10-Q
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, 2015
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.)
 
 
760 Market Street, 4th floor
San Francisco, California
94102
(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 30, 2015
Common Stock
86,267,187



Table of Contents

SERVICESOURCE INTERNATIONAL, INC.
Form 10-Q
INDEX
 
 
Page
No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

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PART I FINANCIAL INFORMATION
 
Item 1.
Financial Statements
SERVICESOURCE INTERNATIONAL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
(Unaudited)
 
September 30,
2015
 
December 31,
2014
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
73,829

 
$
90,382

Short-term investments
136,769

 
125,000

Accounts receivable, net
56,131

 
70,163

Deferred income taxes
390

 
398

Prepaid expenses and other
7,086

 
6,815

Total current assets
274,205

 
292,758

Property and equipment, net
25,020

 
25,658

Deferred income taxes, net of current portion
1,471

 
2,488

Goodwill and intangibles, net
9,823

 
10,957

Other assets, net
8,546

 
7,985

Total assets
$
319,065

 
$
339,846

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
1,902

 
$
2,922

Accrued taxes
773

 
1,721

Accrued compensation and benefits
19,866

 
20,056

Deferred revenue
5,942

 
7,018

Accrued expenses
5,562

 
8,882

Other current liabilities
1,307

 
2,569

Total current liabilities
35,352

 
43,168

Convertible notes, net
126,178

 
120,730

Other long-term liabilities
4,779

 
4,660

Total liabilities
166,309

 
168,558

Commitments and contingencies (Note 8)

 

Stockholders’ equity:
 
 
 
Common stock; $0.0001 par value; 1,000,000 shares authorized; 86,226 shares issued and 86,105 shares outstanding as of September 30, 2015; 83,928 shares issued and 83,807 shares outstanding as of December 31, 2014
8

 
8

Treasury stock
(441
)
 
(441
)
Additional paid-in capital
327,512

 
312,017

Accumulated deficit
(175,843
)
 
(141,409
)
Accumulated other comprehensive income
1,520

 
1,113

Total stockholders’ equity
152,756

 
171,288

Total liabilities and stockholders’ equity
$
319,065

 
$
339,846

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,
 
2015
 
2014
 
2015
 
2014
Net revenue
$
59,432

 
$
64,713

 
$
187,242

 
$
197,526

Cost of revenue
42,568

 
49,218

 
131,076

 
145,331

Gross profit
16,864

 
15,495

 
56,166

 
52,195

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
10,667

 
14,343

 
31,667

 
47,225

Research and development
3,474

 
6,402

 
12,942

 
19,999

General and administrative
10,912

 
10,932

 
33,778

 
36,053

Restructuring and other
(2
)
 
1,937

 
3,737

 
1,937

Goodwill impairment

 
21,000

 

 
21,000

Total operating expenses
25,051

 
54,614

 
82,124

 
126,214

Loss from operations
(8,187
)
 
(39,119
)
 
(25,958
)
 
(74,019
)
Interest expense and other, net
(2,513
)
 
(2,867
)
 
(7,097
)
 
(7,638
)
Loss before income taxes
(10,700
)
 
(41,986
)
 
(33,055
)
 
(81,657
)
Income tax provision (benefit)
158

 
(200
)
 
1,380

 
(39
)
Net loss
$
(10,858
)
 
$
(41,786
)
 
$
(34,435
)
 
$
(81,618
)
Net loss per share, basic and diluted
$
(0.13
)
 
$
(0.50
)
 
$
(0.40
)
 
$
(0.99
)
Weighted average common shares outstanding, basic and diluted
85,994

 
83,131

 
85,113

 
82,668

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,
 
2015
 
2014
 
2015
 
2014
Net loss
$
(10,858
)
 
$
(41,786
)
 
$
(34,435
)
 
$
(81,618
)
Other comprehensive loss, net of tax:
 
 
 
 
 
 
 
Foreign currency translation adjustments
184

 
155

 
289

 
489

Unrealized gain (loss) on short-term investments, net of tax
4

 
(235
)
 
118

 
(136
)
Other comprehensive income, net of tax
188

 
(80
)
 
407

 
353

Total comprehensive loss, net of tax
$
(10,670
)
 
$
(41,866
)
 
$
(34,028
)
 
$
(81,265
)
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,
 
2015
 
2014
Cash flows from operating activities
 
 
 
Net loss
$
(34,435
)
 
$
(81,618
)
Adjustments to reconcile net loss to net cash provided by (used) in operating activities:
 
 
 
Depreciation and amortization
10,204

 
9,670

Amortization of debt discount and issuance costs
5,955

 
5,536

Accretion of premium on short-term investments and other
(205
)
 
72

Deferred income taxes
1,020

 
(177
)
Stock-based compensation
10,804

 
16,006

Income tax benefit from stock-based compensation

 
(267
)
Restructuring and other
3,518

 
910

Goodwill impairment

 
21,000

Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net
12,740

 
14,567

Deferred revenue
(1,043
)
 
(1,137
)
Prepaid expenses and other
(1,247
)
 
(108
)
Accounts payable
(620
)
 
(831
)
Accrued taxes
(879
)
 
(593
)
Accrued compensation and benefits
(580
)
 
(822
)
Accrued expenses
(4,031
)
 
3,259

Other liabilities
(844
)
 
(1,661
)
Net cash provided by (used) in operating activities
357

 
(16,194
)
Cash flows from investing activities
 
 
 
Acquisition of property and equipment
(8,273
)
 
(7,625
)
Restricted cash
(1,244
)
 

Cash paid for acquisition, net of cash acquired

 
(32,550
)
Purchases of short-term investments
(73,567
)
 
(70,430
)
Sales of short-term investments
61,430

 
46,181

Maturities of short-term investments
690

 
4,043

Net cash used in investing activities
(20,964
)
 
(60,381
)
Cash flows from financing activities
 
 
 
Repayment on capital leases obligations
(139
)
 
(321
)
Proceeds from common stock issuances
3,476

 
4,380

Income tax benefit from stock-based compensation

 
267

Net cash provided by financing activities
3,337

 
4,326

Net decrease in cash and cash equivalents
(17,270
)
 
(72,249
)
Effect of exchange rate changes on cash and cash equivalents
717

 
1,039

Cash and cash equivalents at beginning of period
90,382

 
170,132

Cash and cash equivalents at end of period
$
73,829

 
$
98,922

 
 
 
 
Supplemental Information:
 
 
 
     Acquired common stock in exchange for an accrued liability
$
(655
)
 
$

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 revenue life cycle 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 dedicated service teams and cloud-based solutions, leveraging benchmarks and best practices derived from its 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 managed services customers based on renewal sales that the Company generates on their behalf under a pay-for-performance or flat-rate model, and subscription fees from customers of its cloud-based solutions. The Company’s corporate headquarters are located in San Francisco, California. The Company has offices in Colorado, Tennessee, Washington, the United Kingdom, Ireland, Malaysia, Philippines, Singapore and Japan.
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 and the instructions to Form 10-Q and Article 10 of Regulation S-X, without audit. Accordingly, they do not include all of the information required by U.S. GAAP for annual financial statements. The unaudited condensed consolidated balance sheet as of December 31, 2014 has been derived from our audited annual consolidated financial statements included in our Annual Report on Form 10-K/A for the year ended December 31, 2014 filed with the SEC on March 17, 2015. 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, 2014, included in our Annual Report on Form 10-K/A.
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 the Company's financial position, operating results, and cash flows for the interim periods presented. Preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the Company’s condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Also, the results for the interim periods are not necessarily indicative of results for the entire year.
Amounts shown in the Accrued liabilities and other caption in the condensed consolidated balance sheet as of December 31, 2014 and the condensed consolidated statement of cash flows for the nine months ended September 30, 2014 have been reclassified into Accrued expenses and Other current liabilities to reflect the current period presentation.
Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standard Board ("FASB") issued Accounting Standard Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (Topic 606), which supersedes the revenue recognition requirements in the FASB's Accounting Standards Codification ("ASC") 605, Revenue Recognition.  This ASU is based on the principle that revenue is recognized to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  The ASU also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract.  In July 2015, the FASB approved a one year deferral of the effective date to December 15, 2017, and early application would be permitted, but not before the original effective date of December 15, 2016, so the effective date will be the first quarter of fiscal year 2018 using one of two retrospective application methods.  The Company is currently evaluating the impact ASU No. 2014-09 will have on its consolidated financial statements.

In April 2015, the FASB issued ASU No. 2015-03, Simplifying the Presentation of Debt Issuance Cost, which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The new guidance is effective for the Company beginning

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in the first quarter of fiscal year 2017, with early adoption permitted. The Company is currently evaluating the impact that adoption of ASU No. 2015-03 will have on its consolidated financial statements.

In April 2015, the FASB issued ASU No. 2015-05, Intangibles - Goodwill and Other - Internal Use Software, which provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, the update specifies that the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. The update further specifies that the customer should account for a cloud computing arrangement as a service contract if the arrangement does not include a software license. ASU No. 2015-05 will be effective for the Company in fiscal year 2016. Early adoption is permitted. An entity can elect to adopt the amendments either (1) prospectively to all arrangements entered into or materially modified after the effective date or (2) retrospectively. The Company is currently evaluating the impact that adoption of ASU No. 2015-03 will have 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. The Company has cash and cash equivalents held on its behalf by a third party of $0.4 million and $0.9 million as of September 30, 2015 and December 31, 2014, respectively. 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 other-than-temporary declines in fair value have occurred, the amount of the decline that is related to 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, 2015 and 2014 were insignificant.
Cash and cash equivalents and short-term investments consisted of the following as of September 30, 2015 and December 31, 2014 (in thousands):
September 30, 2015
 
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Estimated
Fair Value
Description
 
Cash
$
73,624

 
$

 
$

 
$
73,624

Cash equivalents:
 
 
 
 
 
 
 
Money market mutual funds
205

 

 

 
205

Total cash and cash equivalents
73,829

 

 

 
73,829

Short-term investments:
 
 
 
 
 
 
 
Corporate bonds
53,871

 
36

 
(226
)
 
53,681

U.S. agency securities
42,654

 
162

 

 
42,816

Asset-backed securities
29,061

 
52

 
(10
)
 
29,103

U.S. Treasury securities
11,122

 
47

 

 
11,169

Total short-term investments
136,708

 
297

 
(236
)
 
136,769

Cash, cash equivalents and short-term investments
$
210,537

 
$
297

 
$
(236
)
 
$
210,598

December 31, 2014
 

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Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Estimated
Fair Value
Description
 
Cash
$
89,589

 
$

 
$

 
$
89,589

Cash equivalents:
 
 
 
 
 
 
 
Money market mutual funds
793

 

 

 
793

Total cash and cash equivalents
90,382

 

 

 
90,382

Short-term investments:
 
 
 
 
 
 
 
Corporate bonds
49,110

 
29

 
(120
)
 
49,019

U.S. agency securities
42,004

 
56

 
(17
)
 
42,043

Asset-backed securities
21,083

 
8

 
(34
)
 
21,057

U.S. Treasury securities
12,859

 
27

 
(5
)
 
12,881

Total short-term investments
125,056

 
120

 
(176
)
 
125,000

Cash, cash equivalents and short-term investments
$
215,438

 
$
120

 
$
(176
)
 
$
215,382

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, 2015 (in thousands):
 
 
Amortized
Cost
 
Estimated
Fair Value
Less than 1 year
$
11,834

 
$
11,830

Due in 1 to 3 years
125,079

 
125,145

Total
$
136,913

 
$
136,975

As of September 30, 2015, the Company did not consider any of its investments to be other-than-temporarily impaired.
Note 3 — Fair Value of Financial Instruments

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, 2015 and indicates the fair value hierarchy of the valuation (in thousands):

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Total
 
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
Description
 
Cash equivalents:
 
 
 
 
 
Money market mutual funds
$
205

 
$
205

 
$

Total cash equivalents
205

 
205

 

Short-term investments:
 
 
 
 
 
Corporate bonds
53,681

 

 
53,681

U.S. agency securities
42,816

 

 
42,816

Asset-backed securities
29,103

 

 
29,103

U.S. Treasury securities
11,169

 

 
11,169

Total short-term investments
136,769

 

 
136,769

Cash equivalents and short-term investments
$
136,974

 
$
205

 
$
136,769


The Company has restricted cash of $1.2 million and $0 within Other assets as of September 30, 2015, and December 31, 2014, respectively. The restricted cash is classified within Level 1.
The following table presents information about the Company’s financial instruments that are measured at fair value as of December 31, 2014 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
$
793

 
$
793

 
$

Total cash equivalents
793

 
793

 

Short-term investments:
 
 
 
 
 
Corporate bonds
49,019

 

 
49,019

U.S. agency securities
42,043

 

 
42,043

Asset-backed securities
21,057

 

 
21,057

U.S. Treasury securities
12,881

 

 
12,881

Total short-term investments
125,000

 

 
125,000

Cash equivalents and short-term investments
$
125,793

 
$
793

 
$
125,000


The convertible notes issued by the Company in August 2013 are shown on the accompanying consolidated balance sheets at their original issuance value, net of unamortized discount, and are not marked to market each period. The approximate fair value of the convertible notes as of September 30, 2015 and December 31, 2014 was $125.4 million and $111.2 million, respectively. 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 or any long-term debt other than the Convertible debt as of September 30, 2015 and December 31, 2014.
Note 4 — Goodwill Impairment

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The Company normally performs its annual impairment analysis of goodwill at the reporting unit level in the fourth quarter of each year and between annual tests if events or circumstances indicate that it is more likely than not that the asset is impaired according to the guidance within ASC 350 Intangibles - Goodwill and Other.

During the third quarter of 2014, the Company’s market capitalization had a significant decline, the Company experienced slowing revenue growth for the Cloud and Business Intelligence (“CBI”) reporting unit in the near term and the Company experienced customer losses in the CBI business. Therefore, the Company determined that there were sufficient indicators to require the Company to perform an interim impairment analysis in the third quarter of 2014. The Company compared the fair value of CBI reporting unit as determined under an income approach to its carrying value and determined that the fair value was less than the carrying value. The Company then performed an analysis to measure the amount of the impairment.

Based on the result of the interim impairment analysis, the Company concluded that the majority of the CBI goodwill was impaired at September 30, 2014 and recorded a non-cash goodwill impairment charge of $21.0 million in the three and nine month periods ended September 30, 2014. The Company subsequently impaired the remaining $1.7 million of Cloud and Business Intelligence goodwill in the fourth quarter of 2014 due to continued revenue declines in the ServiceSource Revenue Analytics (formerly Scout Analytics) product offering.

The changes in the carrying amount of goodwill by operating segment as of September 30, 2015 were as follows (in thousands):
 
 
Managed Services
 
Cloud and Business Intelligence
 
Total
Balance as of December 31, 2013
 
$
6,334

 
$

 
$
6,334

Addition due to acquisition
 

 
22,653

 
22,653

Impairment
 

 
(22,653
)
 
(22,653
)
Balance as of December 31, 2014
 
$
6,334

 
$

 
$
6,334

Impairment
 

 

 

Balance as of September 30, 2015
 
$
6,334

 
$

 
$
6,334

Note 5 — Other Current Liabilities

Other current liabilities balances were comprised of the following (in thousands):
 
 
September 30,
2015
 
December 31,
2014
Accrued Interest - Convertible Notes
$
375

 
$
938

Deferred rent
703

 
855

ESPP Withholding
229

 
776

Total
$
1,307

 
$
2,569

Note 6 — Credit Facility and Capital Leases
Revolving Credit Facility

On July 5, 2012, the Company, entered into a three-year credit agreement which provided for a secured revolving line of credit based on eligible accounts receivable up to $30.0 million with a $2.0 million letter of credit sublimit. On May 5, 2014, the Company entered into an amendment to the credit agreement which reduced the secured revolving line of credit to $10.0 million. The credit agreement expired on July 5, 2015
Letter of Credit
On February 3, 2015, the Company issued a $1.2 million letter of credit in connection with a lease for a new San Francisco facility. The letter of credit is secured by $1.2 million of a money market account which is classified as restricted cash on the accompanying condensed consolidated balance sheet.
Capital Leases

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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 4.94% and 5.8% at September 30, 2015 and 2014, respectively.
Future minimum annual payments under capital lease obligations as of September 30, 2015 were as follows (in thousands):
 
September 30,
2015
Years Ending December 31,
 
2015 (remaining three months)
$
48

2016
121

2017
67

2018
69

2019
52

Total
$
357

Note 7 — Debt
Senior Convertible Notes
In August 2013, the Company issued senior convertible notes (the “Notes”) in exchange for gross proceeds of $150.0 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, beginning 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 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.
The Notes were not convertible at September 30, 2015 under the circumstances listed above. However, the holders of the Notes may convert their Notes at any time 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, or the holders of at least 25% in principal amount of the outstanding Notes may 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. The Notes were not subject to repurchase at September 30, 2015.
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

12


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 were recorded as a deferred asset in other asset, net, 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 net carrying amount of the liability component of the Notes consists of the following (in thousands):
 
September 30, 2015

 
December 31, 2014

Principal amount
$
150,000

 
$
150,000

Unamortized debt discount
(23,822
)
 
(29,270
)
Net carrying amount
$
126,178

 
$
120,730

The following table presents the interest expense recognized related to the Notes (in thousands):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Contractual interest expense at 1.5% per annum
$
563

 
$
563

 
$
1,688

 
$
1,688

Amortization of debt issuance costs
174

 
110

 
507

 
470

Accretion of debt discount
1,877

 
1,738

 
5,448

 
5,043

Total
$
2,614

 
$
2,411

 
$
7,643

 
$
7,201


The net proceeds from the Notes were approximately $145.1 million after payment of the initial purchasers' discount and 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.

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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 November 30, 2022. Rent expense for the three months ended September 30, 2015 and 2014 was $2.3 million and $2.3 million, respectively, and for the nine months ended September 30, 2015 and 2014 was $7.0 million and $6.9 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.
In May 2015 the Company commenced a 7-year office lease expiring in November 2022 for a new corporate headquarters in San Francisco, California to occupy 24,394 square feet of space. This new lease commitment totaled $13.3 million of minimum lease payments over the 7-year lease term.
In October 2015, the Company signed a 6-year lease expiring in July 2021, for a new sales center in the Philippines to occupy 46,134 square feet. The total minimum lease payments are estimated to be approximately $7.0 million over the lease term.
Future annual minimum lease payments under all noncancelable operating leases as of September 30, 2015 were as follows (in thousands): 
 
September 30, 2015
Years Ending December 31,
 
2015 (remaining three months)
$
1,843

2016
6,725

2017
6,551

2018
6,227

2019
5,129

Thereafter
12,189

Total
$
38,664

Litigation
On July 8, 2015, a single plaintiff filed a putative securities class action lawsuit, Weller v. ServiceSource International, Inc. et al., in the U.S. District Court for the Northern District of California (the “Weller Lawsuit”) against the Company and the Company’s former Chief Executive Officer. The Weller Lawsuit was brought on behalf of purchasers of Company stock during the period January 22, 2014 through May 1, 2014, and alleges violations under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act").   In connection with the mandatory lead plaintiff appointment process under the Private Securities Litigation Reform Act (PSLRA), various law firms issued press releases between July 2015 and September 2015 to search for additional shareholders that would be willing to serve as lead plaintiffs in this lawsuit.  This solicitation period ended on September 29, 2015 and no other shareholders came forward, leaving only the named plaintiff as the sole shareholder seeking to be appointed lead plaintiff. The court appointed Weller a lead plaintiff on October 21, 2015. At this time, no motion to certify a class has been filed. The Company believes that the claims are meritless, and will vigorously defend itself against such claims.
From time to time, the Company may be subject to other litigation or threatened litigation arising in the ordinary course of our business. Although the results of litigation and claims cannot be predicted with certainty, the Company is currently not aware of any litigation or threats of litigation in which the final outcome could have a material adverse effect on our business, operating results, financial position, or cash flows. Regardless of the outcome, litigation can have an adverse impact on the Company because of defense and settlement costs, diversion of management resources, and other factors. The Company records a contingent liability when it is probable that a loss has been incurred and the amount is reasonably estimable in accordance with accounting for contingencies.
Note 9 - Share Repurchase Program and Stock-Based Compensation
In August 2015, the Board authorized a stock repurchase program ("the program") with a maximum authorization to repurchase up to $30.0 million worth of common stock of the Company. The program expires in August 2017. The aggregate amount available under the program was approximately $29.3 million as of September 30, 2015. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be

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repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act.
During the three months ended September 30, 2015, under the repurchase program the Company repurchased 158,900 shares of its common stock, which were retired upon repurchase, under the program at an average price of $4.10 per share for an aggregate amount of $0.7 million. The Company cash settles with the program broker periodically and reflects any unsettled amounts as a current liability at each period end.
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,
 
2015
 
2014
 
2015
 
2014
Cost of revenue
$
704

 
$
1,034

 
$
2,200

 
$
3,168

Sales and marketing
796

 
1,497

 
2,443

 
4,917

Research and development
322

 
695

 
1,314

 
2,131

General and administrative
1,438

 
1,848

 
4,847

 
5,790

Total stock-based compensation
$
3,260

 
$
5,074

 
$
10,804

 
$
16,006

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 unit or award, 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.
Option and restricted stock activity under the 2011 Plan for the nine months ended September 30, 2015 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, 2014
5,982

 
10,070

 
$
5.08

 
5,476

Additional shares reserved under the 2011 equity incentive plan
3,364

 

 

 

Granted
(6,494
)
 
4,080

 
4.43

 
2,414

Options exercised/ Restricted stock released

 
(585
)
 
4.04

 
(1,654
)
RSU shares withheld for taxes
161

 

 

 
161

Canceled/Forfeited
3,470

 
(2,163
)
 
5.71

 
(1,307
)
Outstanding — September 30, 2015
6,483

 
11,402

 
4.78

 
5,090


The weighted average grant-date fair value of employee stock options granted during the three months ended September 30, 2015 and 2014 was $1.71 and $1.53 per share, respectively and for the nine months ended September 30, 2015 and 2014 was $1.44 and $1.96 per share, respectively. The unamortized grant date fair value of both stock options and restricted stock awards totaled $29.6 million at September 30, 2015.
Note 10 — Income Taxes


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The Company is subject to taxation in the United States and various state and foreign jurisdictions. Earnings from non-U.S. activities are subject to local country income tax. The Company computes its quarterly income tax provision by using a forecasted annual effective tax rate and adjusts for any discrete items arising during the quarter. The primary difference between the effective tax rate and the federal statutory tax rate relates to the valuation allowances on the Company’s net operating losses and foreign tax rate differences. The Company is currently undergoing examination of the California Franchise Tax Returns relating to California state income taxes of its U.S. operating subsidiary for the years 2008 through 2010. The tax years 2008 through 2014 remain subject to examination by federal state and foreign tax authorities. The Company does not provide for federal income taxes on the undistributed earnings of its foreign subsidiaries as such earnings are to be reinvested indefinitely outside the U.S.

Consistent with the Company’s practice in prior periods for assessing realization of deferred tax assets, management believes that based on the available objective evidence it is more likely than not that the tax benefits of the U.S. and Singapore losses will not be realized. As a result, the Company provided a valuation allowance for all U.S. federal net deferred tax assets, for all Singapore net deferred tax assets, and for substantially all of the Company’s state deferred tax assets other than those as described below.

Management assesses the available positive and negative evidence to estimate if sufficient future taxable income will be generated to use the existing deferred tax assets. A significant piece of objective negative evidence evaluated was a state tax law change that occurred during the second quarter ended June 30, 2015 and impacts the manner in which the Company apportions revenue. Such objective evidence limits the ability to consider other subjective evidence such as our projections for future growth. On the basis of this evaluation through September 30, 2015, the Company continues to record a valuation allowance of approximately $0.5 million to reflect only the portion of the state deferred tax asset that is more likely than not to be realized. Note that changes in tax laws and rates may affect other deferred tax assets and liabilities recorded in the future. These changes are accounted for in the period of enactment and thus are reflected in the Company’s September 30, 2015 financial results. As a result of the state tax law change discussed above, the Company has also recorded approximately $0.3 million as a discrete item in our tax provision through September 30, 2015.

The gross amount of the Company's unrecognized tax benefits was $0.9 million  as of September 30, 2015 and December 31, 2014$0.1 million of which, if recognized, would affect the Company’s effective tax rate.
Note 11 — Segment and Geographical Information
The Company’s Chief Operating Decision Maker (CODM), its Chief Executive Officer, evaluates the performance of its two operating segments based on net revenue and gross profit. Gross profit for each segment includes revenues and the related cost of revenue directly attributable to the segment. The Company does not allocate sales and marketing, research and development, or general and administrative expenses to its operating segments because management does not include the information in its measurement of the performance of the operating segments. The Company does not evaluate its operating segments using discrete asset information.
Managed Services- The Company’s managed services solution consists of end-to-end management and optimization of the recurring revenue process, including quoting, selling and business intelligence. The Company's managed services business is built on its pay-for-performance model, whereby customers pay the Company a commission based on renewal sales that it generates on their behalf. The Company’s managed services offerings include quoting and selling services, in which dedicated service teams have specific expertise in the customers’ businesses, are deployed under the customers’ brands and follow a sales process tailored specifically to increase service contract renewals.
Cloud and Business Intelligence- The Company’s cloud and business intelligence solution consist of subscription sales and professional services to deploy the Company's solutions. Subscription sales consists of selling subscriptions to Renew OnDemand and ServiceSource Revenue Analytics, both SaaS applications. The foundation of the Company’s cloud solution is Renew OnDemand, a SaaS-based renewal management system based on its data warehouse of transactional, analytical and industry data that grows with each service renewal transaction and customer. 
Summarized financial information by reporting segments based on the Company’s internal management reporting and as utilized by the Company’s CODM, is as follows (in thousands):

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Three Months Ended
 September 30,
 
Nine Months Ended
 September 30,
 
 
2015
 
2014
 
2015
 
2014
Net Revenue
 
 
 
 
 
 
 
 
Managed Services
 
$
53,295

 
$
56,629

 
$
167,532

 
$
173,773

Cloud and Business Intelligence
 
6,137

 
8,084

 
19,710

 
23,753

 
 
59,432

 
64,713

 
187,242

 
197,526

 
 
 
 
 
 
 
 
 
Gross Profit
 
 
 
 
 
 
 
 
Managed Services
 
14,701

 
12,896

 
48,033

 
46,143

Cloud and Business Intelligence
 
2,163

 
2,599

 
8,133

 
6,052

 
 
16,864

 
15,495

 
56,166

 
52,195

 
 
 
 
 
 
 
 
 
Unallocated operating expenses
 
25,051

 
54,614

 
82,124

 
126,214

Loss from operations
 
$
(8,187
)
 
$
(39,119
)
 
$
(25,958
)
 
$
(74,019
)

The Company’s business is geographically diversified. For the nine months ended September 30, 2015, 66% of our net revenue was earned in North America and Latin America (“NALA”), 23% in Europe, Middle East and Africa (“EMEA”) and 11% 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 and subscription sales and professional services to deploy the Company's solutions. Predominantly all of the service contracts sold and managed by our sales centers relate to end customers located in the same geography. All of NALA net revenue represents revenue generated in the United States.
Summarized financial information by geographic location based on the Company’s internal management reporting is as follows (in thousands):
 
Three Months Ended
 September 30,
 
Nine Months Ended
 September 30,
 
2015
 
2014
 
2015
 
2014
Net revenue
 
 
 
 
 
 
 
NALA
$
40,760

 
$
43,477

 
$
123,810

 
$
129,434

EMEA
12,329

 
15,156

 
43,535

 
49,599

APJ
6,343

 
6,080

 
19,897

 
18,493

Total net revenue
$
59,432

 
$
64,713

 
$
187,242

 
$
197,526


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Note 12 — Restructuring and Other

The Company announced at the beginning of the third quarter of 2014 a restructuring effort to better align its cost structure with current revenue levels. The restructuring plans are accounted for in accordance with ASC 420, Exit or Disposal Cost Obligations. The Company recognized restructuring and other charges of $0 million and $3.7 million during the three and nine months ended September 30, 2015. Restructuring and other costs consists of $1.1 million of separation payments and related employee benefits, and $2.6 million of stock based compensation related to the accelerated vesting of certain equity awards granted to the Company's former interim CFO and CEO.
Restructuring and other activities for the nine months ended September 30, 2015 is summarized as follows (in thousands):
 
Restructuring
 
Other
 
Total
Restructuring and other liability at December 31, 2014
$
364

 
$
251

 
$
615

Restructuring and other charges
353

 
3,384

 
3,737

Cash paid
(717
)
 
(705
)
 
(1,422
)
Acceleration of stock-based compensation expense in additional paid-in capital

 
(2,579
)
 
(2,579
)
Restructuring and other liability at September 30, 2015
$

 
$
351

 
$
351




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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/A for the year ended December 31, 2014.
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 recurring revenue opportunity under management; 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, ServiceSource Revenue Analytics (formerly Scout Analytics), ServiceSource Customer Success or our other SaaS offerings; our strategy with respect to our business services and SaaS businesses, cloud offering and managed services and cost allocation and management efforts; 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 convertible notes and related matters concerning our note hedges and warrants; our stock repurchase program; our competitive position; the effects of competition; industry environment; potential growth opportunities; our expected benefits from the acquisition of Scout Analytics; and our expected benefits from international expansion. 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
ServiceSource International, Inc. (NASDAQ: SREV) is the global leader in customer revenue growth and retention solutions across the Revenue Lifecycle. As a subset of the Customer Lifecycle Management business segment, the Revenue Lifecycle addresses critical elements of customer success, recurring revenue growth and renewal processes, which include on-boarding, adoption, upsell, cross-sell, retention and renewals. Our solutions are designed to optimize the retention rates and recurring revenue performance for our customers to drive revenue growth and decrease churn from their own, existing business-to-business ("B2B") customers.
Our solutions are comprised of technology-enabled managed services and best-practice processes. In delivering our services, we leverage industry and company data, leading-edge technology and best-practices drawn from our significant and in-depth database of renewal benchmarks. By integrating managed services, cloud software and data, we provide end-to-end management and optimization of the customer onboarding, adoption, subscription and service-contract renewal process.
Our managed services business leverages either a pay-for-performance or a flat-rate model whereby our customers pay us a commission based on renewal sales that we generate on their behalf. Our cloud software offerings currently include: ServiceSource Revenue Analytics (formerly Scout Analytics), Renew OnDemand and the ServiceSource Customer Success application, all of which automate and provide data-driven insights into these highly valuable but typically manual business processes. Our technology capabilities and managed services can drive higher subscription, maintenance and support revenue while improving customer retention and increasing business predictability.

The scalability of our solution enables us to sell in over 40 languages from seven centers around the globe. Our solution is designed to optimize recurring revenue across different revenue models, distribution models, and segments, including

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hardware, software, SaaS, industrial systems, information and media, as well as technology-enabled health care and life sciences.

As part of our introduction of Renew OnDemand in prior years, we had been expanding the organization, investing in our engineering and sales and marketing organization primarily in advance of our goal of an increase in revenues from both existing customers and new customers due to increased adoption of our new SaaS platform. We also acquired Scout Analytics in January 2014, believing that Scout Analytics’ new business acquisitions in the months prior to the merger demonstrated growth potential for the near term. For both SaaS platforms, we experienced a slower adoption rate than we originally planned. As a result of this slower adoption, the Company announced a restructuring plan in the third quarter of 2014, with the intention of reducing the resources to better match the expected revenues. In addition, with the incurred losses in combination with lower stock price, we performed a goodwill and long lived asset impairment analysis in the third and fourth quarters of 2014. In 2014, we recorded a goodwill and other intangible asset impairment of $25.1 million for the Cloud and Business Intelligence segment.
Key Business Metrics
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 recurring revenue opportunity under management and number of engagements.

Recurring Revenue Opportunity Under Management. At December 31, 2014, we estimated our opportunity under management to be over $13.5 billion. 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 service on behalf of our customers over the subsequent twelve-month period. Opportunity under management is not a measure of our expected revenue. 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 our 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 our contracts with them, periodic internal business reviews of our expectations as to the value of end customer contracts that will be made available to us by our 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 recurring 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 managed services revenue also depends on our close rates and commissions. 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

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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: historical, 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. 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.

In 2014, we experienced a decline in opportunity under management for our managed services business due to a number of contractions and non-renewals by some of our customers. We expect the reduction in opportunity under management experienced in 2014 will continue to impact our revenues for the remainder of 2015 and into 2016 until we can replace this decline in 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 renewals, we designate the set of renewals and associated revenues and costs 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 167 and 192 engagements as of September 30, 2015 and 2014, 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 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.

For cloud offerings, the SPA may be more limited and focused on the benefits of the respective technology and therefore may take less time.

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. These commissions are based on the estimated total contract value, with a material portion of the commission expensed upfront and 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

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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 managed services 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.

Our new customer contracts typically have an initial term between two and four years. Our contracts generally require our customers to deliver a minimum value of 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. Revenue is recognized in the period in which our services are performed or, in the case of performance commissions, when the performance condition is achieved. 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 factors such as, but not limited to, minimum contractual commitments, the performance improvement potential identified by our SPA process, our success in generating improved renewal rates for our customers, and our customers’ historical renewal rates, for example, help to provide us with revenue visibility, but may all affect our performance favorably or unfavorably.

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.

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.

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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 foreseeable future, we would expect this pattern to continue.

Establishment of “Software-as-a-Service” Business unit. 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.

We have several SaaS-based applications that we develop and support: Renew OnDemand (our purpose-built offering to manage and maximize recurring revenue), ServiceSource Revenue Analytics (formerly Scout Analytics, our SaaS offering to help companies with predictive analytics for recurring revenue), and other SaaS cloud offerings such as ServiceSource Customer Success. Our research and development costs are primarily related to these SaaS based applications. We intend to maintain customer support, training and professional service organizations to support deployments of our solutions. Our current spending incorporates a level of investment required for development of our products and are targeted at improving the tools and infrastructure that will make the product easier to deploy and support in the future. We believe that the level of effort to deploy and maintain these applications will decline over time, due to product development investments made in 2014 and early 2015 to improve the application layer of the solutions and to improve the underlying database architecture and reduce the overall cost of our cloud infrastructure. As a result, we expect costs to decline in 2015 and rise more slowly or at the same pace as revenue growth in future years.
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 less than 10% of total revenue. We expect revenues generated from subscriptions of Renew OnDemand and ServiceSource SaaS cloud offerings to decline for the remainder of 2015 due to subscription losses from our initial customers. Subscription fees are accounted for separately from our managed service commissions, and they are billed in advance over a monthly, quarterly or annual basis. Subscription revenue is typically 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 56% and 51% of our net revenue for the nine months ended September 30, 2015 and 2014, respectively.

Effective April 2015, our largest customer reduced the scope of our managed services engagement with us and its subscription of our legacy system. Our opportunity under management reflects this reduction as of December 31, 2014.

The loss of revenue from any of our top customers for any reason, including the failure to renew our contracts, termination of some or all of our services, a change of relationship with any of our key customers or their acquisition, can cause a significant decrease in our revenue. We experienced a slight decrease in revenue in the three and nine months ended September 30, 2015 due to cancellations and reductions in the number of customer engagements, including some among our top customers, in excess of new customer engagement additions and expansions for the managed services segment. The

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customer engagement cancellations and reductions in the second half of 2014 were higher than our historical rates, and we have continued to experience the effects of these cancellations and reductions on our revenue in the third quarter of 2015.

Our business is geographically diversified. Through the nine months ended September 30, 2015, 66% of our net revenue was earned in North America and Latin America (“NALA”), 23% in Europe, Middle East and Africa (“EMEA”) and 11% 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. 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 region.
Cost of Revenue and Gross Profit

Our cost of revenue expenses include employee 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 slowly stabilize, but 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”. We are currently taking measures to reduce the costs to deliver our solutions and support our customer engagements, in order to improve our gross profit. Over the remaining quarter in 2015, we expect to see current cost reduction offset by investments we are making to drive further reductions to our cost to deliver and improved gross profit in 2016. We are also evaluating additional measures to further reduce our costs of revenue as opportunity under management has declined and we now are delivering our SAAS offerings on a more focused criteria than our initial engagements.

Operating Expenses

Sales and Marketing. Sales and marketing expenses consist primarily of compensation and sales commissions for our sales and marketing staff, allocated costs 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 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. When commissions are paid out upon contract signing and are not contingent on future payments and continued employment, we expense the sales commission upon contract signing. We currently expect sales and marketing expenses to increase for the remainder of 2015, but decrease or remain flat as a percentage of revenue in future years.

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 and related applications for revenue analytics. In connection with the development and enhancements of our SaaS cloud 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 decline in 2015.

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 for the remainder of 2015, but remain flat or slightly lower as a percentage of revenues in future years as we streamline our operations where possible.

Restructuring and other. Restructuring and other expenses consist primarily of employees’ severance payments, related employee benefits, retention bonuses and charges related to cancellation of contracts.

Goodwill impairment. The goodwill impairment charge consists of impairment based on the outcome of an impairment analysis. The Company performs its annual impairment analysis of goodwill in the fourth quarter of each year and between

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annual tests if events or circumstances indicate that it is more likely than not that the asset is impaired. We recorded a goodwill impairment charge of $21.0 million in the third quarter of 2014. Additionally, the further decline in the Company’s market capitalization or other events or circumstances may require additional impairment charges to be recorded in future periods against any remaining goodwill.

Interest expense and other, net

Interest expense. Interest expense consists primarily of interest expense associated with our convertible debt, fees related to our credit facility, 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 slightly in 2015 from accretion of debt discount, amortization of deferred financing costs and contractual interest costs as a result of our August 2013 issuance of $150.0 million aggregate principal amount of convertible notes due August 2018.

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 income 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 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 our ability to realize the tax benefits associated with 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, and 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 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. 

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Three Months Ended
 September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(in thousands)
Net revenue
$
59,432

 
$
64,713

 
$
187,242

 
$
197,526

Cost of revenue
42,568

 
49,218

 
131,076

 
145,331

Gross profit
16,864

 
15,495

 
56,166

 
52,195

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
10,667

 
14,343

 
31,667

 
47,225

Research and development
3,474

 
6,402

 
12,942

 
19,999

General and administrative
10,912

 
10,932

 
33,778

 
36,053

Restructuring and other
(2
)
 
1,937

 
3,737

 
1,937

Goodwill impairment

 
21,000

 

 
21,000

Total operating expenses
25,051

 
54,614

 
82,124

 
126,214

Loss from operations
(8,187
)
 
(39,119
)
 
(25,958
)
 
(74,019
)
Interest expense and other, net
(2,513
)
 
(2,867
)
 
(7,097
)
 
(7,638
)
Loss before income taxes
(10,700
)
 
(41,986
)
 
(33,055
)
 
(81,657
)
Income tax provision (benefit)
158

 
(200
)
 
1,380

 
(39
)
Net loss
$
(10,858
)
 
$
(41,786
)
 
$
(34,435
)
 
$
(81,618
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Three Months Ended
 September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(in thousands)
Includes stock-based compensation of:
 
 
 
 
 
Cost of revenue
$
704

 
$
1,034

 
$
2,200

 
$
3,168

Sales and marketing
796

 
1,497

 
2,443

 
4,917

Research and development
322

 
695

 
1,314

 
2,131

General and administrative
1,438

 
1,848

 
4,847

 
5,790

Total stock-based compensation
$
3,260

 
$
5,074

 
$
10,804

 
$
16,006



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,
 
2015
 
2014
 
2015
 
2014
 
(as % of net revenue)
Net revenue
100
 %
 
100
 %
 
100
 %
 
100
 %
Cost of revenue
72
 %
 
76
 %
 
70
 %
 
74
 %
Gross profit
28
 %
 
24
 %
 
30
 %
 
26
 %
Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
18
 %
 
22
 %
 
17
 %
 
24
 %
Research and development
6
 %
 
10
 %
 
7
 %
 
10
 %
General and administrative
18
 %
 
17
 %
 
18
 %
 
18
 %
Restructuring and other
 %
 
3
 %
 
2
 %
 
1
 %
Goodwill impairment
 %
 
32
 %
 
 %
 
11
 %
Total operating expenses
42
 %
 
84
 %
 
44
 %
 
64
 %
Loss from operations
(14
)%
 
(60
)%
 
(14
)%
 
(38
)%


Three months and nine months ended September 30, 2015 and September 30, 2014

Net Revenue 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
Change
 
% Change
 
2015
 
2014
 
Change
 
% Change
 
(in thousands)
 
 
 
(in thousands)
 
 
Net revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Managed Services
$
53,295

 
$
56,629

 
$
(3,334
)
 
(6
)%
 
$
167,532

 
$
173,773

 
$
(6,241
)
 
(4
)%
Cloud and Business Intelligence
6,137

 
8,084

 
(1,947
)
 
(24
)%
 
19,710

 
23,753

 
$
(4,043
)
 
(17
)%
Total net revenue
$
59,432

 
$
64,713

 
$
(5,281
)
 
(8
)%
 
$
187,242

 
$
197,526

 
$
(10,284
)
 
(5
)%

Net revenue decreased $5.3 million, or 8%, for the third quarter of 2015 compared to the third quarter of 2014. The overall decrease in revenue was due to customer cancellations and reductions in the number of customer engagements in excess of new customer engagement additions from previous quarter. Customer cancellations and reductions in the number of customer engagements in the third quarter of 2015 were lower than previous quarters but continue to be slightly more than new business generated. We expect the effects of prior quarters’ cancellations and reductions on our revenue to continue through the remainder of 2015.

Managed services revenue decreased $3.3 million, or 6%, for the third quarter of 2015 compared to the third quarter of 2014 due to customer cancellations. The customer cancellations and reductions in the number of customer engagements occurred primarily in the second half of 2014 and are expected to continue to impact 2015 revenue.

The $1.9 million, or 24%, decrease in revenue from our Cloud and Business Intelligence (“CBI”) for the third quarter of 2015 compared to the third quarter of 2014, was attributable to a loss of subscription revenue related to the elimination of certain services provided to one of our largest customers.
Net revenue decreased $10.3 million, or 5%, in the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014. The overall decrease in revenue was due to customer cancellations and reductions in the number of customer engagements in excess of new customer engagement additions in previous quarters and the loss of subscription revenue related to the elimination of certain services provided to one of our largest customers. Customer cancellations and reductions in the number of customer engagements in the in the nine months ended September 30, 2015 were lower than previous quarters but continue to be slightly more than new business generated. We expect the effects of prior quarters’ cancellations and reductions on our revenue to continue through the remainder of 2015.

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Managed services revenue decreased $6.2 million, or 4% in the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014, and was attributable to customer cancellations and reductions in the number of engagements in excess of new customer engagement additions in previous quarters.
The $4.0 million, or 17% decrease in revenue from our CBI in the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014, was primarily attributable to a loss of subscription revenue related to the elimination of certain services provided to one of our largest customers.
Cost of Revenue and Gross Profit 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
Change
 
% Change
 
2015
 
2014
 
Change
 
% Change
 
(in thousands)
 
 
 
(in thousands)
 
 
Cost of revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Managed Services
$
38,594

 
$
43,733

 
$
(5,139
)
 
(12
)%
 
$
119,499

 
$
127,629

 
$
(8,130
)
 
(6
)%
Cloud and Business Intelligence
3,974

 
5,485

 
(1,511
)
 
(28
)%
 
11,577

 
17,702

 
(6,125
)
 
(35
)%
Total cost of revenue
$
42,568

 
$
49,218

 
$
(6,650
)
 
(14
)%
 
$
131,076

 
$
145,331

 
$
(14,255
)
 
(10
)%

The $5.1 million, or 12%, decrease in our cost of revenue for our managed services business in the third quarter of 2015 compared to the third quarter of 2014 reflects a $5.6 million decrease in compensation expense of managed services as a result of lower headcount, offset by a $1.2 million increase in temporary labor and a $0.7 million decrease in overhead allocations.

The $1.5 million, or 28%, decrease in our cost of revenue for our CBI business in the third quarter of 2015 compared to the third quarter of 2014, reflected a $0.8 million reduction in compensation expense as a result of lower headcount and a $0.7 million decrease in temporary labor and consultants, all driven by lower sales.
The $8.1 million, or 6%, decrease in our cost of revenue for our managed services business in the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014 reflects a $9.1 million decrease in compensation expense of managed services as a result of lower headcount, offset by a $3.4 million increase in temporary labor, and a $2.7 million decrease in allocated overhead.
The $6.1 million, or 35%, decrease in our cost of revenue for our CBI business in the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014, reflected a $3.2 million reduction in compensation costs related to lower headcount. Also contributing to the decrease was a $2.2 million reduction in temporary labor and consultant costs, a $1.9 million reduction in information technology spending, a $0.4 million decrease in travel expenses and a $0.2 million decrease in allocated overhead offset by a $1.7 million increase in depreciation expenses.

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
Change
 
% Change
 
2015
 
2014
 
Change
 
% Change
 
(in thousands)
 
 
 
(in thousands)
 
 
Gross profit
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Managed Services
$
14,701

 
$
12,896

 
$
1,805

 
14
 %
 
$
48,033

 
$
46,143

 
$
1,890

 
4
%
Cloud and Business Intelligence
2,163

 
2,599

 
(436
)
 
(17
)%
 
8,133

 
6,052

 
$
2,081

 
34
%
Total gross profit
$
16,864

 
$
15,495

 
$
1,369

 
9
 %
 
$
56,166

 
$
52,195

 
$
3,971

 
8
%

The increase in managed services gross profit in the third quarter of 2015 and the nine months ended September 30, 2015 compared to the third quarter of 2014 and the nine months ended September 30, 2014, respectively was mainly driven by the lower headcount and related personnel costs.

The decrease in CBI gross profit in the third quarter of 2015 compared to the third quarter of 2014 was mainly due to lower annualized contract value growth. Gross profit in the nine months ended September 30, 2015 increased for our CBI business due to continued focus on cost reductions. Also, contributing to the cost reductions were lower cost of professional services and lower support and hosting costs related to our software solutions.

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Table of Contents

Operating Expenses
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
Change
 
% Change
 
2015
 
2014
 
Change
 
% Change
 
(in thousands)
 
 
 
(in thousands)
 
 
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sales and marketing
$
10,667

 
$
14,343

 
$
(3,676
)
 
(26
)%
 
$
31,667

 
$
47,225

 
$
(15,558
)
 
(33
)%
Research and development
3,474

 
6,402

 
(2,928
)
 
(46
)%
 
12,942

 
19,999

 
(7,057
)
 
(35
)%
General and administrative
10,912

 
10,932

 
(20
)
 
 %
 
33,778

 
36,053

 
(2,275
)
 
(6
)%
Restructuring and other
(2
)
 
1,937

 
(1,939
)
 
(100
)%
 
3,737

 
1,937

 
1,800

 
93
 %
Goodwill impairment

 
21,000

 
(21,000
)
 
(100
)%
 

 
21,000

 
(21,000
)
 
(100
)%
Total operating expenses
$
25,051

 
$
54,614

 
$
(29,563
)
 
(54
)%
 
$
82,124

 
$
126,214

 
$
(44,090
)
 
(35
)%
Includes stock-based compensation of:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sales and marketing
$
796

 
$
1,497

 
$
(701
)
 
 
 
$
2,443

 
$
4,917

 
$
(2,474
)
 
 
Research and development
322

 
695

 
(373
)
 
 
 
1,314

 
2,131

 
(817
)
 
 
General and administrative
1,438

 
1,848

 
(410
)
 
 
 
4,847

 
5,790

 
(943
)
 
 
Total stock-based compensation
$
2,556

 
$
4,040

 
$
(1,484
)
 
 
 
$
8,604

 
$
12,838

 
$
(4,234
)
 
 
Sales and marketing expenses
The $3.7 million, or 26%, decrease in sales and marketing expenses in the third quarter of 2015 compared to the third quarter of 2014 resulted from $1.8 million decrease in compensation expense. Also contributing to the decrease was a $0.8 million decrease in temporary labor and consultant costs, a $0.4 million decrease in marketing programs, a $0.2 million decrease in recruiting fees and a $0.1 million decrease in travel expenses.
The $15.6 million, or 33%, decrease in sales and marketing expenses in the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014 resulted primarily from decreased compensation of $8.9 million due to lower headcount. The lower headcount period over period is the result of our efforts to rationalize our cost structure. Also contributing to the decrease was a $2.9 million decrease in temporary labor and consultant costs, a $1.1 million decrease in travel expenses, a $1.1 million decrease in marketing programs, a $0.7 million decrease in overhead allocations and a $0.6 million decrease in recruiting fees.
Research and development expenses
The $2.9 million, or 46%, decrease in research and development expense in the third quarter of 2015 compared to the third quarter of 2014 was primarily due to a $1.6 million decrease in costs related to a decrease in headcount, a $1.0 million decrease in temporary labor and consulting costs and a $0.2 million decrease in information technology costs and $0.2 million in overhead allocations, all related to efforts to reduce the level of research and development spend starting in the second half of 2014.
The $7.1 million, or 35% decrease in research and development expense in the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014 was primarily due to a $4.3 million decrease in compensation expense, a $2.1 million decrease in temporary labor and consulting costs, a $0.4 million decrease in information technology costs, a $0.1 million decrease in travel expenses and a $0.1 million decrease in recruiting expenses, all related to our efforts to reduce research and development spend starting in the second half of 2014.
Internal-use software development capitalization increased by $1.1 million and $3.1 million for the three and nine months ended September 30, 2015 compared to the three and nine months ended September 30, 2014, respectively, primarily due to new development efforts on the Customer Lifecycle products. We expect research and development spending to remain flat for the remainder of 2015 and rise more slowly or at the same pace as revenue growth in future years. We expect to capitalize internal-use software costs in the future and the amount capitalized will depend on the level of new product development.
General and administrative expenses
General and administrative expense in the third quarter of 2015 was flat compared to the third quarter of 2014.

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The $2.3 million, or 6%, decrease in general and administrative expense in the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014 reflected a $1.7 million decrease in compensation expense related to lower headcount and a $4.3 million decrease across the following: temporary labor and professional services, facilities costs, technology spending, travel, recruiting and depreciation, all offset by a $3.7 million reduction in overhead allocations to other departments.
Restructuring and other expenses
The $1.9 million decrease in restructuring and other in the third quarter of 2015 compared to the third quarter of 2014 was related to our recognition of restructuring and other charges beginning in the third quarter of 2014 when we announced an efforts to better align our cost structure with current revenue levels. Those efforts were very limited in the third quarter of 2015.

The increase in restructuring and other expenses in the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014 was related to the recognition of additional employee termination related costs of $3.7 million in 2015. The charge consists primarily of stock compensation expense related to the accelerated vesting of certain equity awards granted to our former interim CFO and CEO, and separation payments.
Goodwill impairment

We have not recorded a goodwill impairment charge in 2015. The goodwill impairment charge recorded in the third quarter of 2014 is related to the outcome of impairment analysis which resulted in a non-cash goodwill impairment charge of $21.0 million relating to our Cloud and Business Intelligence reporting unit. We perform an annual impairment analysis of goodwill in the fourth quarter of each year and between annual tests if events or circumstances indicate it is more likely than not that the asset is impaired. Additionally, a further decline in our market capitalization or other event or circumstances may require additional impairment charges to be recorded in future periods remaining goodwill.
Interest expense and other, net
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
Change
 
% Change
 
2015
 
2014
 
Change
 
% Change
 
(in thousands)
 
 
 
(in thousands)
 
 
Interest expense and other, net
$
2,513

 
$
2,867

 
$
(354
)
 
(12
)%
 
$
7,097

 
$
7,638

 
$
(541
)
 
(7
)%

Interest expense and other, net decreased by $0.4 million, or 12%, in the third quarter of 2015 compared to the third quarter of 2014 was due partially to foreign currency gains in the third quarter of 2015. Interest expense for the third quarter of 2015 as compared to the third quarter of 2014 was slightly higher due to the accretion of debt discount, the amortization of debt issuance costs and interest expense for the convertible notes.
Interest expense and other, net decreased by $0.5 million, or 7%, in the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014 was partially due to foreign currency gains offset by slightly higher interest expense which was due to slightly higher accretion of debt discount, the amortization of debt issuance costs and interest expense related to our convertible notes.
Income Tax Provision
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
Change
 
% Change
 
2015
 
2014
 
Change
 
% Change
 
(in thousands)
 
 
 
(in thousands)
 
 
Income tax provision (benefit)
$
158

 
$
(200
)
 
$
358

 
*
 
$
1,380

 
$
(39
)
 
$
1,419

 
*
*Not meaningful.
For the third quarter of 2015, we recorded income tax expense of $0.2 million. This amount primarily represents anticipated taxes in jurisdictions where we have profitable operations, including certain U.S. states and foreign jurisdictions, offset by limited benefits available from losses in Ireland. No benefit was provided for losses incurred in U.S. and Singapore because those losses are offset by a full valuation allowance.

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For the third quarter of 2014, we recorded income tax benefit of $0.2 million. This amount primarily represents anticipated taxes in jurisdictions where we have profitable operations, including certain U.S. state and foreign jurisdictions, offset by benefits available from foreign losses. No benefit was provided for losses incurred in U.S. and Singapore because those losses are offset by a full valuation allowance.
For the nine months ended September 30, 2015, we recorded a charge to income tax expenses of $1.4 million. This includes the impact of state income tax law changes that were recorded during the second quarter ended June 30, 2015. The remaining portion of our tax expense relates to anticipated taxes in jurisdictions where we have profitable operations, including certain U.S. state and foreign jurisdictions, offset by benefits available from foreign losses. No benefit was provided for losses incurred in the U.S. and Singapore because those losses are offset by a full valuation allowance.
For the nine months ended September 30, 2014, we recorded a $0.1 million to income tax benefit. This amount primarily represents anticipated taxes in jurisdictions where we have profitable operations, including certain U.S. states and foreign jurisdictions, offset by limited benefits available from losses in Ireland. No benefit was provided for losses incurred in U.S. and Singapore because those losses are offset by a full valuation allowance.
Liquidity and Capital Resources
At September 30, 2015, we had cash, cash equivalents and short-term investments of $210.6 million, which primarily consisted of demand deposits, money market mutual funds, corporate bonds and U.S. government obligations. At September 30, 2015, we had cash and cash equivalents of $4.5 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 indefinitely reinvested in foreign operations and we do not have current plans 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.
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 converted earlier. Upon conversion, the Notes will be settled in cash, shares of our stock, or any combination thereof, at 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 were not subject to conversion or repurchase at September 30, 2015 and are classified as a noncurrent liability on our condensed consolidated balance sheet.
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. We believe our existing cash and cash equivalents and short-term investments will be sufficient to meet our working capital and capital expenditure needs for at least the next twelve months.
Share Repurchase Program
In August 2015, the Board authorized a stock repurchase program (“the program”) with a maximum authorization repurchase up to $30.0 million worth of common stock of the Company. The program expires in August 2017. The aggregate amount available under the program was approximately $29.3 million at September 30, 2015. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
During the three months ended September 30, 2015, the Company repurchased 158,900 shares of its common stock, which were retired upon repurchase, under the program at an average price of $4.10 per share for a total of $0.7 million. All repurchases were made using cash resources.
Credit Facility
The Company’s three-year credit agreement which provided for a secured revolving line of credit based on eligible accounts receivable up to $10.0 million expired on July 5, 2015. There were no borrowings under this facility during 2014 and 2015 and the expiration of this revolving line of credit has no impact on our ability to fund our current business operations.
Letter of Credit and Restricted Cash

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In May 2015 the Company commenced a 7-year office lease expiring in November 2022 for a new corporate headquarters in San Francisco, California. In connection with this new lease commitment, the Company was required to issue a $1.2 million letter of credit to the landlord. The letter of credit is secured by $1.2 million of a money market account which is classified as restricted cash in our condensed consolidated balance sheet as of September 30, 2015.
Summary Cash Flows
The following table sets forth a summary of our cash flows (in thousands):
 
Nine Months Ended
September 30,
 
2015
 
2014
Net cash provided by (used in) operating activities
$
357

 
$
(16,194
)
Net cash used in investing activities
(20,964
)
 
(60,381
)
Net cash provided by financing activities
3,337

 
4,326

Net decrease in cash and cash equivalents, net of impact of foreign exchanges on cash
(16,553
)
 
(71,210
)
Operating Activities
Net cash provided by operating activities was $0.4 million during the nine months ended September 30, 2015. Net loss during the period was $34.4 million adjusted by non-cash charges of $10.2 million for depreciation and amortization, $6.0 million of amortization of debt discount and issuance costs, $3.5 million of restructuring and other charges, and $10.8 million for stock-based compensation. Cash generated from operations during the nine months ended September 30, 2015 resulted from sequential changes in our working capital including a $12.7 million decrease in accounts receivable, a $0.6 million decrease in accounts payable, a $0.6 million decrease in accrued compensation and benefits, and a $4.0 million decrease in accrued expenses.
Net cash used in operating activities was $16.2 million during the nine months ended September 30, 2014. Net loss during the period was $81.6 million adjusted by non-cash charges of $9.7 million for depreciation and amortization, $16.0 million for stock-based compensation and $21.0 million for goodwill impairment. Cash generated from operations during the nine months ended September 30, 2014 resulted from sequential changes in our working capital including a $14.6 million decrease in net accounts receivable, a $0.8 million decrease in accounts payable and a $0.8 million decrease in accrued compensation and benefits.
Investing Activities
During the nine months ended September 30, 2015 cash used in investing activities was principally for the purchases of short-term investments, net of sales and maturities of $11.4 million, property and equipment addition of $8.3 million and $1.2 million increase in restricted cash related to a letter of credit required for our new San Francisco facility lease. Property and equipment additions include $5.1 million of capitalized internal-use software development cost.
During the nine months ended September 30, 2014 cash used in investing activities was principally for the purchases of short-term investments, net of sales and maturities of $20.2 million, acquisition of Scout Analytics of $32.6 million and to a lesser extent for property and equipment purchases of $7.6 million.
Financing Activities
Cash provided by financing activities of $3.3 million in the nine months ended September 30, 2015 primarily resulted from the exercise of common stock options and the purchase of common stock under our employee stock purchase plan of $3.5 million.
Cash provided by financing activities of $4.3 million in the nine months ended September 30, 2014 primarily resulted from the exercise of common stock options and the purchase of common stock under our employee stock purchase plan of $4.4 million offset by payment of capital leases obligations.
Off-Balance Sheet Arrangements


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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, 2015, the future minimum payments under these commitments were as follows (in thousands):
 
 
Total
 
Less than 1 year
 
1-3 years
 
4-5 years
 
More than 5 years
Obligations under capital leases
$
357

 
$
153

 
$
204

 
$

 
$

Operating lease obligations
38,664

 
6,898

 
18,539

 
8,473

 
4,754

Total
$
39,021

 
$
7,051

 
$
18,743

 
$
8,473

 
$
4,754

The contractual commitment amounts