted stock grant
Under the 2011 Plan, options granted are generally subject to a four-year vesting period whereby options become 25% vested after a one-year period and the remainder then vests monthly through the end of the vesting period. Vested options may be exercised up to ten years from the vesting commencement date, as defined in the 2011 Plan. Vested but unexercised options expire three months after termination of employment with the Company. The restricted stock units typically vest over four years with a yearly cliff contingent upon employment with the Company on the applicable vesting dates.
The Company has elected to recognize the compensation cost of all stock-based awards on a straight-line basis over the vesting period of the award. Further, the Company applies an estimated forfeiture rate to unvested awards when computing the share compensation expenses. The Company estimates the forfeiture rate for unvested awards based on its historical experience on employee turnover behavior and other factors.
At the end of each fiscal year, the share reserve under the 2011 Plan increases automatically by an amount equal to 4% of the outstanding shares as of the end of that most recently completed fiscal year or 3,840,000 shares, whichever is less. On January 1, 2013, 3.0 million additional shares were reserved under the 2011 Equity Incentive Plan pursuant to the automatic increase.
Determining Fair Value of Stock Awards
The Company estimates the fair value of stock option awards at the date of grant using the Black-Scholes option-pricing model. Options are granted with an exercise price equal to the fair value of the common stock as of the date of grant. Compensation expense is amortized net of estimated forfeitures on a straight-line basis over the requisite service period of the options, which is generally four years. Restricted stock, upon vesting, entitles the holder to one share of common stock for each restricted stock and has a purchase price of $0.0001 per share, which is equal to the par value of the Company’s common stock, and vests over four years. The fair value of the restricted stock is based on the Company’s closing stock price on the date of grant, and compensation expense, net of estimated forfeitures, is recognized on a straight-line basis over the vesting period.
The weighted average Black-Scholes model assumptions for the three and nine months ended September 30, 2013 and 2012 were as follows:
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Expected term (in years)
5.0

 
5.0

 
5.0

 
5.1

Expected volatility
43
%
 
46
%
 
44
%
 
46
%
Risk-free interest rate
1.48
%
 
0.67
%
 
0.95
%
 
0.78
%
Expected dividend yield

 

 

 


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Option and restricted stock activity under the 2011 Plan for the nine months ended September 30, 2013 was as follows (shares in thousands)
 
 
 
 
Options Outstanding
 
Restricted Stock
Outstanding
 
Shares and Units
Available
for Grant
 
Number
of Shares
 
Weighted-
Average
Exercise
Price
 
Number
of Shares
Outstanding — December 31, 2012
4,024

 
15,189

 
$
6.98

 
3,928

Additional shares reserved under the 2011 equity incentive plan
3,025

 

 

 

Granted
(4,746
)
 
2,304

 
7.00

 
2,442

Options exercised/ Restricted stock released

 
(4,494
)
 
4.45

 
(558
)
Canceled/Forfeited
5,000

 
(4,053
)
 
10.47

 
(947
)
Outstanding — September 30, 2013
7,303

 
8,946

 
5.57

 
4,865

    
The weighted average grant-date fair value of employee stock options granted during the three months ended September 30, 2013 and 2012 was $4.86 and $3.41 per share, respectively and for the nine months ended September 30, 2013 and 2012 was $3.03 and $6.07 per share, respectively.
The following table summarizes the consolidated stock-based compensation expense included in the condensed consolidated statements of operations (in thousands):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Cost of revenue
$
802

 
$
763

 
$
2,222

 
$
2,050

Sales and marketing
2,414

 
2,180

 
7,396

 
5,836

Research and development
753

 
562

 
1,758

 
1,455

General and administrative
1,989

 
2,148

 
5,925

 
5,919

Total stock-based compensation
$
5,958

 
$
5,653

 
$
17,301

 
$
15,260

Employee Stock Purchase Plan
The Company’s 2011 Employee Stock Purchase Plan (the “ESPP”) is intended to qualify under Section 423 of the Internal Revenue Code of 1986. Under the ESPP, employees are eligible to purchase common stock through payroll deductions
of up to 10% of their eligible compensation, subject to any plan limitations. The purchase price of the shares on each purchase date is equal to 85% of the lower of the fair market value of the Company’s common stock on the first and last trading days of each twelve month offering period.
The ESPP provides that additional shares are reserved under the plan annually on the first day of each fiscal year in an amount equal to the lesser of (i) 1.5 million shares, (ii) one percent of the outstanding shares of common stock on the last day of the immediately preceding fiscal year, or (iii) an amount determined by the board of directors and/or the compensation committee of the board of directors. On January 1, 2013, 750,000 additional shares were reserved under the ESPP pursuant to the plan's automatic increase provision. As of September 30, 2013, 686,957 shares had been issued under the ESPP and 1,695,089 shares were available for future issuance.
Note 10 — Income Taxes
The Company files U.S. federal and state and foreign income tax returns in jurisdictions with varying statutes of limitations. In the normal course of business the Company is subject to examination by taxing authorities throughout the world. These audits include questioning the timing and amount of deductions, the allocation of income among various tax jurisdictions and compliance with federal, state, local and foreign tax laws. The Company is currently undergoing examination of the California Franchise Tax Returns relating to California state income taxes of its operating subsidiary for the years 2008 through 2010. The 2008 through 2012 tax years generally remain subject to examination by federal, state and foreign tax authorities. The Company’s gross amount of unrecognized tax benefits increased from $0.4 million as of December 31, 2012 to $0.6

15

Table of Contents

million as of September 30, 2013, $55,000 of which, if recognized, would affect the company’s effective tax rate. It is difficult to predict the final timing and resolution of any particular uncertain tax position. Based on the Company’s assessment of many factors, the Company does not expect that changes in the liability for unrecognized tax benefits for the next twelve months will have a significant impact on the Company’s consolidated financial position or results of operations.

During the quarter ended September 30, 2013,, consistent with the Company’s practice in prior periods, management assessed the realizability of deferred tax assets based on the available evidence, including a history of taxable income and estimates of future taxable income. In performing its evaluation, management placed significant emphasis on guidance in ASC 740, which states that “[a] cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.” Based upon available evidence, management concluded on a more-likely-than-not basis that most of the Company‘s U.S. deferred tax assets were not realizable. Significant negative evidence included U.S. pretax losses (as calculated consistent with ASC 740) in each of the Company‘s 2013 quarters and for the cumulative twelve-quarter period ended September 30, 2013,. Additionally, company forecasts indicated a continuation of U.S adjusted pretax losses for calendar year 2013. The Company also concluded on a more-likely-than-not basis that its Singapore and Ireland deferred tax assets were not realizable, based on cumulative pretax losses incurred for the cumulative twelve-quarter period ended September 30, 2013 and forecast pretax losses for the remainder of the year.

Other factors were considered but provided neither positive nor negative objectively-verifiable evidence as to the realization of our deferred tax assets.

At September 30, 2013 management concluded that the cumulative losses for the most recent three years, as well as the losses during calendar 2013, represented significant negative evidence as to why a valuation allowance was warranted. Management also considered the Company’s near-term financial forecast on a jurisdictional basis which indicated that three-year cumulative loss estimates in the U.S., Singapore and Ireland would not reverse in the near future. Assessing these factors and the fact that that the most objective and verifiable data were the cumulative three-year losses in each jurisdiction through September 30, 2013, management concluded that, on a more-likely-than-not basis, the Company’s U.S., Singapore and Ireland tax deferred tax assets would not be realized. As a result, the Company provided a valuation allowance for all US federal deferred tax assets, net of liabilities, for all Ireland and Singapore net deferred tax assets, and for substantially all of the Company’s state deferred tax assets. The remaining deferred tax assets at September 30, 2013 relate to jurisdictions in which the Company has net adjusted historical pretax profits and sufficient forecast profitability to assure future realization of such deferred tax assets.

Management will continue to assess the realization of the Company’s deferred tax assets at each balance sheet date by applying the provisions of ASC 740. These evaluations will consider all positive and negative factors identified by management at each reporting date.

The Company considers the undistributed earnings of its foreign subsidiaries permanently reinvested in foreign operations and has not provided for U.S. income taxes on such earnings.

On January 2, 2013, the American Taxpayer Relief Act of 2012 was enacted, which reinstated the federal research tax credit retroactive to January 1, 2012 and extended the credit through December 31, 2013. The 2012 federal research tax credit along with the first nine months of 2013 federal research tax credit, which would otherwise have been recognized in the first nine months of 2013, is fully offset by a valuation allowance.
Note 11 — Reportable Segments
The Company’s operations are principally managed on a geographic basis and are comprised of three reportable and operating segments: NALA, EMEA, and APJ, as defined below.
The Company reports segment information based on the management approach. The management approach designates the internal reporting used by the Company’s Chief Operating Decision Maker (“CODM”), for making decisions and assessing
performance as the source of the Company’s reportable segments. The CODM is the Company’s Chief Executive Officer. The CODM allocates resources to and assesses the performance of each of the operating segment using information about its revenue and direct profit contribution, which is management’s measure of segment profitability. Management has determined that the Company’s reportable and operating segments are as follows, based on the information used by the CODM:
NALA — Includes operations from offices in San Francisco, California; Denver, Colorado and Nashville, Tennessee related primarily to end customers in North America.

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EMEA — Includes operations from offices in Liverpool, United Kingdom and Dublin, Ireland related primarily to end customers in Europe.
APJ — Includes operations from offices in Singapore related primarily to end customers in Asia Pacific and Japan. Operations in Kuala Lumpur, Malaysia are allocated to the reportable segment of where the customer is located.
The Company does not allocate sales and marketing, research and development, or general and administrative expenses to its geographic regions because management does not include the information in its measurement of the performance of the operating segments. The Company excludes certain items such as stock-based compensation, overhead allocations and other items from direct profit contribution. Revenue for a particular geography reflects fees the Company earns from its customers for sales and renewals of maintenance, support and subscription contracts on their behalf and managed from the Company’s sales center in that geography.
Summarized financial information by geographic location based on the Company’s internal management reporting and as utilized by the Company’s CODM, is as follows (in thousands):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Net revenue
 
 
 
 
 
 
 
NALA
$
45,068

 
$
37,647

 
$
125,357

 
$
110,720

EMEA
15,625

 
14,159

 
51,383

 
45,425

APJ
5,789

 
7,284

 
18,560

 
20,213

Total net revenue
$
66,482

 
$
59,090

 
$
195,300

 
$
176,358

Direct profit contribution
 
 
 
 
 
 
 
NALA
$
23,612

 
$
20,928

 
$
67,222

 
$
60,101

EMEA
7,813

 
6,739

 
25,692

 
23,809

APJ
2,219

 
873

 
4,927

 
2,627

Total direct profit contribution
33,644

 
28,540

 
97,841

 
86,537

Adjustments:
 
 
 
 
 
 
 
Stock-based compensation
(802
)
 
(763
)
 
(2,222
)
 
(2,050
)
Other, net
(6,090
)
 
(3,231
)
 
(17,167
)
 
(9,131
)
Gross profit
$
26,752

 
$
24,546

 
$
78,452

 
$
75,356

12. Related Party Transactions
Richard Campione was elected to the Company’s Board of Directors (the “Board”) on November 29, 2012. On December 19, 2012, the Company entered into a consulting agreement with Mr. Campione under which Mr. Campione provides certain software consulting services to the Company. The Audit Committee of the Board pre-approved this consulting agreement in accordance with the Company’s formal policy regarding related party transactions. The Company paid Mr. Campione $0.3 million for consulting services provided during the term of the agreement, which ended April 30, 2013.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and with our Annual Report on Form 10-K for the year ended December 31, 2012.
This Quarterly Report on Form 10-Q contains “forward-looking statements” that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. These forward-looking statements include, but are not limited to, statements related to changes in market conditions that impact our ability to generate service revenue on behalf of our customers; errors in estimates as to the service revenue we can generate for our customers; our ability to attract new customers and retain existing customers; risks associated with material defects or errors in our software or the effect of data security breaches; our ability to adapt our solution to changes in the market or new competition; our ability to improve our customers’ renewal rates, margins and profitability; our ability to increase our revenue and contribution margin over time from new and existing customers, including as a result of sales of our next-generation technology platform, Renew OnDemand, on a stand-alone subscription basis; our ability to implement Renew OnDemand; the potential effect of mergers and acquisitions on our customer base; business strategies and new sales initiatives; technology development; protection of our intellectual property; investment and financing plans; liquidity, our leverage consisting of our recently issued convertible notes and related matters concerning our note hedges and warrants; our competitive position; the effects of competition; industry environment; and potential growth opportunities. Forward-looking statements are also often identified by the use of words such as, but not limited to, “anticipate,” “believe,” “can,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “project,” “seek,” “should,” “target,” “will,” “would,” and similar expressions or variations intended to identify forward-looking statements. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section of this Quarterly Report on Form 10-Q titled “Risk Factors.” Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.
All dollar amounts expressed as numbers in this MD&A (except per share amounts) are in millions.
OVERVIEW
We manage the service contract renewals process for renewals of maintenance, support and subscription agreements on behalf of our customers. Our integrated solution consists of dedicated service sales teams working under our customers’ brands and our proprietary Renew OnDemand platform and applications. By integrating software, managed services and data, we address the critical steps of the renewals process including data management, quoting, selling and service revenue business intelligence. Our business is built on our pay-for-performance model, whereby our revenues are based on the service renewals customers achieve with our solution, although we have been establishing a base of subscription revenue agreements to our technology platform and applications.
We are currently in the midst of a significant investment cycle in which we have taken steps designed to drive our future growth and profitability. We plan to further build out our infrastructure, develop our technology and support Renew OnDemand, our next-generation technology platform, offer additional cloud-based applications, including on a stand-alone, subscription basis, and hire additional sales, service sales and other personnel. These steps impacted our expenses in recent periods as well as our spending for capital expenditures, and are expected to continue to impact our profitability and cash flows in future periods. We have devoted significant resources to developing Renew OnDemand, our software application suite, and we expect our investment in Renew OnDemand to continue. In addition, we plan to devote significant resources to expanding our sales organization, building out the related partner ecosystem, and further developing our service organization to support the platform. We also plan on making targeted brand investments at industry events such as Dreamforce. On the sales side, we have seen early success with some of the new sales incentives around Renew OnDemand subscriptions, which drives short-term expense, but has improved our time to market this new solution. The capital expenditures and expenses related to Renew OnDemand are in addition to the expenses of operating our existing technology platform. While these expenses will be incurred and recognized in the near-term, we expect to generate revenues from the sale of subscriptions to Renew OnDemand that will increase over time in 2014.

Key Business Metrics


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Table of Contents

In assessing the performance of our business, we consider a variety of business metrics in addition to the financial metrics discussed below under, “Basis of Presentation.” These key metrics include service revenue opportunity under management and number of engagements.

Service Revenue Opportunity Under Management. At September 30, 2013, we estimate our opportunity under management to be over $9 billion. Service revenue opportunity under management (“opportunity under management”) is a forward-looking metric and is our estimate, as of a given date, of the value of all end customer service contracts that we will have the opportunity to sell on behalf of our customers over the subsequent twelve-month period. Opportunity under management is not a measure of our expected revenue. In addition, opportunity under management reflects our estimate for a forward twelve-month period and should not be used to estimate our opportunity for any particular quarter within that period. The value of end customer contracts actually delivered during a twelve-month period should not be expected to occur in even quarterly increments due to seasonality and other factors impacting our customers and their end customers.

We estimate the value of such end customer contracts based on a combination of factors, including the value of end customer contracts made available to us by customers in past periods, the minimum value of end customer contracts that our customers are required to give us the opportunity to sell pursuant to the terms of their contracts with us, periodic internal business reviews of our expectations as to the value of end customer contracts that will be made available to us by customers, the value of end customer contracts included in the Service Performance Analysis ("SPA") and collaborative discussions with our customers assessing their expectations as to the value of service contracts that they will make available to us for sale. While the minimum value of end customer contracts that our customers are required to give us represents a portion of our estimated opportunity under management, a significant portion of the opportunity under management is estimated based on the other factors described above. As our experience with our business, our customers and their contracts has grown, we have continually refined the process, improved the assumptions and expanded the data related to our calculation of opportunity under management.

When estimating service revenue opportunity under management, we must, to a large degree, rely on the assumptions described above, which may prove incorrect. These assumptions are inherently subject to significant business and economic uncertainties and contingencies, many of which are beyond our control. Our estimates therefore may prove inaccurate, causing the actual value of end customer contracts delivered to us in a given twelve-month period to differ from our estimate of opportunity under management. These factors include:

the extent to which customers deliver a greater or lesser value of end customer contracts than may be required or otherwise expected;
roll-overs of unsold service contract renewals from prior periods to the current period or future periods;
changes in the pricing or terms of service contracts offered by our customers;
increases or decreases in the end customer base of our customers;
the extent to which the renewal rates we achieve on behalf of a customer early in an engagement affect the amount of opportunity that the customer makes available to us later in the engagement;
customer cancellations of their contracts with us; and
changes in our customers’ businesses, sales organizations, management, sales processes or priorities.

Our revenue also depends on our close and commissions rates. Our close rate is the percentage of opportunity under management that we renew on behalf of our customers. Our commission rate is an agreed-upon percentage of the renewal value of end customer contracts that we sell on behalf of our customers.

Our close rate is impacted principally by our ability to successfully sell service contracts on behalf of our customers. Other factors impacting our close rate include: the manner in which our customers price their service contracts for sale to their end customers; the stage of life-cycle associated with the products and underlying technologies covered by the service contracts offered to the end customer; the extent to which our customers or their competitors introduce new products or underlying technologies; the nature, size and age of the service contracts; and the extent to which we have managed the renewals process for similar products and underlying technologies in the past.

In determining commission rates for an individual engagement, various factors, including our close rates, as described above, are evaluated. These factors include: historic, industry-specific and customer-specific renewal rates for similar service contracts; the magnitude of the opportunity under management in a particular engagement; the number of end customers associated with these opportunities; and the opportunity to receive additional performance commissions when we exceed certain renewal levels. We endeavor to set our commission rates at levels commensurate with these factors and other factors that may be relevant to a particular engagement.


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Table of Contents

Accordingly, our commission rates vary, often significantly, from engagement to engagement. In addition, we sometimes agree to lower commission rates for engagements with significant opportunity under management.

Number of Engagements. We track the number of engagements we have with our customers. We often have multiple engagements with a single customer, particularly where we manage the sales of service renewals relating to different product lines, technologies, types of contracts or geographies for the customer. When the set of renewals we manage on behalf of a customer is associated with a separate customer contract or a distinct product set, type of end customer contract or geography and therefore requires us to assign a service sales team to manage the differentiated renewals, we designate each set of renewals, and associated revenues and costs to us as a unique engagement. For example, we may have one engagement consisting of a service sales team selling maintenance contract renewals of a particular product for a customer in the United States and another engagement consisting of a sales team selling warranty contract renewals of a different product for the same customer in Europe. These would count as two engagements. We had approximately 145, 120 and 100 engagements as of December 31, 2012, 2011 and 2010, respectively.
Factors Affecting our Performance
Sales Cycle. We sell our integrated solution through our sales organization. At the beginning of the sales process, our quota-carrying sales representatives contact prospective customers and educate them about our offerings. Educating prospective customers about the benefits of our solution can take time, as many of these prospects have not historically relied upon integrated solutions like ours for service revenue management, nor have they typically put out a formal request for proposal or otherwise made a decision to focus on this area. As part of our sales process, we utilize our solutions design team to perform a
Service Performance Analysis (“SPA”) of our prospect’s service revenue. The SPA includes an analysis of best practices and benchmarks the prospect’s service revenue against industry peers. Through the SPA process, which typically takes several weeks, we are able to assess the characteristics and size of the prospect’s service revenue, identify potential areas of performance improvement, and formulate our proposal for managing the prospect’s service revenue. The length of our sales cycle for a new customer, inclusive of the SPA process and measured from our first formal discussion with the customer until execution of a new customer contract, is typically longer than six months and has increased in recent periods.
We generally contract with new customers to manage a specified portion of their service revenue opportunity, such as the opportunity associated with a particular product line or technology, contract type or geography. We negotiate the engagement-specific terms of our customer contracts, including commission rates, based on the output of the SPA, including the areas identified for improvement. Once we demonstrate success to a customer with respect to the opportunity under contract, we seek to expand the scope of our engagement to include other opportunities with the customer. For some customers, we manage all or substantially all of their service contract renewals.
Implementation Cycle. After entering into an engagement with a new customer, and to a lesser extent after adding an engagement with an existing customer, we incur sales and marketing expenses related to the commissions owed to our sales personnel. The commissions are based on the estimated total contract value, with a material portion of the commission expensed upfront with the remaining portion expensed ratably over a period of twelve to fourteen months. We also make upfront investments in technology and personnel to support the engagement. These expenses are typically incurred one to three months before we begin generating sales and recognizing revenue. Accordingly, in a given quarter, an increase in new customers, and, to a lesser extent, an increase in engagements with existing customers, or a significant increase in the contract value associated with such new customers and engagements, will negatively impact our gross margin and operating margins until we begin to achieve anticipated sales levels associated with the new engagements, which is typically two-to-three quarters after we begin selling contracts on behalf of our customers.
Although we expect new customer engagements to contribute to our operating profitability over time, in the initial periods of a customer relationship, the near term impact on our profitability can be negatively impacted by slower-than anticipated growth in revenues for these engagements as well as the impact of the upfront costs we incur, the lower initial level of associated service sales team productivity and lack of mature data and technology integration with the customer. As a result, an increase in the mix of new customers as a percentage of total customers may initially have a negative impact on our operating results. Similarly, a decline in the ratio of new customers to total customers may positively impact our near-term operating results.
Contract Terms. Substantially all of our revenue comes from our pay-for-performance model. Under our pay-for-performance model, we earn commissions based on the value of service contracts we sell on behalf of our customers. In some cases, we earn additional performance-based commissions for exceeding pre-determined service renewal targets.
Since 2009, our new customer contracts have typically had a term of approximately 36 months, although we sometimes have contract terms of up to 60 months. Our contracts generally require our customers to deliver a minimum value of

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qualifying service revenue contracts for us to renew on their behalf during a specified period. To the extent that our customers do not meet their minimum contractual commitments over a specified period, they may be subject to fees for the shortfall. Our customer contracts are cancelable on relatively short notice, subject in most cases to the payment of an early termination fee by the customer. The amount of this fee is based on the length of the remaining term and value of the contract.
We invoice our customers on a monthly basis based on commissions we earn during the prior month, and with respect to performance-based commissions, on a quarterly basis based on our overall performance during the prior quarter. Amounts invoiced to our customers are recognized as revenue in the period in which our services are performed or, in the case of performance commissions, when the performance condition is determinable. Because the invoicing for our services generally coincides with or immediately follows the sale of service contracts on behalf of our customers, we do not generate or report a significant deferred revenue balance. However, the combination of minimum contractual commitments, our success in generating improved renewal rates for our customers, our customers’ historical renewal rates and the performance improvement potential identified by our SPA process, provides us with revenue visibility.
M&A Activity. Our customers, particularly those in the technology sector, participate in an active environment for mergers and acquisitions. Large technology companies have maintained active acquisition programs to increase the breadth and depth of their product and service offerings and small and mid-sized companies have combined to better compete with large technology companies. A number of our customers have merged, purchased other companies or been acquired by other companies. We expect merger and acquisition activity to continue to occur in the future.
The impact of these transactions on our business can vary. Acquisitions of other companies by our customers can provide us with the opportunity to pursue additional business to the extent the acquired company is not already one of our customers.
Similarly, when a customer is acquired, we may be able to use our relationship with the acquired company to build a relationship with the acquirer. In some cases we have been able to maintain our relationship with an acquired customer even where the acquiring company handles its other service contract renewals through internal resources. In other cases, however, acquirers have elected to terminate or not renew our contract with the acquired company. For example, Oracle terminated our contracts with Sun Microsystems effective as of September 30, 2010 and had previously terminated our contract with another customer, BEA Systems, in April 2008.
Economic Conditions and Seasonality. An improving economic outlook generally has a positive, but mixed, impact on our business. As with most businesses, improved economic conditions can lead to increased end customer demand and sales. In particular, within the technology sector, we believe that the recent economic downturn led many companies to cut their expenses by choosing to let their existing maintenance, support and subscription agreements lapse. An improving economy may have the opposite effect.
However, an improving economy may also cause companies to purchase new hardware, software and other technology products, which we generally do not sell on behalf of our customers, instead of purchasing maintenance, support and subscription services for existing products. To the extent this occurs, it would have a negative impact on our opportunities in the near term that would partially offset the benefits of an improving economy.
We believe the current uncertainty in the economy, combined with shifting market forces toward subscription-based models, is impacting a number of our customers and prospective customers, particularly in the traditional enterprise software and hardware segments. These forces have placed pressure on end customer demand for their renewal contracts and also have led to some slower decision making in general. This economic and industry environment has adversely affected the conversion rates for end customers and contracts. To the extent these conditions continue they will impact our future revenues.
In addition to the uncertainty in the macroeconomic environment, we experience a seasonal variance in our revenue typically for the third quarter of the year as a result of lower or flat renewal volume corresponding to the timing of our customers’ product sales particularly in the international regions. The impact of this seasonal fluctuation can be amplified if the economy as a whole is experiencing disruption or uncertainty, leading to deferral of some renewal decisions. As we increase our subscription revenue base, this seasonality will become less apparent. However for at least the next couple years, we would expect this pattern to continue.
Adoption of “Software-as-a-Service” Solutions. Within the software industry, there is a growing trend toward providing software to customers using a software-as-a-service (“SaaS”) model. Under this model, SaaS companies provide access to software applications to customers on a remote basis, and provide their customers with a subscription to use the software, rather than licensing software to their customers. SaaS companies face a distinct set of challenges with respect to customer renewals, given the potentially lower switching costs for customers utilizing their solutions, and are more reliant on renewals for their long-term revenues than traditional software companies. Given the strategic importance of renewals to their model, SaaS companies may be less inclined than traditional software companies to rely on third-party solutions such as ours to manage the sale of renewals of subscription contracts. We have tailored our solution to address the needs of SaaS companies in this area

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and expect to continue to develop and enhance our solution as this market grows, especially with our Renew OnDemand application suite.
In connection with our purpose-built SaaS offering to manage and maximize recurring revenue, we intend to significantly increase our investment in our customer support, training and professional services organizations to support deployments of Renew OnDemand. We anticipate that the cost of providing professional services, support and training will be significant and that our gross profit will be adversely affected as we build out these functions.
Basis of Presentation
Net Revenue
Substantially all of our net revenue is attributable to commissions we earn from the sale of renewals of maintenance, support and subscription agreements on behalf of our customers. We generally invoice our customers for our services in arrears on a monthly basis for sales commissions, and on a quarterly basis for certain performance sales commissions; accordingly, we typically have no deferred revenue related to these services. We do not set the price, terms or scope of services in the service contracts with end customers and do not have any obligations related to the underlying service contracts between our customers and their end customers.
We also earn revenue from the sale of subscriptions to our cloud based applications. To date, subscription revenue has been insignificant, but we expect revenues generated from subscriptions to Renew OnDemand to increase in 2014. Subscription fees are accounted for separately from commissions, and they are billed in advance over a monthly, quarterly or annual basis. Subscription revenue is recognized ratably over the related subscription term.

We have generated a significant portion of our revenue from a limited number of customers. Our top ten customers accounted for 51% and 49% of our net revenue for the three months ended September 30, 2013 and 2012, respectively, and 49% and 48% for the nine months ended September 30, 2013 and 2012, respectively.
Our business is geographically diversified. During the third quarter of 2013, 68% of our net revenue was earned in North America and Latin America (“NALA”), 23% in Europe, Middle East and Africa (“EMEA”) and 9% in Asia Pacific-Japan (“APJ”). Net revenue for a particular geography generally reflects commissions earned from sales of service contracts managed from our sales centers in that geography. Predominantly all of the service contracts sold and managed by our sales centers relate to end customers located in the same geography. Our APJ segment is our most recent segment, and as a result accounts for less of our net revenue. In addition, our Kuala Lumpur location is also our global sales operations center where we have centralized, for our worldwide operations, the key contract renewal processes that do not require regional expertise, such as customer data management and quoting. We do not generate any customer revenue out of Kuala Lumpur, so it is effectively a cost center which contributes to our APJ segment contributing significantly less net revenue when compared to our NALA and EMEA segments.
Cost of Revenue and Gross Profit
Our cost of revenue expenses include compensation, technology costs, including those related to the delivery of our cloud-based solutions, and allocated overhead costs. Compensation includes salary, bonus, benefits and stock-based compensation for our dedicated service sales teams. Our allocated overhead includes costs for facilities, information technology and depreciation, including amortization of internal-use software associated with our service revenue technology platform and cloud applications. Allocated costs for facilities consist of rent, maintenance and compensation of personnel in our facilities departments. Our allocated costs for information technology include costs associated with third-party data centers where we maintain our data servers, compensation of our information technology personnel and the cost of support and maintenance contracts associated with computer hardware and software. To the extent our customer base or opportunity under management expands, we may need to hire additional service sales personnel and invest in infrastructure to support such growth. We currently expect that our cost of revenue will fluctuate significantly and may increase on an absolute basis and as a percentage of revenue in the near term, including for the reasons discussed above under, “—Factors Affecting Our Performance—Implementation Cycle” and as a result of our near term plans to run dual technology platforms for several quarters as we commence the launch of Renew OnDemand while maintaining our existing technology platform.
Operating Expenses
Sales and Marketing. Sales and marketing expenses are the largest component of our operating expenses and consist primarily of compensation and sales commissions for our sales and marketing staff, allocated expenses and marketing programs and events. We sell our solutions through our global sales organization, which is organized across three geographic regions: NALA, EMEA and APJ. Our commission plans provide that payment of commissions to our sales representatives is contingent

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on their continued employment, and we recognize expense over a period that is generally between twelve and fourteen months following the execution of the applicable contract. We currently expect sales and marketing expenses to increase on an absolute basis and as a percentage of revenue in the near term based on commissions earned on customer contracts entered into in prior periods, as well as continued investments in sales and marketing personnel and programs as we expand our business domestically and internationally and pursue new sales initiatives.
Research and Development. Research and development expenses consist primarily of compensation, allocated costs and the cost of third-party service providers. We focus our research and development efforts on developing new products, including Renew OnDemand, our next-generation technology platform, and adding new features to our existing technology platform. In connection with the development and enhancements of our SaaS applications, we capitalize certain expenditures related to the development and enhancement of internal-use software related to our technology platform. We expect research and development spending to increase on an absolute basis and as a percentage of revenue in the near term as we continue to invest in our Renew OnDemand platform and our expectation that future capitalization of internal-use software costs will be insignificant.
General and Administrative. General and administrative expenses consist primarily of compensation for our executive, human resources, finance and legal functions, and related expenses for professional fees for accounting, tax and legal services, as well as allocated expenses. We expect that our general and administrative expenses will increase on an absolute basis to support our anticipated growth.

Other Income (Expense)

Interest expense. Interest expense consists primarily of interest expense associated with fees related to our our credit facility, our convertible debt; capital lease payments; accretion of debt discount; and amortization of debt issuance costs. We recognize accretion of debt discount and amortization of interest costs using the effective interest method. We expect our interest expense to increase significantly from accretion of debt discount, amortization of deferred financing costs and contractual interest costs as a result of our August 2013 issuance of $150 million aggregate principal amount of convertible notes.

Other, Net. Other, net consists primarily of the interest income earned on our cash, cash equivalents and marketable securities investments and foreign exchange gains and losses. We expect other, net to vary depending on the movement in foreign currency exchange rates and the related impact on our foreign exchange gain (loss) and the return of interest on our investments.
Income Tax (Benefit) Provision

We account for income taxes using an asset and liability method, which requires the recognition of taxes payable or refundable for the current year and deferred tax assets and liabilities for the expected future tax consequences of temporary differences that currently exist between the tax basis and the financial reporting basis of our taxable subsidiaries’ assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in operations in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.

We evaluate the need for and amount of any valuation allowance for our deferred tax assets on a jurisdictional basis. This evaluation utilizes the framework contained in ASC 740, Income Taxes, wherein management analyzes all positive and negative evidence available at the balance sheet date to determine whether all or some portion of our deferred tax assets will not be realized. Under this guidance, a valuation allowance must be established for deferred tax assets when it is more likely than not (a probability level of more than 50 percent) that they will not be realized. In assessing the realization of our deferred tax assets, we consider all available evidence, both positive and negative.
    
In performing our evaluation, we place significant emphasis on guidance contained in ASC 740, which states that “[a] cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome.”

We account for unrecognized tax benefits using a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. We record an income tax liability, if any, for the difference between the benefit recognized and measured and the tax position taken or expected to be taken on our tax returns. To the extent that the assessment of such tax positions change, the change in estimate is recorded in

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the period in which the determination is made. The reserves are adjusted in light of changing facts and circumstances, such as the outcome of a tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate.

Results of Operations
The table below sets forth our consolidated results of operations for the periods presented. The period-to-period comparison of financial results presented below is not necessarily indicative of financial results to be achieved in future periods.
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
 
(in thousands)
Net revenue
$
66,482

 
$
59,090

 
$
195,300

 
$
176,358

Cost of revenue
39,730

 
34,544

 
116,848

 
101,002

Gross profit
26,752

 
24,546

 
78,452

 
75,356

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
13,731

 
13,512

 
43,906

 
41,158

Research and development
5,500

 
4,416

 
18,542

 
13,295

General and administrative
11,177

 
10,000

 
33,182

 
30,639

Total operating expenses
30,408

 
27,928

 
95,630

 
85,092

Loss from operations
(3,656
)
 
(3,382
)
 
(17,178
)
 
(9,736
)
Other income (expense):
 
 
 
 
 
 
 
Interest expense
(1,272
)
 
(70
)
 
(1,376
)
 
(180
)
Other, net
179

 
190

 
(119
)
 
(124
)
Loss before income taxes
(4,749
)
 
(3,262
)
 
(18,673
)
 
(10,040
)
Income tax provision
753

 
322

 
2,190

 
31,589

Net loss
$
(5,502
)
 
$
(3,584
)
 
$
(20,863
)
 
$
(41,629
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
 
(in thousands)
Includes stock-based compensation of:
 
 
 
Cost of revenue
$
802

 
$
763

 
$
2,222

 
$
2,050

Sales and marketing
2,414

 
2,180

 
7,396

 
5,836

Research and development
753

 
562

 
1,758

 
1,455

General and administrative
1,989

 
2,148

 
5,925

 
5,919

Total stock-based compensation
$
5,958

 
$
5,653

 
$
17,301

 
$
15,260



The following table sets forth our operating results as a percentage of net revenue:


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Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
 
(as % of net revenue)
 
(as % of net revenue)
Net revenue
100
 %
 
100
 %
 
100
 %
 
100
 %
Cost of revenue
60
 %
 
58
 %
 
60
 %
 
57
 %
Gross profit
40
 %
 
42
 %
 
40
 %
 
43
 %
Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
21
 %
 
23
 %
 
22
 %
 
23
 %
Research and development
8
 %
 
7
 %
 
9
 %
 
8
 %
General and administrative
17
 %
 
17
 %
 
17
 %
 
17
 %
Total operating expenses
46
 %
 
47
 %
 
48
 %
 
48
 %
Loss from operations
(6
)%
 
(5
)%
 
(8
)%
 
(5
)%


Three months ended September 30, 2013 and September 30, 2012

Net Revenue
 
 
Three Months Ended
September 30,
 
 
 
 
 
2013
 
2012
 
 
 
 
 
Amount
 
% of Net Revenue
 
Amount
 
% of Net Revenue
 
Change
 
% Change
 
(in thousands)
Net revenue
 
 
 
 
 
 
 
 
 
 
 
NALA
$
45,068

 
68
%
 
$
37,647

 
64
%
 
$
7,421

 
20
 %
EMEA
15,625

 
23
%
 
14,159

 
24
%
 
1,466

 
10
 %
APJ
5,789

 
9
%
 
7,284

 
12
%
 
(1,495
)
 
(21
)%
Total net revenue
$
66,482

 
100
%
 
$
59,090

 
100
%
 
$
7,392

 
13
 %

Net revenue increased $7.4 million, or 13%, for the third quarter of 2013, compared to the third quarter of 2012. Our revenue performance was driven by a combination of growth in opportunity from new and existing customers including some of our large enterprise accounts, as well as strong performance in our NALA and EMEA service sales centers in closing service revenue renewals. Approximately $0.9 million of the revenue growth in the third quarter of 2013 relates to incremental revenue as a result of one large customer's revenue becoming fixed and determinable in the current quarter as opposed to a quarter in arrears. The increase in our customer engagements resulted from new engagements with certain existing customers as well as new customer acquisitions due to our investments in our sales organization. These increases were partially offset by some customers in APJ where the scope of our services was reduced.
Cost of Revenue and Gross Profit
 
 
Three Months Ended
September 30,
 
 
 
 
 
2013
 
2012
 
Change
 
% Change
 
(in thousands)
 
 
 
 
Cost of revenue
$
39,730

 
$
34,544

 
$
5,186

 
15
 %
         Included stock-based compensation of:
802

 
763

 
39

 
 
Gross profit
26,752

 
24,546

 
2,206

 
9
 %
Gross profit percentage
40
%
 
42
%
 
 
 
(2
)%

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The 15% increase in our cost of revenue in the third quarter of 2013 reflected a $3.0 million increase in compensation, attributable in part to an increase in the number of sales enablement personnel in our global sales operations center in Kuala Lumpur, Malaysia and professional services personnel associated with implementation of our Renew OnDemand application suite for our customers, as well as a $1.8 million increase in technology and amortization expense of our internally developed software. Gross profit percentage in the third quarter of 2013 was down as compared to third quarter of 2012 as scale and outperformance in our managed services business was offset by the increased professional services expenses incurred in the quarter. For the next several quarters, we expect that we will have increased spending to continue support for our legacy service revenue intelligence platform in addition to growing support expenditures for our Renew OnDemand application suite.
Operating Expenses
 
 
Three Months Ended
September 30,
 
 
 
 
 
2013
 
2012
 
 
 
 
 
Amount
 
% of Net Revenue
 
Amount
 
% of Net Revenue
 
Change
 
% Change
 
(in thousands)
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Sales and marketing
$
13,731

 
21
%
 
$
13,512

 
23
%
 
$
219

 
2
%
Research and development
5,500

 
8
%
 
4,416

 
7
%
 
1,084

 
25
%
General and administrative
11,177

 
17
%
 
10,000

 
17
%
 
1,177

 
12
%
Total operating expenses
$
30,408

 
46
%
 
$
27,928

 
47
%
 
$
2,480

 
9
%
Includes stock-based compensation of:
 
 
 
 
 
 
 
Sales and marketing
$
2,414

 
 
 
$
2,180

 
 
 
$
234

 
 
Research and development
753

 
 
 
562

 
 
 
191

 
 
General and administrative
1,989

 
 
 
2,148

 
 
 
(159
)
 
 
Total stock-based compensation
$
5,156

 
 
 
$
4,890

 
 
 
$
266

 
 

Sales and marketing expenses
Sales and Marketing spending increased slightly due to the investments in the reinvention of our brand. We expect additional targeted increases in sales and marketing expense in the fourth quarter of 2013 as we implement new sales incentives for Renew OnDemand and continue to expand marketing efforts to raise awareness of our solutions and brand.
Research and development expenses
The 25% increase in research and development expense in the third quarter of 2013 was primarily due to no capitalization of labor and third party costs for development of internal-use software in the third quarter of 2013 as compared to $1.5 million capitalized costs in the third quarter of 2012, offset by lower expenses due to transition of configuration engineers from R&D to professional services as these individuals focus more on revenue generating activities. We expect research and development spending to increase on an absolute basis and as a percentage of revenue in the near term as we continue to enhance our Renew OnDemand platform. We do not expect future capitalization of internal-use software costs to be significant.
General and administrative expenses
The 12% increase in general and administrative expense in the third quarter of 2013 as compared to the third quarter of 2012 reflected a $0.7 million increase in compensation due to headcount growth across all geographies and investments in our IT infrastructure to support our global operations.
Other Expense, Net


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Three Months Ended
September 30,
 
 
 
 
 
2013
 
2012
 
 
 
 
 
Amount
 
% of Net Revenue
 
Amount
 
% of Net Revenue
 
Change
 
% Change
 
(in thousands)
Interest expense
$
(1,272
)
 
(1.91
)%
 
$
(70
)
 
(0.12
)%
 
$
(1,202
)
 
1,717.14
 %
Other, net
$
179

 
0.27
 %
 
$
190

 
0.32
 %
 
$
(11
)
 
(5.79
)%

Interest expense for the third quarter of 2013 increased by $1.2 million as compared to the same period in 2012 due to accretion of debt discount and the amortization of debt issuance costs of $0.9 million and interest expense of $0.3 million for the convertible notes issued in August 2013.
Income Tax Provision
 
 
Three Months Ended
September 30,
 
 
 
 
 
2013
 
2012
 
Change
 
% Change
 
(in thousands)
 
 
 
 
Income tax provision
$
753

 
$
322

 
$
431

 
134
%

In the third quarter of 2013, we recorded a charge to income tax expense of $0.8 million. This amount primarily represents anticipated taxes in jurisdictions where we have profitable operations, including certain US states, offset by benefits available from foreign losses. No benefit was otherwise provided for losses incurred in the U.S. and Singapore, because these losses are offset by a full valuation allowance.
In the third quarter of 2012, we recorded a tax provision of $0.3 million, primarily reflecting expected cash taxes in jurisdictions where we have profitable operations.

Nine months ended September 30, 2013 and September 30, 2012
Net Revenue
 
 
Nine Months Ended
September 30,
 
 
 
 
 
2013
 
2012
 
 
 
 
 
Amount
 
% of Net Revenue
 
Amount
 
% of Net Revenue
 
Change
 
% Change
 
(in thousands)
Net revenue
 
 
 
 
 
 
 
 
 
 
 
NALA
$
125,357

 
64
%
 
$
110,720

 
63
%
 
$
14,637

 
13
 %
EMEA
51,383

 
26
%
 
45,425

 
26
%
 
5,958

 
13
 %
APJ
18,560

 
10
%
 
20,213

 
11
%
 
(1,653
)
 
(8
)%
Total net revenue
$
195,300

 
100
%
 
$
176,358

 
100
%
 
$
18,942

 
11
 %

Net revenue increased $14.6 million, or 13%, in the nine months ended September 30, 2013, compared to the nine months ended September 30, 2012. Our revenue performance was driven by a combination of growth in opportunity from new and existing customers, as well as strong performance across our NALA and EMEA service sales centers in closing service revenue renewals. The increase in net revenue reflects revenue growth in NALA and EMEA, due to an increase in the number and value of service contracts sold on behalf of our customers and the ramp of new engagements entered into in 2012. These increases were partially offset by some customers in APJ where the scope of our services was reduced.
Cost of Revenue and Gross Profit
 

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Nine Months Ended
September 30,
 
 
 
 
 
2013
 
2012
 
Change
 
% Change
 
(in thousands)
 
 
 
 
Cost of revenue
$
116,848

 
$
101,002

 
$
15,846

 
16
 %
         Included stock-based compensation of:
2,222

 
2,050

 
172

 
 
Gross profit
78,452

 
75,356

 
3,096

 
4
 %
Gross profit percentage
40
%
 
43
%
 
 
 
(3
)%

The 16% increase in our cost of revenue in the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012, reflected an increase in the number of service sales personnel, primarily in NALA and APJ, as we pursue new sales initiatives and professional services personnel associated with implementation of our Renew OnDemand application suite for our customers resulting in a $11.0 million increase in compensation and a $5.9 million increase in allocated costs for facilities, including incremental facility costs related to expansion of facilities in NALA and APJ, and greater allocations for information technology and depreciation. Gross profit in the first half of 2013 was also adversely impacted by the slower ramp of some of our larger new engagements and due to staffing and technology costs associated with the deployment of our cloud applications. For the next several quarters, we expect that our spending will reflect increased amounts to support our legacy service revenue intelligence platform in addition to our recently-announced Renew OnDemand application suite as well as increased spending on deployments of our cloud applications.
Operating Expenses
 
 
Nine Months Ended
September 30,
 
 
 
 
 
2013
 
2012
 
 
 
 
 
Amount
 
% of Net Revenue
 
Amount
 
% of Net Revenue
 
Change
 
% Change
 
(in thousands)
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Sales and marketing
$
43,906

 
22
%
 
$
41,158

 
23
%
 
$
2,748

 
7
%
Research and development
18,542

 
9
%
 
13,295

 
8
%
 
5,247

 
39
%
General and administrative
33,182

 
17
%
 
30,639

 
17
%
 
2,543

 
8
%
Total operating expenses
$
95,630

 
48
%
 
$
85,092

 
48
%
 
$
10,538

 
12
%
Includes stock-based compensation of:
 
 
 
 
 
 
 
Sales and marketing
$
7,396

 
 
 
$
5,836

 
 
 
$
1,560

 
 
Research and development
1,758

 
 
 
1,455

 
 
 
303

 
 
General and administrative
5,925

 
 
 
5,919

 
 
 
6

 
 
Total stock-based compensation
$
15,079

 
 
 
$
13,210

 
 
 
$
1,869

 
 

Sales and marketing expenses

The 7% increase in sales and marketing expenses in the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012, reflected higher stock-based compensation and an increase in the number of sales and marketing personnel, primarily in NALA and EMEA resulting in a $4.5 million increase in compensation. The increase in headcount reflected our investment in sales and marketing resources aimed at expanding our customer base. The increase was partially offset by lower marketing expenses of $1.8 million in the first nine months of 2013 as a result of lower spending on brand development initiatives. We expect additional targeted increases in sales and marketing expense in the fourth quarter of 2013 as we implement new sales incentives for Renew OnDemand and expand marketing efforts to raise awareness of our solutions and brand.
Research and development expenses
The 39% increase in research and development expense in the in the nine months ended September 30, 2013 was primarily due to no capitalization of labor and third party costs for development of internal-use software in the nine months

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ended September 30, 2013 as compared to $5.8 million capitalized costs in the nine months ended September 30, 2012, offset by lower expenses due to transition of configuration engineers from R&D to professional services as these individuals focus more on revenue generating activities. We expect research and development spending to increase on an absolute basis and as a percentage of revenue in the near term as we continue to enhance our Renew OnDemand platform. We do not expect that future capitalization of internal-use software costs to be significant.
General and administrative expenses
The 8 % increase in general and administrative expense in the nine months ended September 30, 2013 as compared to the nine months ended September 30, 2012 reflected a $1.2 million increase in compensation due to hiring and investments in our IT infrastructure to support our global operations.
Other Expense, Net
 
Nine Months Ended
September 30,
 
 
 
 
 
2013
 
2012
 
 
 
 
 
Amount
 
% of Net Revenue
 
Amount
 
% of Net Revenue
 
Change
 
% Change
 
(in thousands)
Interest expense
$
(1,376
)
 
(1
)%
 
$
(180
)
 
 %
 
$
(1,196
)
 
664
 %
Other, net
$
(119
)
 
 %
 
$
(124
)
 
 %
 
$
5

 
(4
)%

Interest expense for the nine months ended September 30, 2013 increased by $1.2 million as compared to the same period in 2012 due to accretion of debt discount and the amortization of debt issuance costs of $0.9 million and interest expense of $0.3 million for the convertible notes issued in August 2013.
Income Tax Provision
 
Nine Months Ended
September 30,
 
 
 
 
 
2013
 
2012
 
Change
 
% Change
 
(in thousands)
 
 
 
 
Income tax provision
$
2,190

 
$
31,589

 
$
(29,399
)
 
(93
)%

For the nine months ended September 30, 2013, we recorded a charge to income tax expense of $2.2 million. This amount primarily represents anticipated taxes in jurisdictions where we have profitable operations, including certain US states, offset by benefits available from foreign losses. No benefit was otherwise provided for losses incurred in U.S. and Singapore, because these losses are offset by a full valuation allowance.
For the nine months ended September 30, 2012, we recorded a charge to income tax expense of $31.6 million. During the second quarter of 2012, a valuation allowance against our U.S. deferred tax assets was recorded in the amount of $31.8 million. Accordingly, the computation of the effective tax rate does not include US losses, nor does it include losses incurred by our Singapore subsidiary, which are offset by a full valuation allowance. Current year-to-date tax expense also reflect the reversal of prior quarter deferred tax benefits, plus tax expense in jurisdictions we have tax profitable operations.
Liquidity and Capital Resources
In August 2013, we issued $150 million aggregate principal amount of 1.50% convertible notes due August 1, 2018 (the "Notes") and concurrently entered into convertible notes hedges and separate warrant transactions. The Notes will mature on August 1, 2018, unless earlier converted. Upon conversion, the Notes will be settled in cash, shares of our stock, or any combination thereof, at the our option. We received proceeds of $145.6 million from the issuance of the convertible notes, net of associated fees, received $21.8 million from the issuance of the warrants and paid $31.4 million for the note hedges. The Notes are classified as a noncurrent liability on our condensed consolidated balance sheet as of September 30, 2013.
At September 30, 2013, we had cash, cash equivalents and short-term investments of $278.3 million, which primarily consisted of money market mutual funds, corporate bonds and U.S. government obligations held by well-capitalized financial

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institutions. In addition, at September 30, 2013, we had cash and cash equivalents of $5.3 million held outside of the U.S. by our foreign subsidiaries that was generated by such subsidiaries and which is used to satisfy their current operating requirements. We consider the undistributed earnings of our foreign subsidiaries to be permanently reinvested in foreign operations and our current plans do not require us to repatriate these earnings to fund our U.S. operations as we have sufficient cash, cash-equivalents and short-term investments held in the U.S. and have access to external funding under our credit agreement.
Our primary operating cash requirements include the payment of compensation and related costs, working capital requirements related to accounts receivable and accounts payable, as well as costs for our facilities and information technology infrastructure. Historically, we have financed our operations principally from cash provided by our operating activities, proceeds from stock offerings and the exercise of stock options, and to a lesser extent, from borrowings under various credit facilities, with no such borrowings in 2013. We believe our existing cash and cash equivalents and short-term investments and our currently available credit facility will be sufficient to meet our working capital and capital expenditure needs for at least the next twelve months.
    
Credit Facility
On June 29, 2012, we terminated a revolving credit facility scheduled to expire in February 2013. The credit facility provided for a $20.0 million line of credit. At the time of termination, no borrowings other than a letter of credit in the face amount of $850,000 were outstanding under the credit facility.
On July 5, 2012, we entered into a three-year credit agreement (the “Credit Agreement”). The Credit Agreement provides for a secured revolving line of credit based on eligible accounts receivable in an amount up to $25.0 million on and before July 5, 2013 and up to $30.0 million thereafter, in each case with a $2.0 million letter of credit sublimit. On June 18, 2013, we elected to reduce our revolving commitment by $5 million from $30 million to $25 million. Proceeds available under the Credit Agreement may be used for working capital and other general corporate purposes. We have the option to prepay the loans under the Credit Agreement in whole or in part at any time without premium or penalty. We also have the option to terminate the commitments under the Credit Agreement in whole at any time, and may reduce the commitments by up to $10.0 million between July 1, 2013 and June 30, 2014.

On August 6, 2013, we entered into a second amendment ("Amendment No. 2") to the Credit Agreement. Amendment No. 2, among other things, allowed us to issue the convertible notes and enter into certain related agreements. 
The loans under the Credit Agreement bear interest, at our option, at a base rate determined in accordance with the Credit Agreement, minus 0.50%, or at a LIBOR rate plus 2.00%. Principal, together with all accrued and unpaid interest, is due and payable on July 5, 2015, the maturity date. We are also obligated to pay a quarterly commitment fee, payable in arrears, based on the available commitments.
The Credit Agreement contains customary affirmative and negative covenants, as well as financial covenants. Affirmative covenants include, among others, delivery of financial statements, compliance certificates and notices of specified events, maintenance of properties and insurance, preservation of existence, and compliance with applicable laws and regulations. Negative covenants include, among others, limitations on our ability and our subsidiaries’ ability to grant liens, incur indebtedness, engage in mergers, consolidations, sales of assets and affiliate transactions. The Credit Agreement requires us to maintain a maximum leverage ratio and a minimum liquidity amount, each as defined in the Credit Agreement.
The Credit Agreement also contains customary events of default including, among other things, payment defaults, breaches of covenants or representations and warranties, cross-defaults with certain other indebtedness, bankruptcy and insolvency events and change in control of the Company, subject to grace periods in certain instances. Upon an event of default, the lender may declare the outstanding obligations of the Company under the Credit Agreement to be immediately due and payable and exercise other rights and remedies provided for under the Credit Agreement.
Our obligations under the Credit Agreement are guaranteed by our subsidiary, ServiceSource Delaware, Inc., and are collateralized by substantially all of our assets and our subsidiary’s assets.
Summary Cash Flows
The following table sets forth a summary of our cash flows for the periods indicated (in thousands):
 

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Nine Months Ended
September 30,
 
2013
 
2012
Net cash provided by operating activities
$
14,764

 
$
9,154

Net cash provided by (used in) investing activities
(74,274
)
 
25,316

Net cash provided by financing activities
157,480

 
10,311

Net increase in cash and cash equivalents, net of impact of foreign exchanges on cash
98,106

 
44,294

Operating Activities
Net cash provided by operating activities was $14.8 million during the nine months ended September 30, 2013. Net loss during the period was $20.9 million adjusted by non-cash charges of $9.0 million for depreciation and amortization and $17.3 million for stock-based compensation. Cash generated from operations during the nine months ended September 30, 2013 resulted from sequential changes in our working capital including a $1.5 million decrease in accounts receivable, a $2.6 million increase in accounts payable and a $1.2 million increase in accrued compensation and benefits.

Net cash provided by operating activities was $9.1 million during the nine months ended September 30, 2012. Our net loss during the period was $41.6 million, which was impacted by a valuation allowance of $33.1 million for a substantial portion of our deferred tax assets and adjusted by non-cash charges of $7.1 million for depreciation and amortization and $15.3 million for stock-based compensation. Cash provided for operations resulted from changes in our working capital, including a $5.1 million increase in other accrued liabilities. Uses of cash were related to a $4.2 million increase in accounts receivable, a $5.1 million decrease in accrued compensation and benefits largely due to bonuses that were accrued at December 30, 2011 and were paid out during the first quarter of 2012 and a $1.1 million decrease in accounts payable.
Investing Activities
During the nine months ended September 30, 2013 cash used in investing activities was principally for the purchases of short-term investments, net of sales and maturities of $71.2 million, and to a lesser extent for property and equipment purchases of $3.1 million. 

During the nine months ended September 30, 2012 cash provided by investing activities was principally from the sales of short-term investments, net of purchases and maturities, of $42.4 million. Use of cash was related to purchases of property and equipment of $17.0 million, including costs capitalized for development of internal-use software. 
Financing Activities
Cash provided by financing activities of $157.5 million in the nine months ended September 30, 2013 was primarily due to net proceeds from our convertible notes of $145.6 million and proceeds from the issuance of warrants of $21.8 million, and proceeds from stock option exercises and the purchase of common stock under our employee stock purchase plan of $22.0 million. These proceeds were partially offset by our payment of $31.4 million for the convertible note hedges.

Cash provided by financing activities was $10.3 million during the nine months ended September 30, 2012 and principally resulted from proceeds of $10.3 million from the exercise of common stock options and the purchase of common stock under our employee stock purchase plan.

Off-Balance Sheet Arrangements
We do not have any relationships with other entities or financial partnerships, such as entities often referred to as structured finance or special-purpose entities, which have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Contractual Obligations and Commitments
Our principal commitments consist of obligations under operating leases for office space and computer equipment. At September 30, 2013, the future minimum payments under these commitments were as follows (in thousands):
 

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Total
 
Less than 1 year
 
1-3 years
 
3-5 years
 
More than 5 years
Obligations under capital leases
$
731

 
$
333

 
$
232

 
$
166

 
$

Operating lease obligations
37,665

 
8,593

 
15,608

 
9,169

 
4,295

 
$
38,396

 
$
8,926

 
$
15,840

 
$
9,335

 
$
4,295

The contractual commitment amounts in the table above are associated with agreements that are enforceable and legally binding, which specify significant terms including payment terms, related services and the approximate timing of the transaction. Obligations under contracts that we can cancel without a significant penalty are not included in the table above.

Additionally in August 2013, we issued senior convertible notes (the “Notes”) raising gross proceeds of $150.0 million. The Notes are governed by an Indenture, dated August 13, 2013, between us and Wells Fargo Bank, National Association, as trustee. The Notes will mature on August 1, 2018, unless earlier repurchased or converted, and bear interest at a rate of 1.50% per year payable semi-annually in arrears on February 1 and August 1 of each year, commencing February 1, 2014.
Also excluded from the table above is the income tax liability we recorded for the difference between the benefit recognized and measured and the tax position taken or expected to be taken on our tax returns (“unrecognized tax benefits”). As of September 30, 2013, our liability for unrecognized tax benefits was $0.1 million. Reasonably reliable estimates of the amounts and periods of related future payments cannot be made at this time.
Critical Accounting Policies and Estimates
Management has determined that our most critical accounting policies are those related to revenue recognition, stock-based compensation, capitalized internal-use software and income taxes. We continue to monitor our accounting policies to ensure proper application of current rules and regulations. There have been no material changes in our critical accounting policies and estimates during the three and nine months ended September 30, 2013 as compared to the critical accounting policies and estimates disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations–Critical Accounting Policies and Estimates” of our Annual Report on Form 10-K for the year ended December 31, 2012 as filed with the Securities and Exchange Commission on March 8, 2013.
Recent Accounting Pronouncements
The information contained in Note 1 to our condensed consolidated financial statements in Item 1 under the heading, “Recently Adopted Accounting Pronouncements,” is incorporated by reference into this Item 2.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We believe that there have been no significant changes in our market risk exposures for the three and nine months ended September 30, 2013, as compared with those discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012.
Item 4. Controls and Procedures
(a)Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) of the end of the period covered by this report (the “Evaluation Date”).
In designing and evaluating our disclosure controls and procedures, management recognizes that any disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objec