UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013

OR

o 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: 000-49862

PROCERA NETWORKS, INC.

(Exact name of registrant as specified in its charter)

Delaware	33-0974674
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

4121 Clipper Court, Fremont, California	94538
(Address of principal executive offices)	(Zip code)

(510) 230-2777

 (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 þ    No o

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

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.

Large accelerated filer  o	Accelerated filer  þ	Non-accelerated filer  o	Smaller reporting company  o
		(Do not check if a 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 o   No þ

As of November 4, 2013, the registrant had 20,626,006 shares of its common stock, par value $0.001, outstanding.

PROCERA NETWORKS, INC.

FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2013

INDEX

			Page
PART I. FINANCIAL INFORMATION
	Item 1.	Consolidated Financial Statements
		Condensed Consolidated Balance Sheets as of September 30, 2013 (unaudited) and December 31, 2012	3
		Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2013 and 2012 (unaudited)	4
		Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2013 and 2012 (unaudited)	5
		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012 (unaudited)	6
		Notes to Condensed Consolidated Financial Statements (unaudited)	7
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	28
	Item 4.	Controls and Procedures	28
PART II. OTHER INFORMATION
	Item 1.	Legal Proceedings	29
	Item 1A.	Risk Factors	29
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	45
	Item 3.	Defaults Upon Senior Securities	45
	Item 4.	Mine Safety Disclosures	46
	Item 5.	Other Information	46
	Item 6.	Exhibits	46
SIGNATURES			47

PART I. FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

Procera Networks, Inc.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except par value)

	September 30,			December 31,
	2013			2012
	(unaudited)			(note)
ASSETS
Current assets:
Cash and cash equivalents	$	77,138		$	30,933
Short-term investments		31,723			100,762
Accounts receivable, net		20,295			16,603
Inventories, net		17,048			11,240
Prepaid expenses and other		3,278			2,012
Total current assets		149,482			161,550
Property and equipment, net		6,197			4,474
Intangible assets, net		6,881			—
Goodwill		13,089			960
Deferred tax asset		891			—
Other non-current assets		95			54
Total assets	$	176,635		$	167,038
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	4,858		$	5,453
Deferred revenue		10,358			6,953
Accrued liabilities		5,706			4,949
Total current liabilities		20,922			17,355
Non-current liabilities:
Deferred revenue		2,572			2,878
Deferred tax liability		1,771			—
Total liabilities		25,265			20,233
Commitments and contingencies		—			—
Stockholders’ equity:
Preferred stock, $0.001 par value; 15,000 shares authorized; none issued and outstanding		—			—
Common stock, $0.001 par value; 32,500 shares authorized; 20,621 and 19,696 shares issued and outstanding at September 30, 2013 and December 31, 2012, respectively		21			20
Additional paid-in capital		218,347			199,793
Accumulated other comprehensive loss		(1,084	)		(76	)
Accumulated deficit		(65,914	)		(52,932	)
Total stockholders’ equity		151,370			146,805
Total liabilities and stockholders’ equity	$	176,635		$	167,038

Note: Amounts have been derived from the December 31, 2012 audited consolidated financial statements.

See accompanying notes to condensed consolidated financial statements.

3

Procera Networks, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

	Three Months Ended					Nine Months Ended
	September 30, 2013			September 30, 2012		September 30, 2013			September 30, 2012
Sales:
Product sales	$	16,301		$	12,948	$	40,328		$	34,640
Support sales		5,032			3,113		13,015			8,418
Total net sales		21,333			16,061		53,343			43,058
Cost of sales:
Product cost of sales		10,080			4,053		22,451			12,671
Support cost of sales		896			487		2,442			956
Total cost of sales		10,976			4,540		24,893			13,627
Gross profit		10,357			11,521		28,450			29,431
Operating expenses:
Research and development		3,945			1,931		12,532			5,414
Sales and marketing		7,322			4,573		21,293			13,053
General and administrative		2,510			2,386		9,498			6,823
Total operating expenses		13,777			8,890		43,323			25,290
Income (loss) from operations		(3,420	)		2,631		(14,873	)		4,141
Interest and other income, net		232			161		203			108
Income (loss) before income taxes		(3,188	)		2,792		(14,670	)		4,249
Income tax provision (benefit)		(205	)		29		(1,688	)		141
Net income (loss)	$	(2,983	)	$	2,763	$	(12,982	)	$	4,108
Net income (loss) per share – basic	$	(0.15	)	$	0.14	$	(0.65	)	$	0.24
Net income (loss) per share – diluted	$	(0.15	)	$	0.14	$	(0.65	)	$	0.23
Shares used in computing net income (loss) per share:
Basic		20,031			19,305		20,007			17,304
Diluted		20,031			19,801		20,007			17,824

See accompanying notes to condensed consolidated financial statements.

4

Procera Networks, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

(unaudited)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2013			2012		2013			2012
Net income (loss)	$	(2,983	)	$	2,763	$	(12,982	)	$	4,108
Unrealized gain (loss) on short-term investments		29			46		(21	)		27
Foreign currency translation adjustments		566			265		(987	)		190
Other comprehensive income (loss)		595			311		(1,008	)		217
Comprehensive income (loss)	$	(2,388	)	$	3,074	$	(13,990	)	$	4,325

See accompanying notes to condensed consolidated financial statements.

5

Procera Networks, Inc.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Nine Months Ended September 30,
	2013			2012
Cash flows from operating activities:
Net income (loss)	$	(12,982	)	$	4,108
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation		1,342			587
Amortization of intangible assets		1,179			—
Stock-based compensation expense:
Stock options		2,852			1,755
Restricted stock awards		962			438
Amortization of premium on investments		773			539
Amortization of deferred compensation		4,301			—
Provision for bad debts		49			6
Provision for excess and obsolete inventory		588			555
Changes in deferred taxes		(1,550	)		—
Changes in assets and liabilities:
Accounts receivable		(3,171	)		(4,865	)
Inventories		(6,393	)		(501	)
Prepaid expenses and other current assets		2,205			(572	)
Deferred compensation advanced to escrow		(2,701	)		—
Accounts payable		(1,220	)		1,640
Accrued liabilities		458			503
Deferred revenue		2,557			3,394
Net cash provided by (used in) operating activities		(10,751	)		7,587
Cash flows from investing activities:
Purchase of Vineyard Networks, net of cash received		(8,962	)		—
Purchase of property and equipment		(2,209	)		(2,588	)
Purchase of short-term investments		(36,019	)		(92,189	)
Sales of short-term investments		11,212			2,002
Maturities of short-term investments		93,120			12,330
Net cash provided by (used in) investing activities		57,142			(80,445	)
Cash flows from financing activities:
Proceeds from issuance of common stock		—			88,025
Proceeds from issuance of common stock – exercise of options		428			2,998
Proceeds from issuance of common stock – exercise of warrants		—			27
Payments on notes payable		(497	)		—
Net cash provided by (used in) financing activities		(69	)		91,050
Effect of exchange rates on cash and cash equivalents		(117	)		55
Net increase in cash and cash equivalents		46,205			18,247
Cash and cash equivalents, beginning of period		30,933			23,900
Cash and cash equivalents, end of period	$	77,138		$	42,147
Non-cash investing and financing activities:
Issuance of common stock in connection with Vineyard acquisition	$	11,140		$	—

See accompanying notes to condensed consolidated financial statements.

6

Procera Networks, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

1. DESCRIPTION OF BUSINESS

Procera Networks, Inc. (“Procera” or the “Company”), is a leading provider of Intelligent Policy Enforcement (“IPE”) solutions, based on Deep Packet Inspection technology, that enable mobile and broadband network operators and entities managing private networks including higher education institutions, businesses and government entities (collectively referred to as network operators) to gain enhanced visibility into, and control of, their networks and to create and deploy new services for their end user subscribers.  The Company sells its products through its direct sales force, resellers, distributors and system integrators in the Americas, Asia Pacific and Europe.

Procera was incorporated in 2002 and its common stock currently trades on the Nasdaq Global Select Market under the trading symbol “PKT”.  The Company reincorporated from the State of Nevada to the State of Delaware in June 2013.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

Procera has prepared the condensed consolidated financial statements included herein pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) applicable to interim financial information.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations.  However, in the opinion of management, the financial statements include all the normal and recurring adjustments that are necessary to fairly present the results of the interim periods presented. The interim results presented are not necessarily indicative of results for any subsequent interim period, the year ending December 31, 2013, or any other future period. The consolidated balance sheet at December 31, 2012 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by United States generally accepted accounting principles (“U.S. GAAP”) for complete financial statements.  These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in Procera’s Annual Report on Form 10-K for the year ended December 31, 2012, filed with the SEC on March 15, 2013.

The condensed consolidated financial statements present the accounts of Procera and its wholly-owned subsidiaries.  All significant inter-company balances and transactions have been eliminated.

During the quarter ended March 31, 2013, the Company identified immaterial errors in the consolidated financial statements for the year ended December 31, 2012, related to the recognition of revenue from a sale to a value added reseller, the accounting for inventory, and general and administrative fee accruals. Based on a quantitative and qualitative analysis of the errors as required by authoritative guidance, management concluded that the errors had no material impact on any of the Company’s previously issued financial statements, are immaterial to the Company’s results for the first quarter of 2013 and expected full year results, and had no material effect on the trend of financial results.

As a result of the immaterial errors discussed above, the unaudited condensed consolidated financial statements for the nine months ended September 30, 2013 reflect the following immaterial adjustments related to prior periods, which were recorded in the quarter ended March 31, 2013: the reversal of a revenue deal resulting in a reduction of $0.6 million of revenue and a reduction of $0.2 million of cost of sales; inventory charges resulting in an increase of $0.4 million in cost of sales, and additional general and administrative costs of $43,000.

Significant Accounting Policies

The accounting and reporting policies of the Company conform to U.S. GAAP and to the practices within the telecommunications industry.  There have been no significant changes in the Company’s significant accounting policies during the three and nine months ended September 30, 2013 compared to what was previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, filed with the SEC on March 15, 2013.

7

Recent Accounting Pronouncements

In July 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2013-7, “Income Taxes (Topic 740): Income Taxes: Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” (“ASU 2013-7”).  ASU 2013-7 provides guidance on the financial statement presentation of an unrecognized tax benefit, as either a reduction of a deferred tax asset or as a liability, when a net operating loss carryforward, similar tax loss or a tax credit carryforward exists.  The amendments will be effective for interim and annual periods beginning after December 15, 2013 and may be applied on a retrospective basis.  Early adoption is permitted.  The Company does not expect the adoption of these amendments to have a significant impact on the Company’s consolidated financial position or results of operations.

In February 2013, the FASB issued ASU No. 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income” (“ASU 2013-02”). ASU 2013-02 finalizes the requirements of ASU 2011-05 that ASU 2011-12 deferred, clarifying how to report the effect of significant reclassifications out of accumulated other comprehensive income. ASU 2013-02 is to be applied prospectively.  The adoption of this standard only impacted the presentation format of the Company’s condensed consolidated financial statements.

3. CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

The following is a summary of cash equivalents and short-term investments by type of instrument at September 30, 2013 and December 31, 2012 (in thousands):

	September 30, 2013
	Amortized		Gross Unrealized					Fair
	Cost		Gains		Losses			Value
Money market funds	$	65,817	$	—	$	—		$	65,817
Commercial paper		4,998		—		—			4,998
U.S. agency securities		8,439		1		—			8,440
Corporate bonds		18,287		1		(3	)		18,285
Total investments	$	97,541	$	2	$	(3	)	$	97,540
Reported as:
Cash equivalents	$	65,817	$	—	$	—		$	65,817
Short-term investments		31,724		2		(3	)		31,723
Total investments	$	97,541	$	2	$	(3	)	$	97,540

	December 31, 2012
	Amortized		Gross Unrealized					Fair
	Cost		Gains		Losses			Value
Money market funds	$	13,505	$	-	$	-		$	13,505
Commercial paper		9,696		-		-			9,696
U.S. agency securities		51,276		18		-			51,294
Corporate bonds		34,751		5		(5	)		34,751
U.S. Government bonds		5,019		2		-			5,021
Total investments	$	114,247	$	25	$	(5	)	$	114,267
Reported as:
Cash equivalents	$	13,505	$	-	$	-		$	13,505
Short-term investments		100,742		25		(5	)		100,762
Total	$	114,247	$	25	$	(5	)	$	114,267

As of September 30, 2013, all investments were classified as available-for-sale with unrealized gains and losses recorded as a separate component of accumulated other comprehensive income (loss).  Cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the date of purchase.  Short-term investments generally have a remaining maturity of greater than three months at the date of purchaseand an effective maturity of less than one year.  As of September 30, 2013, the Company had certain investments with a maturity greater than one year. However, management has the ability, if necessary, to liquidate any of its investments in order to meet the Company’s liquidity needs in the next 12 months.  Accordingly, investments with contractual maturities greater than one year from the date of purchase are classified as short-term on the accompanying condensed consolidated balance sheets.  None of the Company’s short-term investments have been at a continuous unrealized loss position for greater than 12 months.

8

The Company reviews its investments for impairment quarterly.  For investments with an unrealized loss, the factors considered in the review include the credit quality of the issuer, the duration that the fair value has been less than the adjusted cost basis, severity of impairment, reason for the decline in value and potential recovery period, the financial condition and near-term prospects of the investees, and whether the Company would be required to sell an investment due to liquidity or contractual reasons before its anticipated recovery.  Based on its review, the Company did not identify any investments that were other-than-temporarily impaired during the three and nine months ended September 30, 2013.

The Company did not incur any material realized gains or losses in the three and nine months ended September 30, 2013 and 2012.  The cost of securities sold was determined based on the specific identification method.

4. FAIR VALUE MEASUREMENTS

Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  When determining fair value, the Company considers the principal or most advantageous market in which it would transact and considers assumptions that market participants would use when pricing the asset or liability.

The three levels of inputs that may be used to measure fair value are as follows:

Level 1- Quoted prices in active markets for identical assets or liabilities.

Level 2- Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets with insufficient volume or infrequent transactions (less active markets), or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities.

Level 3- Unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of assets or liabilities.

The following is a summary of cash equivalents and short-term investments by type of instrument as of September 30, 2013 and December 31, 2012, measured at fair value on a recurring basis (in thousands):

	September 30, 2013
	Level 1		Level 2		Level 3		Total
Money market funds	$	65,817	$	—	$	—	$	65,817
Commercial paper		—		4,998		—		4,998
U.S. agency securities		—		8,440		—		8,440
Corporate bonds		—		18,285		—		18,285
Total assets measured at fair value	$	65,817	$	31,723	$	—	$	97,540

	December 31, 2012
	Level 1		Level 2		Level 3		Total
Money market funds	$	13,505	$	—	$	—	$	13,505
Commercial paper		—		9,696		—		9,696
U.S. agency securities		—		51,294		—		51,294
Corporate bonds		—		34,751		—		34,751
U.S. Government bonds		—		5,021		—		5,021
Total assets measured at fair value	$	13,505	$	100,762	$	—	$	114,267

In general, and where applicable, the Company uses quoted market prices in active markets for identical assets to determine fair value.  This pricing methodology applies to Level 1 investments which are comprised of money market funds.  If quoted prices in active markets for identical assets are not available, then the Company uses quoted prices for similar assets or inputs other than quoted prices that are observable, either directly or indirectly.  These investments are included in Level 2 and consist of commercial paper, U.S. agency securities, and U.S. Government and corporate bonds. U.S. agency securities and U.S. Government and corporate bonds are valued at a consensus price, which is a weighted average price based on market prices from a variety of industry standard data providers used as inputs to a distribution-curve based algorithm. Commercial paper is valued using market prices where available, adjusting for accretion of the purchase price to face value at maturity.

9

During the three and nine months ended September 30, 2013 and 2012, the Company did not have any transfers between Level 1 and Level 2 fair value instruments.

5. ACQUISITIONS

On January 9, 2013, the Company completed its acquisition of Vineyard Networks Inc. (“Vineyard”), a privately held developer of Layer 7 Deep Packet Inspection (“DPI”) and application classification technology located in Kelowna, Canada. Vineyard’s integrated DPI and application classification technology provides enterprise and service provider networking infrastructure vendors with these capabilities through its integrated software suite, primarily through a variety of subscription based original equipment manufacturer and partner agreements.  This acquisition complements the Company’s hardware and application software-based IPE and DPI solutions, expands the way it sells solutions to customers, and increases the Company’s customer base, previously comprised primarily of network operators, thereby allowing the Company to provide complementary technology and solutions to a greater number of customers.

For the three months ended September 30, 2013, Vineyard contributed approximately $0.8 million in revenue and $0.6 million in net loss. For the nine months ended September 30, 2013, Vineyard contributed approximately $1.7 million in revenue and $1.7 million in net loss.

The total purchase price was $20.9 million, consisting of $9.8 million cash consideration and $11.1 million in the Company’s common stock in exchange for 100% of the outstanding securities of Vineyard.  Of the consideration paid, $2.0 million and $1.9 million in cash and stock, respectively, will be held in escrow for a period of 12, 18 or 36 months from the closing of the acquisition and will be released subject to resolution of certain contingencies.  In addition to the purchase consideration, the Company has recorded deferred compensation of $5.9 million, consisting of approximately $2.7 million in cash consideration and $3.2 million in the Company’s common stock, related to retention agreements with Vineyard’s three founders, which will be disbursed from the escrow account after one year of continuous employment with the Company.  The Company recognized $1.5 million and $4.3 million in compensation costs related to these retention agreements for the three and nine months ended September 30, 2013, respectively.

The Company recognized acquisition-related costs for Vineyard of $1.0 million during the first quarter of 2013. These acquisition related charges were expensed in the period incurred and reported in the Company’s condensed consolidated statements of operations within general and administrative expenses.

The following table summarizes the net assets and liabilities acquired, including identifiable intangible assets, based on their respective fair values at the acquisition date (in thousands):

Assets acquired
Cash	$	822
Accounts receivable, net		525
Other current assets		2,095
Identifiable intangible assets		8,460
Goodwill (1)		12,751
Other assets		303
Total assets acquired		24,956
Liabilities assumed
Accounts payable and other accrued liabilities		420
Deferred revenue		555
Notes payable		511
Deferred tax liability		2,546
Total liabilities assumed		4,032
Net assets acquired	$	20,924

(1) None of the goodwill recognized is expected to be deductible for income tax purposes.

Intangible Assets Acquired

The following table presents details of the intangible assets acquired in connection with the acquisition of Vineyard, which was completed during the first quarter of 2013 (in thousands, except years):

10

	Estimated Useful Life (in years)		Amount
Developed technology		5	$	5,910
Customer relationships		5		2,550
Total			$	8,460

Acquired technology consists of existing research and development projects at the time of the acquisition that have reached technological feasibility. No in-process research and development was included in acquired intangibles as of the acquisition date.

Pro Forma Financial Information

The following tables summarize the supplemental condensed consolidated statements of operations information on an unaudited pro forma basis as if the acquisition of Vineyard occurred on January 1, 2012 and includes adjustments that were directly attributable to the foregoing transaction or were not expected to have a continuing impact on the Company. The pro forma results are for illustrative purposes only for the applicable period and do not purport to be indicative of the actual results that would have occurred had the transactions been completed as of the beginning of the period, nor are they indicative of results of operations that may occur in the future (in thousands, except per share amounts):

	Three Months Ended September 30,							Nine Months Ended September 30,
	2013				2012			2013				2012
Pro forma revenues		$	21,440			$	16,695		$	54,474			$	44,232
Pro forma net income (loss)			(1,408	)			277			(6,393	)			(2,574	)
Basic and diluted earnings (loss) per share		$	(0.07	)		$	0.01		$	(0.31	)		$	(0.14	)

The pro forma financial information reflects acquisition-related expenses incurred, pro forma adjustments for the additional amortization associated with finite-lived intangible assets acquired, deferred compensation costs related to the retention of certain Vineyard employees, the change in stock compensation expense as a result of the exercise of stock options immediately prior to the closing of the Vineyard transaction, stock compensation related to the stock options granted to Vineyard employees, and the related tax expense. The pro forma net loss per share amounts also reflect the impact of the issuance of approximately 518,000 shares in connection with the acquisition as if they were issued in January 2012.

These adjustments are as follows (in thousands):

	Three Months Ended September 30,							Nine Months Ended September 30,
	2013				2012			2013				2012
Acquisition-related expenses for Vineyard		$	—			$	—		$	(1,026	)		$	—
Intangible amortization			—				417			36				1,242
Net change in stock compensation expense			—				267			(636	)			1,461
Increase (decrease) in deferred compensation expense			(1,468	)			1,468			(4,279	)			4,405
Increase in weighted average common shares outstanding for shares issued and not already included in the weighted average common shares outstanding			302				518			309				518

6. GOODWILL AND INTANGIBLE ASSETS

Changes in the carrying value of goodwill for the nine months ended September 30, 2013 were as follows (in thousands):

11

	Nine Months Ended
	September 30,
	2013
Balance, December 31, 2012		$	960
Additions from Vineyard acquisition			12,751
Translation adjustments			(622	)
Balance, September 30, 2013		$	13,089

Intangible assets other than goodwill are amortized on a straight-line basis over their estimated remaining useful lives.

The following table is a summary of acquired intangible assets with remaining net book values at September 30, 2013 (in thousands, except weighted average remaining life):

	Gross Carrying Value		Accumulated Amortization			Net Carrying Value		Weighted Average Remaining Life
Developed technology	$	5,626	$	(820	)	$	4,806		4.27
Customer relationships		2,428		(353	)		2,075		4.27
Balance at September 30, 2013	$	8,054	$	(1,173	)	$	6,881

The Company had no acquired intangible assets with remaining book values at December 31, 2012.

For the three and nine months ended September 30, 2013, amortization expense of $0.3 million and $0.8 million, respectively, related to developed technology was recorded in product cost of sales.  For the three and nine months ended September 30, 2013, amortization expense of $0.2 million and $0.4 million, respectively, related to customer relationships was recorded in sales and marketing expense.

The changes in the carrying value of acquired intangible assets during the nine months ended September 30, 2013 were as follows (in thousands):

	Gross Carrying Value			Accumulated Amortization			Net Carrying Value
Balance at December 31, 2012	$	—		$	—		$	—
Additions		8,460			(1,173	)		7,287
Translation adjustments		(406	)		—			(406	)
Balance at September 30, 2013	$	8,054		$	(1,173	)	$	6,881

The following table presents the estimated future amortization of intangible assets as of September 30, 2013 (in thousands):

Fiscal Year	Amortization
2013 (remaining three months)	$	403
2014		1,611
2015		1,611
2016		1,611
2017		1,611
Thereafter		34
Total	$	6,881

7. CERTAIN FINANCIAL STATEMENT INFORMATION

Accounts receivable:

Accounts receivable at September 30, 2013 and December 31, 2012 consisted of the following (in thousands):

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	September 30, 2013			December 31, 2012
Accounts receivable	$	20,473		$	16,699
Less: allowance for doubtful accounts		(178	)		(96	)
Total	$	20,295		$	16,603

Inventories:

Inventories are stated at the lower of cost, which approximates actual costs on a first in, first out basis, or market. Inventories at September 30, 2013 and December 31, 2012 consisted of the following (in thousands):

	September 30, 2013		December 31, 2012
Finished goods	$	16,864	$	10,886
Raw materials		184		354
Inventories, net	$	17,048	$	11,240

Accrued Liabilities:

Accrued liabilities at September 30, 2013 and December 31, 2012 consisted of the following (in thousands):

	September 30, 2013		December 31, 2012
Payroll and related	$	2,630	$	2,166
Sales commissions		1,300		1,112
Warranty		234		406
Audit and legal services		200		368
Other		1,342		897
Total accrued liabilities	$	5,706	$	4,949

Warranty Reserve

The Company warrants its products against material defects for a specific period of time, generally 12 months. The Company provides for the estimated future costs of warranty obligations in cost of sales when the related revenue is recognized. The accrued warranty costs represent the best estimate at the time of sale of the total costs that the Company expects to incur to repair or replace product parts which fail while still under warranty.  The amount of accrued estimated warranty costs is primarily based on current information on repair costs.  The Company periodically reviews the accrued balances and updates the historical warranty cost trends.

The following table summarizes warranty reserve activity during the nine months ended September 30, 2013 and 2012 (in thousands):

	Nine Months Ended September 30,
	2013			2012
Warranty accrual, beginning of period	$	406		$	565
Changes in liability for pre-existing warranties		(56	)		40
Deductions for warranty claims processed during the period		(116	)		(136	)
Warranty accrual, end of period	$	234		$	469

Accumulated Other Comprehensive Income (Loss):

The components of accumulated other comprehensive income (loss) at September 30, 2013 and December 31, 2012, net of taxes, were as follows (in thousands):

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	Foreign Currency Translation Adjustments			Net Unrealized Gain (Loss) on Short-Term Investments			Total
Accumulated other comprehensive income (loss) as of December 31, 2012	$	(96	)	$	20		$	(76	)
Other comprehensive income (loss), net of tax		(987	)		(21	)		(1,008	)
Accumulated other comprehensive income (loss) as of September 30, 2013	$	(1,083	)	$	(1	)	$	(1,084	)

The Company did not have any reclassifications out of accumulated other comprehensive income (loss) for the three and nine months ended September 30, 2013.  The Company did not have any other-than-temporary loss on its available-for-sale securities for all periods presented.

8. STOCKHOLDERS’ EQUITY

Common Stock Transactions

On January 9, 2013, the Company issued 825,060 unregistered shares with a value of approximately $14.7 million (gross value), pursuant to the Company’s acquisition of Vineyard as part of the purchase consideration in exchange for 100% of the outstanding securities of Vineyard, and deferred compensation to the founders of Vineyard.  On February 13, 2013, the Company filed with the SEC a Registration Statement on Form S-3 covering the resale of these shares.  The Registration Statement on Form S-3 was declared effective by the SEC on March 7, 2013.  Pursuant to the agreement, approximately 518,000 shares were transferred to the former Vineyard shareholders at closing, with the remainder being held in escrow for a period of 12, 18 or 36 months from the closing of the acquisition.

On April 25, 2012, the Company completed a registered offering of 4.5 million shares of common stock.  The shares were sold to the public at $21.00 per share for an aggregate gross sales price of $94.5 million.  The Company received net proceeds of approximately $88.0 million after deducting underwriting commissions and other offering expenses.

Equity Incentive Plan and Stock Option Activity

The Company’s 2007 Equity Incentive Plan, as amended (the “Plan”), provides for the grant of stock options and restricted stock awards (“RSAs”) to eligible employees, consultants, and non-employee directors of the Company.  As of September 30, 2013, 860,651 shares of the Company’s common stock were available for future grant under the Plan.  On January 9, 2013, the Company granted to certain former Vineyard employees who became employees of the Company upon closing of the Vineyard acquisition options to purchase an aggregate of 412,000 shares of the Company’s common stock.  These options were granted outside of the Plan as inducements material to such employees joining the Company.

The following table summarizes the Company’s stock option activity for the nine months ended September 30, 2013 and 2012 (in thousands, except per share data):

	Nine Months Ended September 30,
	2013					2012
	Options			Weighted Average Exercise Price		Options			Weighted Average Exercise Price
Outstanding at the beginning of the period		1,332		$	14.65		1,198		$	10.35
Granted		622			16.25		254			20.97
Exercised		(54	)		7.78		(302	)		9.92
Cancelled		(240	)		18.67		(37	)		11.84
Outstanding at the end of the period		1,660		$	15.23		1,113		$	12.86
Vested and expected to vest at the end of the period		1,555		$	15.08		1,067		$	12.71
Exercisable at the end of the period		609		$	11.40		611		$	11.44

As of September 30, 2013, the aggregate intrinsic value of options outstanding, options vested and expected to vest and options exercisable was $3.9 million, $3.9 million and $3.1 million, respectively.  As of September 30, 2013, the weighted average remaining contractual life of options outstanding, options vested and expected to vest and options exercisable was 8.28 years, 8.22 years and 6.80 years, respectively. The total intrinsic value of options exercised during the three and nine months ended September 30, 2013 was $0.2 million and $0.4 million, respectively.  The total intrinsic value of options exercised during the three and nine months ended September 30, 2012 was $1.4 million and $3.1 million, respectively.

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The weighted average remaining contractual life and weighted average per share exercise price of options outstanding and of options exercisable as of September 30, 2013 were as follows (in thousands, except exercise prices and years):

		Options Outstanding						Options Exercisable
Range of Exercise Prices		Number of Shares		Weighted Average Remaining Contractual Life (years)		Weighted Average Exercise Price		Number of Shares		Weighted Average Exercise Price
$	4.30 – $ 5.70		201		6.19	$	5.06		176	$	5.04
	6.00 – 9.72		133		5.16		7.42		125		7.30
	9.93 – 14.49		358		9.75		13.35		163		13.89
	14.50 – 33.50		968		8.69		19.11		145		19.84
$	4.30 – $ 33.50		1,660		8.28	$	15.23		609	$	11.40

The following table summarizes the Company’s RSA activity for the nine months ended September 30, 2013 and 2012 (in thousands, except per share data):

	Nine Months Ended September 30,
	2013						2012
	Awards			Weighted Average Grant Date Fair Value			Awards			Weighted Average Grant Date Fair Value
Unvested outstanding at the beginning of the period		253			$	15.79		136			$	9.24
Granted		40				14.45		17				20.86
Vested		(18	)			19.05		(25	)			8.75
Cancelled		(1	)			20.25		—				—
Unvested outstanding at the end of the period		274			$	15.36		128			$	10.90

The weighted average remaining contractual term for the RSAs outstanding as of September 30, 2013 was 2.56 years. As of September 30, 2013, the aggregate pre-tax intrinsic value of the RSAs outstanding was $2.7 million.

9. NET INCOME (LOSS)PER SHARE

Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted net income per share reflects the potential dilution that could occur from common shares issuable upon the exercise of outstanding stock options or warrants and the vesting of RSAs, which are reflected in diluted earnings per share by application of the treasury stock method.  Under the treasury stock method, the amount that the employee must pay for exercising stock options or warrants, the amount of stock-based compensation cost for future services that the Company has not yet recognized, and the amount of tax benefit that would be recorded in additional paid-in capital upon exercise are assumed to be used to repurchase shares.

The following table sets forth the computation of basic and diluted net income (loss) per share and potential shares of common stock that are not included in the diluted net income (loss) per share calculation because their effect is anti-dilutive (in thousands, except per share data):

	Three Months Ended September 30,					Nine Months Ended September 30,
	2013			2012		2013			2012
Numerator:
Net income (loss)	$	(2,983	)	$	2,763	$	(12,982	)	$	4,108
Denominator:
Weighted average common shares - basic		20,031			19,305		20,007			17,304
Dilutive effect of employee equity incentive plans		—			496		—			506
Dilutive effect of warrants		—			—		—			14
Weighted average common shares - diluted		20,031			19,801		20,007			17,824
Net income (loss) per share:
Basic	$	(0.15	)	$	0.14	$	(0.65	)	$	0.24
Diluted	$	(0.15	)	$	0.14	$	(0.65	)	$	0.23
Antidilutive securities:
Options and restricted stock		1,192			285		1,185			262

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10. STOCK-BASED COMPENSATION

The following table summarizes employee stock-based compensation expense, net of income tax, as it relates to the Company’s statement of operations for the three and nine months ended September 30, 2013 and 2012 (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
Cost of goods sold		$	101		$	34		$	281		$	98
Research and development			218			76			933			296
Sales and marketing			385			296			1,348			942
General and administrative			365			415			1,252			857
Total stock-based compensation expense		$	1,069		$	821		$	3,814		$	2,193

Stock-based compensation in the three and nine months ended September 30, 2013 includes a one-time $0.7 million charge associated with the acceleration of Vineyard option grants at the closing of the acquisition.

No income tax benefits were recognized in the three and nine months ended September 30, 2013 and 2012 due to current period operating losses and carry-forwards available to offset income in the prior year periods.  No stock-based compensation has been capitalized in inventory due to the immateriality of such amounts.

As of September 30, 2013, total unrecognized compensation cost related to unvested stock options was $8.9 million, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average period of 3.13 years, and total unrecognized compensation cost related to non-vested RSAs was $2.7 million, net of estimated forfeitures, which is expected to be recognized over an estimated weighted average period of 2.56 years.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option valuation model.  The fair value of each RSA is calculated based upon the closing stock price of the Company’s common stock on the date of the grant.  The expense for stock-based awards is recognized over the requisite service period using the straight-line attribution approach.

The following assumptions were used in determining the fair value of stock options granted during the three and nine months ended September 30, 2013 and 2012:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
Expected term (years)		4.77			4.04			4.84			4.10
Expected volatility		78.2	%		79.3	%		78.2	%		75.5	%
Risk-free interest rate		1.43	%		0.58	%		0.92	%		0.67	%
Expected dividend yield		0	%		0	%		0	%		0	%

The weighted average grant date fair value of options granted during the three and nine months ended September 30, 2013 was $8.71 and $9.75, respectively.  The weighted average grant date fair value of options granted during the three and nine months ended September 30, 2012 was $13.14 and $10.98, respectively.

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The Company calculated the expected term of stock options granted using historical exercise data.  The Company used the number of days between the grant and the exercise dates to calculate a weighted average of the holding periods for all awards (i.e., the average interval between the grant and exercise or post-vesting cancellation dates), adjusted as appropriate.  Expected volatilities were estimated using the historical share price performance over a period equivalent to the expected term of the option.  The risk-free interest rate for a period equivalent to the expected term of the option was extrapolated from the U.S. Treasury yield curve in effect at the time of the grant.  The Company has never paid cash dividends and does not anticipate paying cash dividends in the foreseeable future.

11. RELATED PARTY TRANSACTIONS

On July 19, 2010, the Company entered into a Master OEM Purchase and Sales Agreement (the “OEM Agreement”) with GENBAND US LLC and GENBAND Ireland Ltd. (collectively, “GENBAND”), pursuant to which GENBAND may purchase any of the Company’s existing software and hardware products, as well as procure licenses and services related to such products from the Company.  Pursuant to the OEM Agreement, the Company’s Board of Directors supported the election of Mark Pugerude, Chief Strategy Officer of GENBAND, as a director of the Company beginning in fiscal 2012 through the Company’s 2012 Annual Meeting of Stockholders on August 27, 2012, and B.G. Kumar, Executive Vice President and President of the Networking and Applications Product Unit of GENBAND, as a director of the Company beginning on August 27, 2012, the date of the Company’s 2012 Annual Meeting of Stockholders.  Mr. Kumar’s service on the Company’s Board of Directors ended on May 30, 2013, the date of the Company’s 2013 Annual Meeting of Stockholders.

During the three and nine months ended September 30, 2013, the Company recognized revenue of approximately $0.1 million on sales to GENBAND.  During the three and nine months ended September 30, 2012, the Company recognized revenue of approximately $0.1 million and $1.7 million, respectively, on sales to GENBAND.  At December 31, 2012, the Company had accounts receivable of approximately $38,000 from GENBAND.

Effective April 15, 2013, Procera and GENBAND terminated the OEM Agreement and the letter agreement, dated July 19, 2010 (the “Letter Agreement”), between the Company and GENBAND US LLC. The termination of the OEM Agreement and the Letter Agreement was effected pursuant to the execution of a transition agreement between Procera and GENBAND.  The transition agreement permits GENBAND to continue to perform its functions for existing customers, as provided under the OEM Agreement, for the remainder of the current service term, and further provides that Procera will continue to provide support or maintenance to GENBAND’s existing customers under or in connection with the OEM Agreement and for which GENBAND previously submitted a purchase order.

12. COMMITMENTS AND CONTINGENCIES

Legal

The Company is periodically involved in legal actions and claims that arise as a result of events that occur in the normal course of operations.  The Company does not believe that any of its legal actions and claims will have, individually or in the aggregate, a material adverse effect on the Company’s financial position or results of operations.

Operating Leases

The Company leases its operating and office facilities for various terms under long-term, non-cancelable operating lease agreements.  The leases expire at various dates through 2018 and provide for renewal options ranging from month-to-month to three year terms.  In the normal course of business, it is expected that these leases will be renewed or replaced by leases on other properties.  The leases provide for increases in future minimum annual rental payments based on defined increases which are generally meant to correlate with the Consumer Price Index, subject to certain minimum increases.  Also, the agreements generally require the Company to pay executory costs (real estate taxes, insurance and repairs).

As of September 30, 2013, future minimum lease payments due under operating leases are as follows (in thousands):

Fiscal years ending December 31,	Amount
2013 (remaining)	$	255
2014		873
2015		683
2016		561
2017		447
Thereafter		169
Total future minimum lease payments	$	2,988

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The Company entered into a new lease arrangement for its corporate headquarters in Fremont, California effective November 2013, and the minimum lease payment amounts associated with this new lease are reflected in the table above.

Secured Line of Credit

On December 10, 2009, the Company entered into a two-year loan and security agreement for a secured line of credit facility (“Secured Credit Facility”) for short-term working capital purposes with Silicon Valley Bank.  On February 3, 2012, the Secured Credit Facility was amended and restated (the “Amended Secured Credit Facility”) to increase the secured line of credit facility from $2.0 million to $10.0 million and to provide for borrowings through February 2, 2014. Pursuant to the Amended Secured Credit Facility, borrowings bear interest at the prime rate plus 1%, but not less than 4.25% on an annual basis.  The Company will pay Silicon Valley Bank a $35,000 commitment fee in each of the two years under the Amended Secured Credit Facility. The Amended Secured Credit Facility is secured by substantially all of the Company’s assets.  The terms of the Amended Secured Credit Facility include a financial covenant requiring a minimum company liquidity ratio and restrictions on the Company’s ability to incur certain additional indebtedness, pay dividends, create or permit liens on assets or engage in mergers, consolidations or dispositions.  The Amended Secured Credit Facility may be terminated at any time by the Company during the term of the agreement, to take effect three business days after the Company provides written notice to Silicon Valley Bank.  In connection with such termination, the Company would be obligated to pay Silicon Valley Bank a $50,000 termination fee.  The Company was in compliance with the financial covenants as of September 30, 2013.  At September 30, 2013 and December 31, 2012, the Company had no outstanding balance under the Amended Secured Credit Facility.

Concentrations

For the three months ended September 30, 2013, revenue from two customers represented 33% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2013, revenue from Shaw Communications, Inc. represented 13% of net revenue, and two other customers represented 13% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the three months ended September 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 16% and 24% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 17% and 10% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.

At September 30, 2013, accounts receivable from three customers represented 37%, 15% and 11%, respectively, of total accounts receivable, with no other single customer accounting for more than 10% of the accounts receivable balance.  At December 31, 2012, accounts receivable from three customers represented 14%, 12% and 12%, respectively, of total accounts receivable with no other single customer accounting for more than 10% of the accounts receivable balance.

Indemnification

The Company generally agrees to indemnify customers against legal claims that the Company's products infringe certain third party property rights. As of September 30, 2013 and 2012, the Company has not been required to make any payments resulting from infringement claims asserted against customers and has not recorded any related reserves.

13. INCOME TAXES

The Company’s effective tax rate was 12% for the nine months ended September 30, 2013 and 3% for the nine months ended September 30, 2012.  For the three and nine months ended September 30, 2013, the Company recorded an income tax benefit of $0.2 million and $1.7 million, respectively, on a loss before provision for income taxes of $3.2 million and $14.7 million, respectively.  For the three and nine months ended September 30, 2012, the Company recorded an income tax provision of $29,000 and $0.1 million, respectively, on an income before provision for income taxes of $2.8 million and $4.2 million, respectively. The effective tax rate for the nine months ended September 30, 2013 differs from the federal statutory tax rate as a result of the income tax benefit related to the release of Vineyard’s pre-existing income tax valuation allowance, the amortization of the acquired intangibles, state taxes and earnings taxed in foreign jurisdictions.

In 2002, the Company established a valuation allowance for substantially all of its deferred tax assets.   Since that time, the Company has continued to record a valuation allowance.  A valuation allowance is required to be established or maintained when it is more likely than not that all or a portion of deferred tax assets will not be realized.  The Company will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal.

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The Company recognizes interest and penalties related to uncertain tax positions in income tax expense.  As of September 30, 2013, the Company had no accrued interest or penalties related to uncertain tax positions.   The federal returns for the years ended 2009 through the current period and most state returns for the years ended 2008 through the current period remain open to examination.  In addition, all of the net operating losses and research and development credit carryforwards that may be used in future years are still subject to adjustment.  The Company is also subject to examinations in other foreign jurisdictions, including Australia and Sweden beginning in 2006 through the current period.

At September 30, 2013, the Company had $193,000 of unrecognized tax benefits, a total of $158,000 which would affect the Company’s effective tax rate if recognized. The Company does not anticipate that the total unrecognized tax benefits will change significantly over the next 12 months.

14. SEGMENT INFORMATION

The Company operates in one business segment providing specialized products and related services that enable network operators to manage and control their networks.  Sales for geographic regions are based upon the customer’s location.  The location of long-lived assets is based on the physical location of the Company’s regional offices.

The following are summaries of net sales by geographical region (in thousands):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013		2012
Sales:
United States	$	4,572	$	4,949	$	13,916	$	16,042
Canada and Latin America		1,708		2,633		8,401		7,487
Europe, Middle East and Africa		9,737		3,031		19,108		10,749
Asia Pacific		5,316		5,448		11,918		8,780
Total	$	21,333	$	16,061	$	53,343	$	43,058

The following are summaries of long-lived assets by geographical region (in thousands):

	September 30, 2013		December 31, 2012
Long-lived assets:
United States	$	1,495	$	1,750
Canada		293		—
Europe		4,406		2,719
Asia Pacific		3		5
Total	$	6,197	$	4,474

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included elsewhere in this report and the audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2012, filed with the SEC on March 15, 2013.

As used in this Quarterly Report on Form 10-Q, references to the “Company,” “we,” “us,” “our” or similar terms include Procera Networks, Inc. and its consolidated subsidiaries.

Cautionary Note Regarding Forward-Looking Statements

Our disclosure and analysis in this Quarterly Report on Form 10-Q contain certain “forward-looking statements,” as such term is defined in Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  These statements set forth anticipated results based on management’s plans and assumptions. From time to time, we also provide forward-looking statements in other materials we release to the public as well as oral forward-looking statements.  Such statements give our current expectations or forecasts of future events; they do not relate strictly to historical or current facts. We have attempted to identify such statements by using words such as “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe,” “will,” “could,” “initial,” “future,” “may,” “predict,” “potential,” “should” and similar expressions in connection with any discussion of future events or future operating or financial performance or strategies. Such forward-looking statements include, but are not limited to, statements regarding:

● trends related to and management’s expectations regarding future results of operations, required capital expenditures, revenues from existing and new products and sales channels, and cash flows, including but not limited to those statements set forth below in this Item 2;

● sales efforts, expenses, interest rates, foreign exchange rates, and the outcome of contingencies, such as legal proceedings;

● our services, including the development and deployment of products and services and strategies to expand our targeted customer base and broaden our sales channels;

● the operation of our Company with respect to the development of products and services; and

● our liquidity and financial resources, including anticipated capital expenditures, funding of capital expenditures and anticipated levels of indebtedness.

We cannot guarantee that any forward-looking statement will be realized. Achievement of future results is subject to risks, uncertainties and potentially inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from past results and those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements.

We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any further disclosures we make on related subjects in our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. We also provide cautionary discussion of risks and uncertainties related to our businesses which are identified under the caption “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q.  We believe these factors, individually or in the aggregate, as well as general risks and uncertainties such as those relating to general economic conditions and demand for our products and services, could cause our actual results to differ materially from expected and historical results. We note these factors for investors as permitted by Section 21E of the Exchange Act. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties.

Overview

We are a leading provider of Internet Intelligence solutions designed for carriers, service providers and enterprises worldwide.  Procera’s PacketLogic solutions provide actionable intelligence and policy enforcement to ensure a high quality experience for any Internet connected devices.  Network operators deploy our technology to enable real-time visibility, superior performance and scalability, and deliver personalized services for millions of enterprises and consumers.  Enterprises utilize our embedded Network Application Visibility Library (“NAVL”) solutions to ensure that they can deliver “bring your own device” and Cloud services to their employees.  We believe that the intelligence our products provide about users and their usage enables our network operator customers to make informed business decisions.  Our network operator customers include mobile service providers, broadband service providers, cable multiple system operators (“MSOs”), Internet Service Providers (“ISPs”), educational institutions, enterprises and government agencies.  We sell our products directly to network operators; through partners, value added resellers and system integrators; and to other network solution suppliers for incorporation into their network solutions.

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Our Intellegent Policy Enforecement (“IPE”) products are part of the high-growth market for mobile packet and broadband core products.  The market for IPE products was $596 million in 2012 and is expected to grow to $1.9 billion in 2017, a 2012–2017 compounded annual growth rate of 26%.  Our bundled products deliver a solution that is a key element of the mobile packet and broadband core ecosystems.  Our solutions are often integrated with additional elements in the mobile packet and broadband core, including Policy Management and Charging functions, and are compliant with the widely adopted 3rd Generation Partnership Program (“3GPP”) standard.  In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, network operators are seeking higher degrees of intelligence, optimization, network management, service creation and delivery in order to differentiate their offerings and deliver a high quality of experience to their subscribers.  We believe the need to create more intelligent and innovative mobile and broadband networks will continue to drive demand for our products.

Our embedded solutions enable network solutions suppliers to more quickly add Internet Intelligence to their platforms, since our NAVL products have been designed to be highly portable among many platforms and processors. NAVL eliminates the need for network solutions providers to research and develop their own Deep Packet Inspection technology, saving significant time and resources while enabling them to more effectively compete in their market space.

Our products are marketed under the PacketLogic and NAVL brand names.  We have a broad spectrum of products delivering IPE at the access, edge and core layers of the network.  Our products are designed to offer maximum flexibility to our customers and enable differentiated services and revenue-enhancing applications, all while delivering a high quality of service for subscribers.

We face competition from suppliers of standalone and integrated IPE and deep packet inspection (“DPI”) products including Allot Communications Ltd., Tektronix (acquired Arbor Networks), Blue Coat Systems, Brocade Communications Systems, Cisco Systems, Inc., Citrix Systems (acquired Bytemobile), SAIC (acquired Cloudshield Technologies), Ericsson, F5 Networks, Huawei Technologies Company and Sandvine Corporation.  Some of our competitors supply platform products with different degrees of DPI functionality, such as switch/routers, routers, session border controllers and VoIP switches.  Some of our competitors are also our customers.

Most of our competitors are larger and more established enterprises with substantially greater financial and other resources.  Some competitors may be willing to reduce prices and accept lower profit margins to compete with us.  As a result of such competition, we could lose market share and sales, or be forced to reduce our prices to meet competition.  However, we do not believe there is a dominant supplier in our market.  Based on our belief in the superiority of our technology, we believe that we have an opportunity to increase our market share and benefit from what we believe will be growth in the DPI market.

On January 9, 2013, we completed our acquisition of Vineyard Networks, Inc. (“Vineyard”), a privately held developer of Layer 7 Deep Packet Inspection and application classification technology located in Kelowna, Canada. Vineyard’s integrated DPI and application classification technology provides enterprise and service provider networking infrastructure vendors with these capabilities through its integrated software suite, primarily through a variety of subscription based Original Equipment Manufacturer and Partner agreements.  This acquisition complements our hardware and application software-based IPE and DPI solutions, expands the way we sell solutions to customers, and increases our customer base, previously comprised primarily of network operators, thereby allowing us to provide complementary technology and solutions to a greater number of customers.

Our Company is headquartered in Fremont, California and we have key operating entities in Kelowna, Canada and Varberg, Sweden, as well as a geographically dispersed sales force.  We sell our products through our direct sales force, resellers, distributors, systems integrators and other equipment manufacturers in the Americas, Asia Pacific and Europe.

Critical Accounting Estimates

The discussion and analysis of our financial condition and results of operations are based upon financial statements which have been prepared in accordance with Generally Accepted Accounting Principles in the United States (“U.S. GAAP”).  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities.  On an ongoing basis, we evaluate these estimates.  We base our estimates on historical experience and on assumptions that are believed to be reasonable.  These estimates and assumptions provide a basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions, and these differences may be material.

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We believe the following critical accounting policies reflect our most significant estimates, judgments and assumptions used in the preparation of our consolidated financial statements:

● Revenue Recognition;

● Valuation of Goodwill, Intangible and Long-Lived Assets;

● Allowance for Doubtful Accounts;

● Stock-Based Compensation; and

● Accounting for Income Taxes.

These critical accounting policies and related disclosures appear in our Annual Report on Form 10-K for the year ended December 31, 2012, filed with the SEC on March 15, 2013.

Results of Operations

Comparison of Three and Nine Months Ended September 30, 2013 and 2012

Revenue

Revenue for the three and nine months ended September 30, 2013 and 2012 was as follows (in thousands, except percentages):

	Three Months Ended September 30,									Nine Months Ended September 30,
	2013			2012		Increase			2013			2012		Increase
Net product revenue		$	16,301	$	12,948		26	%		$	40,328	$	34,640		16	%
Net support revenue			5,032		3,113		62	%			13,015		8,418		55	%
Total revenue		$	21,333	$	16,061		33	%		$	53,343	$	43,058		24	%

Our revenue is derived from two sources: 1) product revenue, which includes sales of our hardware appliances bundled with software licenses, separate software licenses and software upgrades; and 2) service revenue, which consists primarily of software maintenance and customer support revenue and secondarily of professional services.  Maintenance and customer support revenue is recognized over the support period, which is typically 12 months.

Total product revenue in the three and nine months ended September 30, 2013 was $16.3 million and $40.3 million, an increase of 26% and 16%, respectively, compared with $12.9 million and $34.6 million in the three and nine months ended September 30, 2012. The increase in product revenue in the three and nine months ended September 30, 2013 compared to the comparable prior year periods reflected the recognition of a significant orderfrom one of our Tier 1 service provider customers, in addition to follow-on orders from existing customers and continued sales to our network operator customers, including mobile service providers, fixed line service providers, and cable multiple system operators.  We also continued to add new enterprise and higher education customers.   The increase in revenue also reflected our continued expansion in international markets, including the Middle East, Japan and Latin America.  The increase in support revenue in the three and nine months ended September 30, 2013 compared to the comparable prior year periods reflected the continued expansion of the installed base of our product to which we have sold ongoing support services, as well as growth in professional services revenue. For the three and nine months ended September 30, 2013, Vineyard contributed $0.6 million and $1.0 million in product revenue, respectively, and $0.2 million and $0.7 million in support revenue, respectively.  There was no revenue in our results for Vineyard in 2012 as the acquisition was completed in early 2013.  For the three months ended September 30, 2013, revenue from two customers represented 33% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2013, revenue from Shaw Communications, Inc. represented 13% of net revenue, and two other customers represented 13% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the three months ended September 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 16% and 24% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 17% and 10% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.

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Sales to customers located in the United States as a percentage of total revenue were 21% and 26% for the three and nine months ended September 30, 2013, respectively, compared to 31% and 37% for the three and nine months ended September 30, 2012, respectively.

We believe that our revenue will increase in the remaining quarter of the fiscal year ending December 31, 2013, both sequentially and as compared with the fourth quarter of the fiscal year ended December 31, 2012.

Cost of Sales

Cost of sales includes material costs and direct labor for products sold, amortization of acquired developed technology, costs expected to be incurred for warranty, adjustments to inventory values, including the write-down of slow moving or obsolete inventory, and costs for support and professional services personnel.

The following table presents the breakdown of cost of sales by category for the three and nine months ended September 30, 2013 and 2012 (in thousands, except percentages):

	Three Months Ended September 30,									Nine Months Ended September 30,
	2013			2012			Increase			2013			2012			Increase
Product costs	$	10,080		$	4,053			149	%	$	22,451		$	12,671			77	%
Percent of net product revenue		62	%		31	%					56	%		37	%
Support costs	$	896		$	487			84	%	$	2,442		$	956			155	%
Percent of net support revenue		18	%		16	%					19	%		11	%
Total cost of sales	$	10,976		$	4,540			142	%	$	24,893		$	13,627			83	%
Percent of total net revenue		51	%		28	%					47	%		32	%

Total cost of sales in the three and nine months ended September 30, 2013 increased by $6.4 million and $11.3 million, respectively, compared to the three and nine months ended September 30, 2012.  Cost of sales as a percentage of revenue increased by 23 and 15 percentage points for the three and nine months ended September 30, 2013, respectively, compared to the same periods in the prior year.  The increase in cost of sales in 2013 primarily reflected higher material costs associated with increased product sales and higher support costs for increased customer support and professional services personnel. The increase also reflected amortization of developed technology intangible assets acquired as part of the Vineyard acquisition in January 2013 of $0.3 million and $0.8 million in the three and nine months ended September 30, 2013, respectively.  The increase in cost of sales as a percentage of revenue primarily reflected a higher proportion of hardware sales, including greater chasis-based hardware sales in the three and nine months ended September 30, 2013 as compared to the corresponding periods of 2012. Stock-based compensation recorded to cost of sales in the three and nine months ended September 30, 2013 was $0.1 million and $0.3 million, respectively, compared to $34,000 and $0.1 million, respectively, in the corresponding periods of 2012.

Gross Profit

Gross profit for the three and nine months ended September 30, 2013 and 2012 was as follows (in thousands, except percentages):

	Three Months Ended September 30,										Nine Months Ended September 30,
	2013				2012				Decrease		2013				2012				Decrease
Gross profit		$	10,357			$	11,521			10		$	28,450			$	29,431			3
Percent of total net revenue			49	%			72	%					53	%			68	%

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Our total gross profit margin for the three and nine months ended September 30, 2013 decreased by 23 and 15 percentage points to 49% and 53%, respectively, compared to 72% and 68% for the three and nine months ended September 30, 2012, respectively.  The decrease resulted from a higher proportion of hardware sales, particularly chasis-based hardware sales in the three and nine months ended September 30, 2013, higher support and service costs and amortization of acquired intangible assets.  We expect our gross profit margin to increase in the remaining quarter of the fiscal year ending December 31, 2013, as compared with the third quarter of 2013.

Operating Expenses

Operating expenses for the three and nine months ended September 30, 2013 and 2012 were as follows (in thousands, except percentages):

	Three Months Ended September 30,									Nine Months Ended September 30,
	2013			2012			Increase			2013			2012			Increase
Research and development		$	3,945		$	1,931		104	%		$	12,532		$	5,414		131	%
Sales and marketing			7,322			4,573		60	%			21,293			13,053		63	%
General and administrative			2,510			2,386		5	%			9,498			6,823		39	%
Total		$	13,777		$	8,890		55	%		$	43,323		$	25,290		71	%

In the three and nine months ended September 30, 2013, our total operating expenses increased to support the scale of our operations as we hired additional employees in each function of our Company, invested in testing equipment for the development of our products, invested in infrastructure, and increased the use of outside services, including legal, audit and accounting services. Additionally, our costs have increased due to the integration of Vineyard personnel and related operating costs.

We anticipate that our operating expenses will continue to increase in subsequent periods and that total operating expenses for the remaining quarter of the year ending December 31, 2013 will exceed those incurred during the third quarter of 2013.

Research and Development

Research and development expenses include costs associated with personnel focused on the development or improvement of our products, prototype materials, initial product certifications, testing equipment and software costs.  Research and development costs include sustaining and enhancement efforts for products already released and development costs associated with planned new products.  Research and development expenses for the three and nine months ended September 30, 2013 and 2012 were as follows (in thousands, except percentages):

	Three Months Ended September 30,											Nine Months Ended September 30,
	2013				2012				Increase			2013				2012				Increase
Research and development		$	3,945			$	1,931			104	%		$	12,532			$	5,414			131	%
As a percentage of net revenue			18	%			12	%						23	%			13	%

Research and development expenses for the three and nine months ended September 30, 2013 increased by $2.0 million and $7.1 million, respectively, compared to the three and nine months ended September 30, 2012 as a result of increased research and development personnel and the corresponding additional employee compensation costs, including the addition of Vineyard personnel, and amortization of deferred compensation of $0.8 million and $2.2 million, respectively, in the three and nine months ended September 30, 2013 associated with the Vineyard acquisition, as well as an increase in testing equipment costs.  The additional personnel are expected to allow us to enhance our core product features and functionality in order to support new sales and to achieve follow-on sales to our current customers.  Stock-based compensation recorded to research and development expenses in the three and nine months ended September 30, 2013 was $0.2 million and $0.9 million, respectively, compared with $0.1 million and $0.3 million, respectively, for the corresponding periods in 2012.  Research and development expenses as a percentage of revenue increased 6 and 10 percentage points for the three and nine months ended September 30, 2013, respectively, compared to the corresponding periods in 2012 primarily due to the addition of Vineyard employees.

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Sales and Marketing

Sales and marketing expenses primarily include personnel costs, sales commissions and marketing expenses, such as trade shows, channel development and literature. Sales and marketing expenses for the three and nine months ended September 30, 2013 and 2012 were as follows (in thousands, except percentages):

	Three Months Ended September 30,											Nine Months Ended September 30,
	2013				2012				Increase			2013				2012				Increase
Sales and marketing		$	7,322			$	4,573			60	%		$	21,293			$	13,053			63	%
As a percentage of net revenue			34	%			28	%						40	%			30	%

Sales and marketing expenses for the three and nine months ended September 30, 2013 increased by $2.7 million and $8.2 million, respectively, compared to the three and nine months ended September 30, 2012.  The increase reflected the addition of sales and marketing personnel as a result of the Vineyard acquisition, hiring of additional sales and marketing employees, and the corresponding higher compensation costs and higher commission costs as a result of the increase in revenue.  The increase also reflected the amortization of deferred compensation of $0.7 million and $2.1 million, respectively, and the amortization of acquired intangible assets of $0.2 million and $0.4 million, respectively, in the three and nine months ended September 30, 2013 associated with the Vineyard acquisition.  Stock-based compensation recorded to sales and marketing expenses in the three and nine months ended September 30, 2013 was $0.4 million and $1.3 million, respectively, compared with $0.3 million and $0.9 million, respectively, in the corresponding periods of 2012.  Sales and marketing expenses as a percentage of revenue increased 6 and 10 percentage points for the three and nine months ended September 30, 2013, respectively, compared to the corresponding periods in 2012 primarily due to the addition of Vineyard related costs.

General and Administrative

General and administrative expenses consist primarily of personnel and facilities costs related to our executive, finance functions and fees for professional services.  Professional services include costs for legal advice and services, accounting and tax professionals, independent auditors and investor relations. General and administrative expenses for the three and nine months ended September 30, 2013 and 2012 were as follows (in thousands, except percentages):

	Three Months Ended September 30,											Nine Months Ended September 30,
	2013				2012				Increase			2013				2012				Increase
General and administrative		$	2,510			$	2,386			5	%		$	9,498			$	6,823			39	%
As a percentage of net revenue			12	%			15	%						18	%			16	%

General and administrative expenses for the three and nine months ended September 30, 2013 increased by $0.1 million and $2.7 million, respectively, compared to the three and nine months ended September 30, 2012, reflecting increased accounting and human resource personnel related costs, legal and audit fees and increased use of contractors and outside services. The increase also reflects $1.6 million in business development costs for legal, accounting and investment banking fees in the nine months ended September 30, 2013 compared to $0.6 million in business development costs in the nine months ended September 30, 2012 associated with completed and potential mergers, acquisitions and partnership agreements. Stock-based compensation recorded to general and administrative expense in the three and nine months ended September 30, 2013 was $0.4 million and $1.3 million, respectively, compared to $0.4 million and $0.9 million, respectively, in the corresponding periods in 2012.  General and administrative expenses as a percentage of revenue decreased 3 percentage points and increased 2 percentage points for the three and nine months ended September 30, 2013, respectively, compared to the corresponding periods in 2012.  The decrease as a percentage of revenue in the three months ended September 30, 2013 resulted from a smaller 5% increase in general and administrative expenses, as compared with a 33% increase in revenue.  The increase as a percentage of revenue for the nine months ended September 30, 2013 reflected additional personnel, professional services and business development costs, which resulted in general and administrative expenses increasing at a faster rate than revenue in the nine month period.

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Interest and Other Income (Expense), Net

	Three Months Ended September 30,									Nine Months Ended September 30,
	2013			2012			Increase			2013			2012			Increase
	($ in thousands)									($ in thousands)
Interest and other income (expense), net		$	232		$	161		44	%		$	203		$	108		88	%

Interest and other income (expense), net increased in the three and nine months ended September 30, 2013 compared to the three and nine months ended September 30, 2012.  The increase in the three months ended September 30, 2013 reflected higher foreign currency gains partially offset by lower interest income.  The increase in the nine months ended September 30, 2013 reflected relatively flat interest income offset by lower forign currency losses.

Provision for Income Taxes

	Three Months Ended September 30,										Nine Months Ended September 30,
	2013				2012			Change			2013				2012			Change
	($ in thousands)										($ in thousands)
Provision for income taxes		$	(205	)		$	29		(807	)%		$	(1,688	)		$	141		(1297	)%

We are subject to taxation primarily in the U.S., Australia, Canada, Japan, Singapore and Sweden as well as in a number of U.S. states, including California.  The tax benefit for the three and nine months ended September 30, 2013 primarily reflects the following Vineyard acquisition related items: amortization of intangible assets acquired and the tax impact of book/tax differences on deferred revenue.  The tax benefit for the nine months ended September 30, 2013 also included the reversal of Vineyard’s pre-existing income tax valuation allowance upon acquisition.

We have established a valuation allowance for substantially all of our deferred tax assets.  We calculated the valuation allowance in accordance with the provisions of Accounting Standards Codification Topic 740, which requires that a valuation allowance be established or maintained when it is “more likely than not” that all or a portion of deferred tax assets will not be realized.  We will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal.

Liquidity and Capital Resources

Cash, Cash Equivalents and Investments

The following table summarizes the changes in our cash balance for the periods indicated:

	Nine Months Ended
	September 30,
	2013				2012
	($ in thousands)
Net cash provided by (used in) operating activities		$	(10,751	)	$	7,587
Net cash provided by (used in) investing activities			57,142			(80,445	)
Net cash provided by (used in) financing activities			(69	)		91,050
Effect of exchange rate changes on cash and cash equivalents			(117	)		55
Net increase in cash and cash equivalents		$	46,205		$	18,247

During the nine months ended September 30, 2013, we used $10.8 million in cash from operating activities as compared to $7.6 million generated from operating activities for the nine months ended September 30, 2012.  Cash used by operating activities during the nine months ended September 30, 2013 primarily consisted of our net loss of $13.0 million and net working capital uses of cash of $8.3 million, offset by non-cash charges of $10.5 million. Non-cash charges consisted primarily of stock-based compensation of $3.8 million, amortization of intangible assets of $1.2 million, amortization of premium on investments of $0.8 million, depreciation expense of $1.3 million and amortization of deferred compensation of $4.3 million, partially offset by changes in deferred taxes of $1.6 million. Working capital uses of cash consisted primarily of an increase in inventory of $6.4 million resulting from material purchases in anticipation of future sales, an increase in accounts receivable of $3.2 million resulting from higher sales, an advance payment to escrow of $2.7 million recorded as deferred compensation related to retention agreements with Vineyard’s three founders which are payable after one year of continuous employment with the Company and a decrease in accounts payable of $1.2 million associated with payments on inventory purchases.  Working capital sources of cash included a decrease in prepaid expenses and other current assets of $2.2 million primarily resulting from the receipt of a tax credit, an increase in accrued liabilities of $0.5 million as a result of higher accrued commissions and bonuses on the higher level of sales, and a $2.6 million increase in deferred revenues as a result of our expanding customer base.

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Net cash provided by investing activities of $57.2 million during the nine months ended September 30, 2013 consisted of proceeds from net purchases, sales and maturities of short-term investments of $68.3 million, partially offset by net cash consideration associated with the acquisition of Vineyard of $9.0 million, and purchases of lab and testing equipment for use in research and development of $2.2 million.

Net cash used in financing activities of $0.1 million during the nine months ended September 30, 2013 consisted of the repayment of debt acquired from Vineyard of $0.5 million, offset by proceeds from the exercise of stock options of $0.4 million.

Our cash, cash equivalents and short-term investments at September 30, 2013 consisted of bank deposits with third party financial institutions, money market funds, U.S. agency securities, commercial paper and corporate bonds.  Our investments are intended to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations and delivers an appropriate yield in relationship to our investment guidelines and market conditions.  Cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the date of purchase.  Short-term investments generally have a remaining maturity of greater than three months at the date of purchase and the portfolio of short-term investments have a weighted-average maturity of less than one year.  All investments are classified as available for sale.

In January 2013, we acquired Vineyard in Kelowna, Canada.  The aggregate total consideration of approximately $20.9 million consisted of $9.8 million in cash and 825,060 shares of our common stock.  In addition to the purchase consideration, we have recorded deferred compensation of $5.9 million, consisting of approximately $2.7 million in cash consideration and $3.2 million in our common stock, related to retention agreements with Vineyard’s three founders, which will be disbursed from the escrow account after one year of continuous employment with the Company.

On December 10, 2009, we entered into a two-year loan and security agreement for a secured credit facility of $2.0 million for short-term working capital purposes with Silicon Valley Bank.  Borrowings under the facility bore interest at the prime rate plus 1%, but not less than 5% per annum.  On February 3, 2012, the agreement was amended and restated to increase the credit facility from $2.0 million to $10.0 million for an additional two-year period beginning on that date.  Borrowings under the amended and restated credit facility bear interest at the prime rate plus 1%, but not less than 4.25% on an annual basis.  At September 30, 2013, we had no borrowings outstanding under this credit facility.

Based on our current cash, cash equivalents and short-term investment balances, and anticipated cash flow from operations, we believe that our working capital will be sufficient to meet the cash needs of our business for at least the next 12 months.  Our future capital requirements will depend on many factors, including our rate of growth, the expansion of our sales and marketing activities, development of additional channel partners and sales territories, the infrastructure costs associated with supporting a growing business and greater installed base of customers, introduction of new products, enhancement of existing products and the continued acceptance of our products.  We may also enter into arrangements that require investment such as entering into complementary businesses, service expansion, technology partnerships or acquisitions.

Off-Balance Sheet Arrangements

As of September 30, 2013, we had no off-balance sheet items as described by Item 303(a)(4) of Regulation S-K.  We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments or other contingent arrangements that expose us to material continuing risks, contingent liabilities, or any other obligations under a variable interest in an unconsolidated entity that provide us with financing, liquidity, market risk or credit risk support.

Contractual Obligations

We lease facility space under non-cancelable operating leases in California and Sweden that extend through 2018. The details of these contractual obligations are further explained in Note 12 of the Notes to Condensed Consolidated Financial Statements.

We use third-party contract manufacturers to assemble and test our hardware products.  In order to reduce manufacturing lead-times and ensure an adequate supply of inventories, our agreements with some of these manufacturers allow them to procure long lead-time component inventory based on rolling production forecasts provided by us.  We may be contractually obligated to purchase long lead-time component inventory procured by certain manufacturers in accordance with our forecasts.  In addition, we issue purchase orders to our third-party manufacturers that may not be cancelable at any time.  As of September 30, 2013, we had open non-cancelable purchase orders amounting to approximately $10.3 million, primarily with our third-party contract manufacturers.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

Foreign Currency Risk

Our sales contracts are denominated predominantly in U.S. Dollars, Swedish Krona, Canadian Dollars, Australian Dollars and the Euro.  We incur operating expenses in U.S. Dollars, Swedish Krona, Canadian Dollars and Australian Dollars.  Therefore, we are subject to fluctuations in these foreign currency exchange rates.  To date, exchange rate fluctuations have had minimal impact on our revenues, operating results and cash flows, and we have not used derivative instruments to hedge our foreign currency exposures.  However, the effect of a 10% change in foreign currency exchange rates could have a material effect on our future operating results or cash flows, depending on which foreign currency exchange rates change and the directional change against the U.S. Dollar.

Interest Rate Sensitivity

We had unrestricted cash, cash equivalents and short term investments totaling approximately $108.9 million at September 30, 2013.  Cash equivalents and short-term investments are composed of money market funds, U.S. agency securities, commercial paper and corporate bonds.  Our investment policy requires investments to be of high credit quality, primarily rated A/A2, with the objective of minimizing the potential risk of principal loss.  Short-term investments generally have an effective maturity of less than one year and are classified as available-for sale and, consequently, are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive income (loss).  Because of the short weighted-average maturity of our investment portfolio at September 30, 2013, we believe that the fair value of our investment portfolio would not be significantly impacted by either a hypothetical 100 basis point increase or decrease in market interest rates.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We have adopted and maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that controls and procedures, no matter how well designed and operated, cannot provide absolute assurance of achieving the desired control objectives.

As required by Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that as of the end of the period covered by this report, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during the period ended September 30, 2013 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

We are at times involved in litigation and other legal claims in the ordinary course of business. When appropriate in management’s estimation, we may record reserves in our financial statements for pending litigation and other claims.  Although it is not possible to predict with certainty the outcome of litigation, we do not believe that any of the current pending legal proceedings to which we are a party or to which any of our property is subject will have a material impact on our results of operations or financial condition.

Item 1A. Risk Factors

We have marked with an asterisk (*) those risk factors below that reflect material changes from the risk factors included in our Annual Report on Form 10-K for the year ended December 31, 2012, filed with the Securities and Exchange Commission (the “SEC”) on March 15, 2013.

You should carefully consider the risks described below, together with all of the other information included in this Quarterly Report on Form 10-Q, in considering our business and prospects.  Set forth below and elsewhere in this report and in other documents we file with the SEC are descriptions of the risks and uncertainties that could cause our actual results to differ materially from the results contemplated by the forward-looking statements contained in this report. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations.  Each of these risk factors could adversely affect our business, operating results and financial condition, as well as adversely affect the value of an investment in our common stock.

Risks Related to Our Business

We have a limited operating history on which to evaluate our Company.

The products we sell today are derived primarily from the products of the Netintact companies that we purchased in 2006. We are continually working to improve our operations on a combined basis.

Furthermore, we have only recently launched many of our products and services on a worldwide basis, and we are continuing to develop relationships with distribution partners and otherwise exploit sales channels in new markets.  Therefore, investors should consider the risks and uncertainties frequently encountered by companies in new and rapidly evolving markets, which include the following:

● successfully introducing new products and entering new markets;

● successfully servicing and upgrading new products once introduced;

● increasing brand recognition;

● developing strategic relationships and alliances;

● managing expanding operations and sales channels;

● successfully responding to competition; and

● attracting, retaining and motivating qualified personnel.

If we are unable to address these risks and uncertainties, our results of operations and financial condition may be adversely affected.

*Our actual operating results may differ significantly from our guidance and investor expectations.

From time to time, we may release guidance in our earnings releases, earnings conference calls or otherwise, regarding our future performance that represents our management’s estimates as of the time of release of the guidance.  Any such guidance, which will include forward-looking statements, will be based on projections prepared by our management.

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Projections are based upon a number of assumptions and estimates that, while presented with numerical specificity, are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. These projections are also based upon specific assumptions with respect to future business decisions, some of which will change.  We may state possible outcomes as high and low ranges, which are intended to provide a sensitivity analysis as variables are changed but are not intended to represent that actual results could not fall outside of the suggested ranges.  The principal reason why we may release guidance is to provide an opportunity for our management to discuss our business outlook with analysts and investors.  With or without our guidance, analysts and other investors may publish their own expectations regarding our business, financial performance and results of operations.  We do not accept any responsibility for any projections or reports published by any such third persons.

Guidance is necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the guidance furnished by us will not materialize or will vary significantly from actual results.  Accordingly, our guidance is only an estimate of what our management believes is realizable as of the time of release. Actual results will vary from our guidance, and the variations may be material.  If our actual performance does not meet or exceed our guidance or investor expectations, the trading price of our common stock may decline.

*Our PacketLogic family of products is our primary product line. A substantial majority of our current revenues and a significant portion of our future growth depend on our ability to continue its commercialization.

A substantial majority of our current revenues and much of our anticipated future growth depend on the development, introduction and market acceptance of new and enhanced products in our PacketLogic product line that address additional market requirements in a timely and cost-effective manner.  In the past, we have experienced delays in product development and such delays may occur in the future.  We do not currently have plans or resources to develop additional product lines and, as a result, our future growth will largely be determined by market acceptance and continued development of our PacketLogic product line.

If additional customers do not adopt, purchase and deploy our PacketLogic products, our revenues will not grow and may decline.  In addition, should our prospective customers fail to recognize, or our current customers lose confidence in, the value or effectiveness of our PacketLogic product line, the demand for our products and services will likely decline. Any significant price compression in our targeted markets as a result of newly introduced solutions could have a material adverse effect on our business.  Moreover, when we announce new products or product enhancements that have the potential to replace or shorten the life cycle of our existing products, customers may defer purchasing our existing products.  These actions could harm our operating results by unexpectedly decreasing sales and exposing us to greater risk of product obsolescence.

*Sales of our products to large broadband service providers often involve a lengthy sales cycle, which may cause our revenues to fluctuate from period to period and could result in us expending significant resources without making any sales.

Our sales cycles often are lengthy, because our prospective customers generally follow complex procurement procedures and undertake significant testing to assess the performance of our products within their networks. As a result, we may invest significant time from initial contact with a prospective customer before that customer decides to purchase and incorporate our products in its network.  We may also expend significant resources attempting to persuade large broadband service providers to incorporate our products into their networks without any measure of success. Even after deciding to purchase our products, initial network deployment and acceptance testing of our products by a large broadband service provider may last several years.  Carriers, especially in North America, often require that products they purchase meet Network Equipment Building System, or “NEBS” certification requirements, which relate to the reliability of telecommunications equipment.  While our PacketLogic products and future products are and are expected to continue to be designed to meet NEBS certification requirements, they may fail to do so, and any failure to meet NEBS certification requirements could have a material adverse impact on our ability to sell our products.

Due to our lengthy sales cycle, particularly to larger customers, and our revenue recognition practices, we expect our revenue may fluctuate significantly from period to period. In pursuing sales opportunities with larger enterprises, we expect that we will make fewer sales to larger entities, but that the magnitude of individual sales will be greater.  We may report substantial revenue growth in the period that we recognize the revenue from a large sale, which may not be repeated in an immediately subsequent period.  Because our revenues may fluctuate materially from period to period, the price of our common stock may decline. In addition, even after we have received commitments from a customer to purchase our products, in accordance with our revenue recognition practices, we may not be able to recognize and report the revenue from that purchase for months or years after the time of purchase. As a result, there could be significant delays in our receipt and recognition of revenue following sales orders for our products.

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Historically, we have received, and in the future we may receive, a material portion of a quarter’s sales orders during the last two weeks of the quarter. Accordingly, there is a risk that our revenue may move from one quarter to the next if we cannot fulfill all of the orders and satisfy all the revenue recognition criteria under our accounting policies before the quarter ends.  In addition, if anticipated purchase orders are not finalized in a timely manner, our products are not shipped on time, we fail to manage our inventory properly, we fail to release new products on schedule, or for any other reason, our revenue for that quarter could fall below our expectations or those of securities analysts and investors, which may result in a decline in our stock price.

In addition, if a competitor succeeds in convincing a prospective customer to adopt that competitor’s product, it may be difficult for us to displace the competitor at a later time because of the cost, time, effort and perceived risk to network stability involved in changing to a different vendor’s products.  As a result, we may incur significant sales and marketing expenses without generating any sales.

*A failure to manage inventories thus incurring excess inventory or shortages could result in decreased revenue and gross margins and harm our business.

In determining the required quantities of our products to produce, we must make significant judgments and estimates based on inventory levels, market trends and other related factors. Because of the inherent nature of estimates, there could be significant differences between our estimates and the actual amounts of inventory we require. This can result in shortages if we fail to anticipate demand, or excess inventory and write-offs if we order more than we need or if anticipated sales do not occur.

In addition, at any time, a significant amount of our inventory may be located off-site at customer locations while our customers evaluate and conduct trials of our products. If these trials do not result in sales of our products, we may need to take inventory charges or fully write-off such inventory. Additionally, inventory levels in excess of customer demand may result in inventory write-downs, and the sale of excess inventory at discounted prices could significantly impair our brand recognition and have an adverse effect on our business, results of operations or financial condition.

*A substantial portion of our revenues may be dependent on a small number of Tier 1 service providers that purchase in large quantities. If we are unable to maintain or replace our relationships with these customers, our revenues may fluctuate and our growth may be limited.

Since 2008, when we first sold our products to Tier 1 service providers, a significant portion of our revenue has come from a limited number of customers.  There can be no guarantee that we will be able to continue to achieve revenue growth from these customers because their capacity requirements have become or will become fulfilled.  Additionally, we cannot guarantee that any customer will place follow-on orders after fulfillment of current orders.  For this reason, we do not expect that any single customer will remain a significant customer from year to year, and we will need to attract new customers in order to sustain our revenues.  Moreover, our current customers may cancel orders or their agreements with us. Order cancellations could adversely affect our product sales and revenues and, therefore, harm our business and results of operations.

For the three months ended September 30, 2013, revenue from two customers represented 33% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2013, revenue from Shaw Communications, Inc. represented 13% of net revenue, and two other customers represented 13% and 11% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the three months ended September 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 16% and 24% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.  For the nine months ended September 30, 2012, revenue from Shaw Communications, Inc. and a second customer represented 17% and 10% of net revenue, respectively, with no other single customer accounting for more than 10% of net revenue.The proportion of our revenue derived from a limited number of customers may be even higher in any future year or quarter.  If we cannot maintain or replace the customers that purchase large amounts of our products, if our customers do not place follow-on orders, or if they do not purchase products at the levels or at the times that we anticipate, or successfully negotiate higher discounts, our ability to maintain or grow our revenue will be adversely affected.

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*Changes in customer or product mix, downward pressure on sales prices, changes in volume of orders and other factors could cause our gross margin percentage to fluctuate or decline in the future.

Our gross profit margins have fluctuated from period to period, and these fluctuations are expected to continue in the future. Within the last two years, our gross profit margin has fluctuated from 49% in the quarter ended September 30, 2013 to 72% in the quarter ended September 30, 2012. Factors that may cause our gross margins to fluctuate include customer and product mix, market acceptance of our new products, competitive pricing dynamics, geographic and/or market segment pricing strategies, decreases in average selling prices of our products, our ability to successfully develop new products, and our ability to manage manufacturing, labor and materials cost. A higher proportion of hardware sales versus software and service revenue in any period generally results in a lower gross profit margin for that period. In addition, our industry has been characterized by declining product prices over time, and we are under continuous pressure to reduce our prices to increase or even maintain our market share. Forecasting our gross margins is difficult due to our lengthy sales cycle, particularly to larger customers, and our revenue recognition practices. Because our gross profit margins may fluctuate materially from period to period, or decline over time, the price of our common stock may decline.

If we are unable to effectively manage our anticipated growth, we may experience operating inefficiencies and have difficulty meeting demand for our products.

We seek to manage our growth so as not to exceed our available capital resources.  If our customer base and market grow rapidly, we would need to expand to meet this demand.  This expansion could place a significant strain on our management, products and support operations, sales and marketing personnel and other resources, which could harm our business.

If demand for our products and services grows rapidly, we may experience difficulties meeting the demand. For example, the installation and use of our products require customer training.  If we are unable to provide adequate training and support for our products, the implementation process will be longer and customer satisfaction may be lower.  In addition, we may not be able to exploit fully the growing market for our products and services, and our competitors may be better able to satisfy this demand.  We cannot assure you that our systems, procedures or controls will be adequate to support the anticipated growth in our operations.  The failure to meet the challenges presented by rapid customer and market expansion could cause us to miss sales opportunities and otherwise have a negative impact on our sales and profitability.

We may not be able to install management information and control systems in an efficient and timely manner, and our current or planned personnel, systems, procedures and controls may not be adequate to support our future operations.

*Acquisitions may divert management’s attention, increase expenses and disrupt or otherwise have a negative impact on our business.

We may seek to acquire or make investments in complementary businesses, products, services or technologies on an opportunistic basis when we believe they will assist us in executing our business strategy. Growth through acquisitions has been a viable strategy used by other network control and management technology companies.  We acquired the Netintact entities in 2006, and its products have formed the core of our current product offering.  In January 2013, we acquired Vineyard Networks, Inc. (“Vineyard”), a company based in Kelowna, Canada. We have integrated the employees of Vineyard into our organizational structure, and we are developing plans for further product and organizational integration, which will require both time and investment to accomplish. Any failure to properly integrate the personnel and or technology we acquire into Procera, including successfully maintaining cohesive technology development in distant locations could have an adverse effect on us and our results of operations. Any future acquisitions that we may pursue could distract or divert the attention of our management and employees and cause us to incur various expenses related to identifying, investigating and pursuing suitable acquisitions, whether or not they are consummated.

Following any acquisition, the integration of the acquired business, product, service or technology is complex, time consuming and expensive, and may disrupt our business.  These challenges include the timely and efficient execution of a number of post-transaction integration activities, including:

● integrating the operations and technologies of the two companies;

● retaining and assimilating the key personnel of each company;

● retaining existing customers of both companies and attracting additional customers;

● leveraging our existing sales channels to sell new products into new markets;

● developing an appropriate sales and marketing organization and sales channels to sell new products into new markets;

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● retaining strategic partners of each company and attracting new strategic partners; and

● implementing and maintaining uniform standards, internal controls, processes, procedures, policies and information systems.

The process of integrating operations and technology could cause an interruption of, or loss of momentum in, our business and the loss of key personnel.  The diversion of management’s attention and any delays or difficulties encountered in connection with an acquisition and the integration of our operations and technology could have an adverse effect on our business, results of operations or financial condition.  Furthermore, the execution of these post-transaction integration activities will involve considerable risks and may not come to pass as we envision.  The inability to integrate the operations, technology and personnel of an acquired business with ours, or any significant delay in achieving integration, could have a material adverse effect on results of operations and financial condition and, as a result, on the market price of our common stock.

We may not achieve the desired benefits from our acquisitions, including the revenue and other synergies and growth that we anticipate from the acquisition in the timeframe that we originally expect, and the costs of achieving these benefits may be higher than what we originally had anticipated because of a number of risks, including but not limited to the possibility that the acquisition may not further our business strategy as we expected and the possibility that we may not be able to expand the reach and customer base for current and future products as expected.  As a result of these risks, our acquisitions may not immediately contribute to our earnings as expected, or at all, we may not achieve expected revenue synergies or realization of efficiencies related to the integration of the businesses when expected, or at all, and we may not achieve the other anticipated strategic and financial benefits of the acquisitions.

*Mergers or other strategic transactions involving our competitors could weaken our competitive position, limit our growth prospects or reduce our revenues.

We believe that there may be consolidation in our industry, which could lead to increased price competition and other forms of competition. Increased competition may cause pricing pressure and loss of market share, either of which could have a material adverse effect on our business, may limit our growth prospects or reduce our revenues and margins.  Our competitors may establish or strengthen cooperative relationships with strategic partners or other parties.  Established companies may not only develop their own products but may also merge with or acquire our current competitors as a means of entering our markets.  New competitors or alliances among competitors may emerge and rapidly acquire significant market share.  Any of these circumstances could materially and adversely affect our business and operating results.

*We operate in a highly competitive market and may be unable to compete effectively with competitors which are substantially larger and more established and have greater resources.

In our rapidly evolving and highly competitive market, we compete on the price as well as the performance of our products.  We expect competition to remain intense in the future.  Increased competition could result in reduced prices and gross margins for our products and loss of market share, and could require us to increase spending on research and development, sales and marketing and customer support, any of which could have a negative financial impact on our business.  We compete with Allot Communications Ltd., Tektronix (acquired Arbor Networks), Blue Coat Systems, Brocade Communications Systems, Cisco Systems, Inc., Citrix Systems (acquired Bytemobile), SAIC (acquired Cloudshield Technologies), Ericsson, F5 Networks, Huawei Technologies Company and Sandvine Corporation, as well as other companies which sell products incorporating competing technologies.  In addition, our products and technology compete with other types of products that offer monitoring capabilities, such as probes and related software.  We also face indirect competition from companies that offer broadband service providers increased bandwidth and infrastructure upgrades that increase the capacity of their networks, which may lessen or delay the need for bandwidth management solutions.

Most of our competitors are substantially larger than we are and have significantly greater name recognition and financial, sales and marketing, technical, manufacturing and other resources and more established distribution channels than we do.  In addition, some prospective customers have in the past advised us that their concerns about our financial condition disqualified us from competing successfully for their business.  While we have enhanced our balance sheet by raising additional capital through a public sale of our common stock, it is possible that one or more prospective customers could raise similar concerns in the future.  We may not be able to compete successfully against our current or potential competitors as our competitors may, among other things, be able to respond more rapidly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products than we can.  Furthermore, prospective customers often have expressed greater confidence in the product offerings of our competitors.   Additional competitors may enter our existing or future markets with solutions that may be less expensive, provide higher performance or provide additional features than our solutions.  Given the opportunities in the bandwidth management solutions market, we also expect that other companies may enter with alternative products and technologies, which could reduce the sales or market acceptance of our products and services, perpetuate intense price competition or make our products obsolete.  If any technology that is competing with ours is or becomes more reliable, higher performing, less expensive or has other advantages over our technology, then the demand for our products and services would decrease, which would harm our business.

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We need to increase the functionality of our products and offer additional features in order to be competitive.

The market in which we operate is highly competitive and unless we continue to enhance the functionality of our products by adding additional features, our competitive position may deteriorate and the average selling prices for our products may decrease over time.  Such a decrease also could result from the introduction of competing products or from the standardization of deep packet inspection (“DPI”) technology.  To counter this trend, we endeavor to enhance our products by offering higher system speeds and additional performance features, such as additional protection functionality, supporting additional applications and enhanced reporting tools.  We may also need to reduce our per unit manufacturing costs at a rate equal to or faster than the rate at which selling prices may decline.  If we are unable to reduce these costs or to offer increased functionally and features, our results of operations and financial condition may be adversely affected.

If our products contain undetected software or hardware errors or performance deficiencies, we could incur significant unexpected expenses, experience purchase order cancellations and lose sales.

Network products frequently contain undetected software or hardware errors, failures or bugs when new products or new versions or updates of existing products are released to the marketplace.  Because we frequently introduce new versions and updates to our product line, previously unaddressed errors in the accuracy or reliability of our products, or issues with their performance, may arise.  We expect that such errors or performance deficiencies will be found from time to time in the future in new or existing products, including the components incorporated therein, after the commencement of commercial shipments.  These problems may have a material adverse effect on our business by requiring us to incur significant warranty repair costs and support related replacement costs, diverting the attention of our engineering personnel from new product development efforts, delaying the recognition of revenue and causing potentially significant customer relations problems.

In addition, if our products are not accepted by customers due to software or hardware defects or performance deficiencies, orders contingent upon acceptance may be cancelled or deferred until we have remedied the defects, which could result in lost sales opportunities or delayed revenue recognition.  In this circumstance, or if warranty returns exceed the amount we have accrued for defect returns based on our historical experience, our results of operations and financial condition may be adversely affected.

Our products must properly interface with products from other vendors.  As a result, when problems occur in a computer or communications network, it may be difficult to identify the sources of these problems.  The occurrence of hardware and software errors, whether or not caused by our products, could result in the delay or loss of market acceptance of our products and any necessary revisions may cause us to incur significant expenses.  The occurrence of any such problems would likely have a material adverse effect on our results of operations and financial condition.

*We have incurred losses in previous periods and may incur losses in future periods.

We had an accumulated deficit of $65.9 million as of September 30, 2013. We may incur losses from operations in future periods.  The profitability we achieved in the years ended December 31, 2012 and 2011 were the first in our history and may not be indicative of sustained profitability in future periods.  Any losses incurred in the future may result from increased costs related to continued investments in sales and marketing, product development and administrative expenses, and/or less than anticipated revenues.  Furthermore, if our revenue growth does not continue or is slower than anticipated, or our operating expenses exceed expectations, our results of operations and financial condition may be adversely affected.

*We may need to raise further capital, which could dilute or otherwise adversely affect your interest in our Company.

We believe that our existing cash, cash equivalents and short term investments, along with the cash that we expect to generate from operations and any debt financing that management currently believes is available, will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for the next twelve months.

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A number of factors may negatively impact our level of cash availability and working capital requirements, including, without limitation:

● lower than anticipated revenues;

● higher than expected cost of goods sold or operating expenses;

● our inability to liquidate short-term investments; or

● the inability of our customers to pay for the goods and services ordered.

We believe that the ability to obtain equity and debt financing in the future will depend on our operating results, general economic conditions and global credit market conditions.  If additional funds are raised through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders will be reduced and such securities may have rights, preferences and privileges senior to those of our common stock.  There can be no assurance that additional financing will be available on terms favorable to us or at all.  If adequate funds are not available on acceptable terms, we may not be able to fund expansion, take advantage of unanticipated growth or acquisition opportunities, develop or enhance services or products or respond to competitive pressures.  In addition, we may be required to defer or cancel product development programs, lay-off employees and/or take other steps to reduce our operating expenses.  Our inability to raise additional financing or the terms of any financing we do raise could have a material adverse effect on our business, results of operations and financial condition.

*Competition for experienced and skilled personnel is intense and our inability to attract and retain qualified personnel could significantly damage our business.

Our future performance will depend to a significant extent on the ability of our management to operate effectively, both individually and as a group.  We are dependent on our ability to attract, retain and motivate high caliber key personnel.  We have recently hired new employees in many different positions and our growth expectations will require us to attract experienced personnel to augment our current staff.  We expect to recruit experienced professionals in such areas as software and hardware development, sales, technical support, product marketing and management.  We currently plan to expand our indirect channel partner program and we need to attract qualified business partners to broaden these sales channels.  In our market there is significant competition for qualified personnel and we may not be able to attract and retain such personnel.  Our business may suffer if we encounter material delays in hiring additional personnel.

Our performance is substantially dependent on the continued services and on the performance of our executive officers and other key employees, including our Chief Executive Officer, James Brear, and our Chief Technical Officer, Alexander Haväng.  The loss of the services of any of our executive officers or other key employees could materially and adversely affect our business.  In addition, our engineering department is based in Varberg, Sweden, and many of our engineers were formerly employees of Netintact, which we acquired in 2006.   In January 2013, we acquired Vineyard and we now employ many former Vineyard engineers and product developers at its location in Kelowna, Canada.  We are continuing to develop plans to integrate the Canadian and Swedish engineering teams, and this integration effort may result in changes to current job responsibilities.  If some or all of our Sweden-based engineers or Canada-based engineers or product developers were no longer employed by us, our ability to develop new products and serve existing customers could be materially and adversely impacted, and our results of operations and financial condition could be negatively affected.

We believe we will need to attract, retain and motivate talented management and other highly skilled employees in order to execute on our business plan.  We may be unable to retain our key employees or attract, assimilate and retain other highly qualified employees in the future.  Competitors and others have in the past, and may in the future, attempt to recruit our employees.  In California, where we are headquartered, non-competition agreements with employees generally are unenforceable. As a result, if an employee based in California leaves the Company for any reason, he or she will generally be able to begin employment with one of our competitors or otherwise compete immediately against us.

We currently do not have key person insurance in place.  If we lose one of our key officers, we would need to attract, hire, and retain an equally competent person to take his or her place.  There is no assurance that we would be able to find such an employee in a timely fashion.  If we fail to recruit an equally qualified replacement or incur a significant delay, our business plans may slow down.  We could fail to implement our strategy or lose sales and marketing and development momentum.

Failure to expand our sales teams or educate them about technologies and our product families may harm our operating results.

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The sale of our products requires a multi-faceted approach directed at several levels within a prospective customer’s organization.  We may not be able to increase net revenue unless we expand our sales teams to address all of the customer requirements necessary to sell our products.  We expect to continue hiring in sales and marketing, but there can be no assurance that personnel additions will have a positive effect on our business.

If we are not able to successfully integrate new employees into the Company or to educate current and future employees with regard to rapidly evolving technologies and our product families, our results of operations and financial condition may be adversely affected.

Increased customer demands on our technical support services may adversely affect our relationships with our customers and our financial results.

We offer technical support services with our products because they are complex and time consuming to implement.  We may be unable to respond quickly enough to accommodate short-term increases in customer demand for support services.  We also may be unable to modify the format of our support services to compete with changes in support services offered by our competitors.  Further customer demand for these services, without increases in corresponding revenues, could increase costs and adversely affect our operating results.  If we experience financial difficulties, do not maintain sufficiently skilled workers and resources to satisfy our contracts, or otherwise fail to perform at a sufficient level under these contracts, the level of support services to our customers may be significantly disrupted, which could materially harm our relationships with these customers and our results of operations.

We must continue to develop and increase the productivity of our indirect distribution channels to increase net revenue and improve our operating results.

A key focus of our distribution strategy is developing and increasing the productivity of our indirect distribution channels through resellers and distributors.  If we fail to develop and cultivate relationships with significant resellers, or if these resellers are not able to execute on their sales efforts, sales of our products may decrease and our operating results could suffer.  Many of our resellers also sell products from other vendors that compete with our products.  We cannot assure you that we will be able to enter into additional reseller and/or distribution agreements or that we will be able to manage our product sales channels.  Our failure to do any of these could limit our ability to grow or sustain revenue.  In addition, our operating results will likely fluctuate significantly depending on the timing and amount of orders from our resellers.  We cannot assure you that our resellers and/or distributors will continue to market or sell our products effectively or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. Such failure would negatively affect revenue and our potential to achieve profitability.

We rely on a small number of contract manufacturers to build our hardware products.  If we are unable to have our products manufactured quickly enough to keep up with demand or we experience manufacturing quality problems, our operating results could be harmed.

If the demand for our products grows, we will need to increase our capacity for material purchases, production, testing and quality control functions.  Any disruptions in product flow could limit our revenue growth and adversely affect our competitive position and reputation, and result in additional costs or cancellation of orders under agreements with our customers.

While our PacketLogic products are software based, we rely on independent contract manufacturers to manufacture the hardware components on which our products are installed and operate.  In certain circumstances, these contract manufacturers also provide logistics services, which may include loading our software products onto the hardware platforms, testing and inspecting the products, and then shipping them directly to our customers.  If these contract manufacturers are unable to meet our demand, or fail to provide such logistics services as we may request in a timely manner, we may experience delays in product shipments.  Other performance problems with contract manufacturers may arise in the future, such as inferior quality, insufficient quantity of products, or the interruption or discontinuance of operations of a manufacturer, any of which could have a material adverse effect on our business and operating results.

We do not know whether we will effectively manage our contract manufacturers or whether these manufacturers will meet our future requirements for timely delivery of product components of sufficient quality and quantity. If one or more of our contract manufacturers were to experience financial difficulties or decide not to continue its business relationship with us, we would need to identify other contract manufacturers to perform these services, and there could be product delivery delays while we seek to establish and implement the new relationship.  We also plan to introduce new products and product enhancements, which will require that we rapidly achieve volume production by coordinating our efforts with those of our suppliers and contract manufacturers. Any delays in meeting customer demand or quality problems resulting from the inability of our contract manufacturers to provide us with adequate supplies of high-quality product components, including problems relating to logistic services, could result in lost or reduced future sales to key customers and could have a material adverse effect on our sales and results of operations.

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As part of our cost management efforts, we endeavor to lower per unit product costs from our contract manufacturers by means of volume efficiencies and the utilization of manufacturing sites in lower-cost geographies. However, we cannot be certain when or if such cost reductions will occur.  The failure to obtain such cost reductions would adversely affect our gross margins and operating results.

If our suppliers fail to adequately supply us with certain original equipment manufacturer, or OEM, sourced components, our product sales may suffer.

Reliance upon OEMs, as well as industry supply conditions, generally involves several additional risks, including the possibility of a shortage of components and reduced control over delivery schedules (which can adversely affect our distribution schedules), and increases in component costs (which can adversely affect our profitability).  Most of our hardware products, or the components of our hardware components, are based on industry standards and are therefore available from multiple manufacturers. If our suppliers were to fail to deliver, alternative suppliers should be available, although qualification of the alternative manufacturers and establishment of reliable suppliers could result in delays and a possible loss of sales, which could affect operating results adversely.  However, in some specific cases we have single-sourced components because alternative sources are not currently available.  If these components were not available for a period of time, we could experience product supply interruptions, delays or inefficiencies, which could have a material adverse effect on our results of operations and financial condition.

*We have limited ability to protect our intellectual property and defend against claims which may adversely affect our ability to compete.

We rely primarily on trademark law, copyright law, trade secret law and contractual rights to protect our intellectual property rights in our PacketLogic product line.  We cannot assure you that the actions we have taken will adequately protect our intellectual property rights or that other parties will not independently develop similar or competing products that do not infringe on our intellectual property rights.  We enter into confidentiality or license agreements with our employees, consultants and corporate partners, and take appropriate measures to control access to and distribution of our software, documentation and other proprietary information.  Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise misappropriate or use our products or technology.

In an effort to protect our unpatented proprietary technology, processes and know-how, we require our employees, consultants, collaborators and advisors to execute confidentiality agreements.  These agreements, however, may not provide us with adequate protection against improper use or disclosure of confidential information.  These agreements may be breached, and we may not become aware of, or have adequate remedies in the event of, any such breach.  In addition, in some situations, these agreements may conflict with, or be subject to, the rights of third parties with whom our employees, consultants, collaborators or advisors have previous employment or consulting relationships.  Furthermore, others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets.  Under our OEM Purchase and Sales Agreement with GENBAND LLC, which was terminated by mutual agreement on April 15, 2013,we had granted GENBAND access to our PacketLogic source code, which is the human readable version of the computer code used in our products. Subject to a requirement to pay us royalties, GENBAND had the right to use our source code to develop derivative products that it may develop and market under GENBAND's business marks.  Additionally, in some cases, customers have the right to request access to our source code upon demand.  Some of our customers have obtained the source code for our products by exercising this right, and others may do so in the future. In addition, some of our customers have required us to deposit the source code of our products into a source code escrow.  The conditions triggering the release of the escrowed source code vary by customer, but include, among other things, breach of the applicable customer agreement, failure to provide required product support or maintenance, or if we are subject to a bankruptcy proceeding or otherwise fail to carry on our business in the ordinary course.  Disclosing the content of our source code may limit the intellectual property protection we can obtain or maintain for that source code or the products containing that source code and may facilitate intellectual property infringement claims against us.  It also could permit a customer to which source code is disclosed to support and maintain that software product without being required to purchase our support or maintenance services. Each of these could harm our business, results of operations and financial condition.

Our industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent and other intellectual property rights.  This type of litigation often is very costly and can continue for a lengthy period of time.  If we are found to infringe on the proprietary rights of others, or if we agree to settle any such claims, we could be compelled to pay damages or royalties and either obtain a license to those intellectual property rights or alter our products so that they no longer infringe upon such proprietary rights.  Any license could be very expensive to obtain or may not be available at all. Similarly, changing our products or processes to avoid any claims of infringement may be costly or impractical.  Litigation resulting from claims that we are infringing the proprietary rights of others, or litigation that we initiate to protect our intellectual property rights, could result in substantial costs and a diversion of resources from sales and/or development activities, and could have a material adverse effect on our results of operations and financial condition.

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We have operations outside of the United States and a significant portion of our customers and suppliers are located outside of the United States, which subjects us to a number of risks associated with conducting international operations.

We market and sell our products throughout the world and have personnel in many parts of the world. In addition, we have sales offices and research and development facilities outside the United States and we conduct, and expect to continue to conduct, a significant amount of our business with companies that are located outside the United States, particularly in Europe and Asia.  Any international expansion efforts that we may undertake may not be successful. In addition, conducting international operations subjects us to new risks that we have not generally faced in the United States. These risks include:

· trade and foreign exchange restrictions;

· foreign currency exchange fluctuations;

· economic or political instability in foreign markets;

· greater difficulty in enforcing contracts, accounts receivable collection and longer collection periods;

· changes in regulatory requirements;

· difficulties and costs of staffing and managing foreign operations;

· the uncertainty and limitation of protection for intellectual property rights in some countries;

· costs of compliance with foreign laws and regulations and the risks and costs of non-compliance with such laws and regulations;

· costs of complying with U.S. laws and regulations for foreign operations, including import and export control laws, tariffs, trade barriers, economic sanctions and other regulatory or contractual limitations on our ability to sell our products in certain foreign markets, and the risks and costs of non-compliance;

· heightened risks of unfair or corrupt business practices in certain geographies and of improper or fraudulent sales arrangements;

· the potential for political unrest, acts of terrorism, hostilities or war;

· longer accounts receivable payment cycles and difficulties in collecting accounts receivable;

· management communication and integration problems resulting from cultural differences and geographic dispersion; and

· multiple and possibly overlapping tax structures.

Our product and service sales may be subject to foreign governmental regulations, which vary substantially from country to country and change from time to time. Failure to comply with these regulations could adversely affect our business.  Further, in many foreign countries it is common for others to engage in business practices that are prohibited by our internal policies and procedures or U.S. regulations applicable to us.  Although we implemented policies and procedures designed to ensure compliance with these laws and policies, there can be no assurance that all of our employees, contractors, distribution channels and agents will comply with these laws and policies. Violations of laws or key control policies by our employees, contractors, distribution channels or agents could result in delays in revenue recognition, financial reporting misstatements, fines, penalties or the prohibition of the importation or exportation of our products and services and could have a material adverse effect on our business and results of operations.

Unstable market and economic conditions may have serious adverse consequences on our business.

Our general business strategy may be adversely affected by the current volatile global business environment and continued unpredictable and unstable market conditions.  If financial markets continue to experience volatility or deterioration, it may make any debt or equity financing that we require more difficult, more costly, and more dilutive.  In addition, a renewed or deeper economic downturn may result in reduced demand for our products, or adversely impact our customers’ ability to pay for our products, which would harm our operating results.  There is also a risk that one or more of our current service providers, manufacturers and other partners may not survive in the current economic environment, which would directly affect our ability to attain our operating goals on schedule and on budget.  Failure to secure any necessary financing in a timely manner and on favorable terms could have a material adverse effect on our results of operations and financial condition.

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*Our operating results could be adversely affected by product sales occurring outside the United States and fluctuations in the value of the United States Dollar against foreign currencies.

A significant and increasing percentage of our sales are generated outside of the United States. In most circumstances, our sales are denominated in the local currency.  Revenues and operating expenses denominated in foreign currencies could affect our operating results as foreign currency exchange rates fluctuate.  Changes in exchange rates between these foreign currencies and the U.S. Dollar will affect the recorded levels of our assets and liabilities because we translate foreign net sales, costs of goods, assets and liabilities into U.S. Dollars for presentation in our financial statements.  The primary foreign currencies for which we currently have exchange rate fluctuation exposure are the European Union Euro, the Swedish Krona and the Australian Dollar. If our revenues continue to grow, in part because we have entered new foreign markets, we could be exposed to exchange rate fluctuations in other currencies.  For example, during the year ended December 31, 2012, we established a sales office in Japan in order to attempt to penetrate the important Japanese marketplace in which we are a new competitor.  Exchange rates between currencies such as the Japanese Yen and the U.S. Dollar have fluctuated significantly in recent years and may do so in the future. Hedging foreign currencies can be difficult, and other companies have incurred significant losses as a result of their foreign currency operations.  We cannot predict the impact of future exchange rate fluctuations on our operating results. We currently do not hedge our foreign currency risk.

In addition, the current sovereign debt crisis concerning certain European countries, including Greece, Italy, Ireland, Portugal and Spain, and related European financial restructuring efforts, may cause the value of the Euro to decline.  Recent rating agency downgrades on European sovereign debt and growing concern over the potential default of European government issuers has further contributed to this uncertainty.  Because we are unlikely to be able to increase our selling prices to compensate for any deterioration in currencies, such currency fluctuations could adversely affect our operating results.

Accounting charges may cause fluctuations in our annual and quarterly financial results which could negatively impact the market price of our common stock.

Our financial results may be materially affected by non-cash and other accounting charges. Such accounting charges may include:

● amortization of intangible assets, including acquired product rights;

● impairment of goodwill;

● stock-based compensation expense; and

● impairment of long-lived assets.

The foregoing types of accounting charges may also be incurred in connection with or as a result of business acquisitions. The price of our common stock could decline to the extent that our financial results are materially affected by the foregoing accounting charges.  Our effective tax rate may increase, which could increase our income tax expense and reduce our net income.

Our effective tax rate could be adversely affected by several factors, many of which are outside of our control, including:

● changes in the relative proportions of revenues and income before taxes in the various jurisdictions in which we operate that have differing statutory tax rates;

● changing tax laws, regulations and interpretations in multiple jurisdictions in which we operate, as well as the requirements of certain tax rulings;

● changes in accounting and tax treatment of stock-based compensation;

● the tax effects of purchase accounting for acquisitions and restructuring charges that may cause fluctuations between reporting periods; and

● tax assessments, or any related tax interest or penalties, which could significantly affect our income tax expense for the period in which the settlements take place.

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The price of our common stock could decline if our financial results are materially adversely affected by one or more of the foregoing factors.

Our internal controls may be insufficient to ensure timely and reliable financial information.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, as amended, or the Sarbanes-Oxley Act, we are required to evaluate and provide a management report of our systems of internal control over financial reporting and our independent registered public accounting firm is required to attest to our internal control over financial reporting. Effective internal controls over financial reporting are necessary for us to provide reliable financial reports and effectively prevent fraud.  A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States, or U.S. GAAP. A company’s internal control over financial reporting includes those policies and procedures that:

● pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;

● provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. GAAP, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and

● provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.  For the years ended December 31, 2012, 2011 and 2010, we did not identify any material weaknesses in our internal controls.

Under the supervision of our Audit Committee, we are continuing the process of identifying and implementing corrective actions where required to improve the design and effectiveness of our internal control over financial reporting, including the enhancement of systems and procedures.  We have a small finance and accounting staff and limited resources and we expect that we will continue to be subject to the risk of material weaknesses and significant deficiencies.

Even after corrective actions are implemented, the effectiveness of our controls and procedures may be limited by a variety of risks including:

● faulty human judgment and simple errors, omissions or mistakes;

● collusion of two or more people;

● inappropriate management override of procedures; and

● the risk that enhanced controls and procedures may still not be adequate to assure timely and reliable financial information.

If we fail to have effective internal controls and procedures for financial reporting in place, we could be unable to provide timely and reliable financial information.  Additionally, if we fail to have effective internal controls and procedures for financial reporting in place, it could adversely affect our ability to comply with financial reporting requirements under certain government contracts.

Legislative actions, higher insurance costs and new accounting pronouncements are likely to impact our future financial position and results of operations.

Legislative and regulatory changes and future accounting pronouncements and regulatory changes have, and will continue to have, an impact on our future financial position and results of operations.  In addition, insurance costs, including health and workers’ compensation insurance premiums, have increased in recent years and are likely to continue to increase in the future. Recent and future pronouncements related to the accounting treatment of executive compensation and employee stock options may also impact operating results.  These and other potential changes could materially increase the expenses we report under generally accepted accounting principles, and adversely affect our operating results.

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*Changes in accounting standards, especially those that relate to management estimates and assumptions, are unpredictable and subject to interpretation by management and our independent registered public accounting firm and may materially impact how we report and record our financial condition.

Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. Some of these policies require use of estimates and assumptions that may affect the value of our assets or liabilities and financial results and are critical because they require management to make difficult, subjective and complex judgments about matters that are inherently uncertain.  Under each of these policies, it is possible that materially different amounts would be reported under different conditions, using different assumptions, or as new information becomes available.  From time to time, the Financial Accounting Standards Board (“FASB”) and the SEC change the financial accounting and reporting standards that govern the preparation of our financial statements. In addition, accounting standard setters and those who interpret the accounting standards (such as the FASB, the SEC, other regulators and our outside independent registered public accounting firm) may change or even reverse their previous interpretations or positions on how these standards should be applied. These changes can be hard to predict and can materially impact how we record and report our financial condition and results of operations. In addition, in May 2012 we dismissed PMB Helin Donovan, LLP as our independent registered public accounting firm and retained Ernst & Young LLP as our independent registered public accounting firm. At the time of our dismissal of PMB Helin Donovan, LLP, we did not have any disagreement with PMB Helin Donovan, LLP regarding our accounting policies and practices.  Our new independent registered public accounting firm may view our estimates and assumptions, or interpret policies, differently than our prior independent registered public accounting firm. In some cases, we could be required to apply a new or revised standard retroactively, or apply an existing standard differently (and also retroactively), resulting in a change in our results on a going forward basis or a potential restatement of historical financial results.

Unauthorized disclosure of data or unauthorized access to our information systems could adversely affect our business.

We may experience interruptions in our information systems on which our global operations depend.  Further, we may face attempts by others to gain unauthorized access through the Internet to our information technology systems, to intentionally hack, interfere with or cause physical or digital damage to or failure of such systems (such as significant viruses or worms), which attempts we may be unable to prevent.  We could be unaware of an incident or its magnitude and effects until after it is too late to prevent it and the damage it may cause. Any security breaches, unauthorized access, unauthorized usage, virus or similar breach or disruption could result in loss of confidential information, personal data and customer content, damage to our reputation, early termination of our contracts, litigation, regulatory investigations or other liabilities.  If our security measures, or those of our partners or service providers, are breached as a result of third-party action, employee error, malfeasance or otherwise and, as a result, someone obtains unauthorized access to confidential information, personal data or customer content, our reputation will be damaged, our business may suffer or we could incur significant liability.  The theft, unauthorized use, or a cybersecurity attack that results in the publication of our trade secrets and other confidential business information as a result of such an incident could negatively affect our competitive position and the value of our investment in product or research and development, and third parties might assert against us or our customers claims related to resulting losses of confidential or proprietary information or end-user data and/or system reliability.  In any such event, our business could be subject to significant disruption, and we could suffer monetary and other losses, including reputational harm.

Our headquarters are located in Northern California where disasters may occur that could disrupt our operations and harm our business.

Our corporate headquarters is located in Silicon Valley in Northern California. Historically, this region has been vulnerable to natural disasters and other risks, such as earthquakes, which at times have disrupted the local economy and posed physical risks to us and our local suppliers. In addition, terrorist acts or acts of war targeted at the United States, and specifically Silicon Valley, could cause damage or disruption to us, our employees, facilities, partners, suppliers, distributors and resellers, and customers, which could have a material adverse effect on our operations and financial results. Although we currently have significant redundant capacity in Sweden in the event of a natural disaster or other catastrophic event in Silicon Valley, our business could nonetheless suffer. Our operations in Sweden are subject to disruption by extreme winter weather.

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The requirements of being a public company may strain our resources and divert management’s attention.

As a public company, we are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the listing requirements of The Nasdaq Stock Market LLC and other applicable securities rules and regulations.  Compliance with these rules and regulations will increase our legal and financial compliance costs, make some activities more difficult, time-consuming or costly and increase demand on our systems and resources.  The Exchange Act requires, among other things, that we file annual, quarterly and current reports with respect to our business and operating results and maintain effective disclosure controls and procedures and internal control over financial reporting. In order to maintain and, if required, improve our disclosure controls and procedures and internal control over financial reporting to meet this standard, significant resources and management oversight may be required.  As a result, management’s attention may be diverted from other business concerns, which could harm our business and operating results. Although we have hired several employees to comply with these requirements, we may need to hire more employees in the future, which will increase our costs and expenses.

In addition, changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act, the Dodd-Frank Wall Street Reform and Consumer Protection Act, new regulations of the SEC and The Nasdaq Stock Market LLC, have and will create additional compliance requirements for companies such as ours.  To maintain high standards of corporate governance and public disclosure, we have invested, and intend to continue to invest, in reasonably necessary resources to comply with evolving standards.  These investments have resulted in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities and may continue to do so in the future.

Risks Related to Our Industry

The market for our products in the network provider market is still emerging and our growth may be harmed if carriers do not adopt DPI solutions.

The market for DPI technology is still emerging and the majority of our customers to date have been small and midsize broadband service providers and universities.  We believe that the Tier 1 carriers, as well as cable and mobile operators, present a significant market opportunity and are an important element of our long term strategy, but they are still in the early stages of adopting and evaluating the benefits and applications of DPI technology. Carriers may decide that full visibility into their networks or highly granular control over content based applications is not critical to their business.  They may also determine that certain applications, such as VoIP or Internet video, can be adequately prioritized in their networks by using router and switch infrastructure products without the use of DPI technology.  They may also, in some instances, face regulatory constraints that could change the characteristics of the markets. Carriers may also seek an embedded DPI solution in capital equipment devices such as routers rather than the stand-alone solution offered by us.  Furthermore, widespread adoption of our products by carriers will require that they migrate to a new business model based on offering subscriber and application-based tiered services.  If carriers decide not to adopt DPI technology, our market opportunity would be reduced and our growth rate may be harmed, which could have a material adverse effect on our results of operations and financial condition.

If the bandwidth management solutions market fails to grow, our business will be adversely affected.

We believe that the market for bandwidth management solutions is in an early stage of development. We cannot accurately predict the future size of the market, the products needed to address the market, the optimal distribution strategy, or the competitive environment that will develop.  In order for us to execute our strategy, our potential customers must recognize the value of more sophisticated bandwidth management solutions, decide to invest in the management of their networks and the performance of important business software applications and, in particular, adopt our bandwidth management solutions.  The growth of the bandwidth management solutions market also depends upon a number of factors, including the availability of inexpensive bandwidth, especially in international markets, and the growth of wide area networks.  The failure of the market to grow would adversely affect our sales and sales prospects, which could have a material adverse effect on our results of operations and financial condition and cause a decline in the price of our common stock.

Demand for our products depends, in part, on the rate of adoption of bandwidth-intensive broadband applications, such as peer-to-peer, and latency-sensitive applications, such as voice-over Internet protocol, or VoIP, Internet video and online video gaming applications.

Our products are used by broadband service providers and enterprises to provide awareness, control and protection of Internet traffic by examining and identifying packets of data as they pass an inspection point in the network, particularly bandwidth-intensive applications that cause congestion in broadband networks and impact the quality of experience of users.  In addition to the general increase in applications delivered over broadband networks that require large amounts of bandwidth, such as peer-to-peer applications, demand for our products is driven particularly by the growth in applications which are highly sensitive to network delays and therefore require efficient network management.  These applications include VoIP, Internet video and online video gaming applications.  If the rapid growth in adoption of VoIP and in the popularity of Internet video and online video gaming applications does not continue, the demand for our products may not grow as anticipated, which could have a material adverse effect on our results of operations and financial condition.

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The network equipment market is subject to rapid technological progress and to remain competitive, we must continually introduce new products or upgrades that achieve broad market acceptance.

The network equipment market is characterized by rapid technological progress, frequent new product introductions, changes in customer requirements and evolving industry standards.  If we do not regularly introduce new products or upgrades in this dynamic environment, our product lines may become less competitive or obsolete.  Developments in routers and routing software could also significantly reduce demand for our products. Alternative technologies could achieve widespread market acceptance and displace the technology on which we have based our product architecture.  We cannot assure you that our chosen technological approaches will achieve broad market acceptance or that other technology or devices will not supplant our products and technology.

Our products must comply with evolving industry standards and complex government regulations or else our products may not be widely accepted, which may prevent us from growing our net revenue or achieving profitability.

The market for network equipment products is characterized by the need to support new standards as they emerge, evolve and achieve acceptance.  We will not be competitive unless we continually introduce new products and product enhancements that meet these emerging standards.  We may not be able to effectively address the compatibility and interoperability issues that arise as a result of technological changes and evolving industry standards. Our products must be compliant with various United States federal government requirements and regulations and standards defined by agencies such as the Federal Communications Commission (the “FCC”), in addition to standards established by governmental authorities in various foreign countries and recommendations of the International Telecommunication Union.  If we do not comply with existing or evolving industry standards or if we fail to obtain timely domestic or foreign regulatory approvals or certificates, we will not be able to sell our products where these standards or regulations apply, which may prevent us from sustaining our net revenue or maintaining profitability.

Recently adopted regulatory actions may result in reduced capital spending by broadband service providers, which could adversely impact our opportunities for continued revenue growth.

In December 2010, the FCC adopted rules which, among other things, prohibit broadband service providers from preventing end-user customers from accessing lawful content or running applications of their choice over the Internet, and from connecting and using devices that do not harm the network; they also require facilities-based broadband service providers to treat lawful content, applications and services in a nondiscriminatory manner, and to make certain disclosures concerning their practices as they relate to the openness of their networks.  However, the FCC’s rules permit broadband service providers to employ reasonable techniques to manage traffic on their networks. In addition, the FCC’s rules exempt from these rules (1) certain services provided to national or homeland security authorities, and (2) certain managed or specialized services provided to enterprise customers.  Many of our services appear to fall within these categories of exempt services, and we do not believe that these rules have or will have a material impact on our operations.  However, the rules are the subject of legal challenges, and we are unable to predict the outcome of these lawsuits.  Moreover, if the FCC were to construe narrowly or eliminate existing exemptions, the impact of the rules on our operations could be different and, while the issue remains unresolved, broadband service providers may lessen their capital investments in their networks.  In such a circumstance, we may have fewer opportunities to sell our products to both current and prospective customers, and our opportunity for continued revenue growth could be adversely impacted.  If our revenue growth slows or our revenues decrease, our results of operations and our financial condition also may be adversely impacted.

Risks Related to Ownership of Our Common Stock

Our common stock price is likely to continue to be highly volatile.

The market price of our common stock has been and is likely to continue to be highly volatile. The market for small cap technology companies, including us, has been particularly volatile in recent years.   We cannot assure stockholders that our stock will trade at the same levels of other stocks in our industry or that, in general, stocks in our industry will sustain their current market prices.

Factors that could cause such volatility may include, among other things:

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● actual or anticipated fluctuations in our quarterly operating results;

● announcements of technology innovations by our competitors;

● changes in financial estimates by securities analysts;

● conditions or trends in the network control and management industry;

● the acceptance by institutional investors of our stock;

● rumors, announcements or press articles regarding our operations, management, organization, financial condition or financial statements;

● the gain or loss of a significant customer; or

● the stock market in general, and the market prices of stocks of technology companies, in particular, have experienced extreme price volatility that has adversely affected, and may continue to adversely affect, the market price of our common stock for reasons unrelated to our business or operating results.

*Holders of our common stock may be diluted in the future.

We are authorized to issue up to 32.5 million shares of common stock and 15.0 million shares of preferred stock. Our Board of Directors has the authority, without seeking stockholder approval, to issue additional shares of common stock and/or preferred stock in the future for such consideration as our Board of Directors may consider sufficient.  In addition, in connection with our acquisition of Vineyard, we issued an aggregate of 825,060 shares of our common stock to the former shareholders of Vineyard. If we were to issue equity securities as all or part of the purchase price for any future acquisitions, the issuance of such equity securities would have a dilutive effect on our existing stockholders.  Additionally, if we finance acquisitions by issuing equity securities, our existing stockholders may be diluted.  At September 30, 2013, there were 20,620,756 shares of our common stock outstanding and outstanding stock options to purchase 1.7 million shares of our common stock, of which options to purchase 412,000 shares of our common stock were granted to new employees in connection with our acquisition of Vineyard in January 2013.  At September 30, 2013, we had an authorized reserve of 860,651 shares of common stock, which we may grant as stock options, restricted stock, restricted stock units or other equity awards pursuant to our existing equity incentive plan.

The issuance of additional common stock and/or preferred stock in the future would reduce the proportionate ownership and voting power of our common stock held by existing stockholders and also could cause the trading price of our common stock to decline.

If securities or industry analysts do not publish research or publish inaccurate or unfavorable research about our business, our stock price and trading volume could decline.

The trading market for our common stock will depend in part on the research and reports that securities or industry analysts publish about us or our business. If we do not establish and maintain adequate research coverage or if one or more of the analysts who covers us downgrades our stock or publishes inaccurate or unfavorable research about our business, our stock price would likely decline.  If one or more of these analysts ceases coverage of our Company or fails to publish reports on us regularly, demand for our stock could decrease, which could cause our stock price and trading volume to decline.

*Delaware law and our certificate of incorporation and bylaws contain provisions that may discourage, delay or prevent a change in our management team that our stockholders may consider favorable or otherwise have the potential to impact our stockholders’ ability to control our Company.

Delaware law and our certificate of incorporation and bylaws contain provisions that may have the effect of preserving our current management or may impact our stockholders’ ability to control our Company, such as:

● authorizing the issuance of “blank check” preferred stock with rights senior to those of our common stock, without any need for action by stockholders;

● eliminating the ability of stockholders to call special meetings of stockholders;

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● restricting the ability of stockholders to take action by written consent, which requires stockholder action to be taken at an annual or special meeting of stockholders;

● establishing advance notice requirements for nominations for election to the Board of Directors or for proposing matters that can be acted on by stockholders at stockholder meetings; and

● prohibiting cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates.

These provisions could allow our Board of Directors to affect your rights as a stockholder since our Board of Directors can make it more difficult for common stockholders to replace members of the Board of Directors. Because our Board of Directors is responsible for appointing the members of our management team, these provisions could in turn affect any attempt to replace our current management team.  In addition, the issuance of preferred stock could make it more difficult for a third party to acquire us and may impact the rights of common stockholders.  All of the foregoing could adversely impact the price of our common stock and your rights as a stockholder.

We do not pay and do not expect to pay cash dividends on our common stock.

We have not paid any cash dividends.  We do not anticipate paying cash dividends on our common stock in the foreseeable future and we cannot assure investors that funds will be legally available to pay dividends, or that, even if the funds are legally available, dividends will be declared and paid.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

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Item 4. Mine Safety and Disclosures

Not applicable.

Item 5. Other Information

None.

Item 6. Exhibits

3.1*	Certificate of Incorporation filed on June 13, 2013, filed as Exhibit 3.1 to our current report on Form 8-K filed on June 14, 2013 and incorporated herein by reference.
3.2*	Bylaws, effective June 13, 2013, filed as Exhibit 3.2 to our current report on Form 8-K filed on June 14, 2013 and incorporated herein by reference.
4.1*	Form of Common Stock Certificate, filed as Exhibit 4.1 to our current report on Form 8-K filed on June 14, 2013 and incorporated herein by reference.
31.1	Certification of Principal Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Principal Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Principal Executive Officer and Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS	XBRL Instance Document.
101.SCH	XBRL Taxonomy Extension Schema.
101.CAL	XBRL Taxonomy Extension Calculation Linkbase.
101.DEF	XBRL Taxonomy Extension Definition Linkbase.
101.LAB	XBRL Taxonomy Extension Label Linkbase.
101.PRE	XBRL Taxonomy Extension Presentation Linkbase.

*  Previously filed.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Procera Networks, Inc.
	By:	/s/ Charles Constanti
November 6, 2013		Charles Constanti, Chief Financial Officer
		(Principal Financial and Accounting Officer)

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Exhibit Index

3.1*	Certificate of Incorporation filed on June 13, 2013, filed as Exhibit 3.1 to our current report on Form 8-K filed on June 14, 2013 and incorporated herein by reference.
3.2*	Bylaws, effective June 13, 2013, filed as Exhibit 3.2 to our current report on Form 8-K filed on June 14, 2013 and incorporated herein by reference.
4.1*	Form of Common Stock Certificate, filed as Exhibit 4.1 to our current report on Form 8-K filed on June 14, 2013 and incorporated herein by reference.
31.1	Certification of Principal Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Principal Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Principal Executive Officer and Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS	XBRL Instance Document.
101.SCH	XBRL Taxonomy Extension Schema.
101.CAL	XBRL Taxonomy Extension Calculation Linkbase.
101.DEF	XBRL Taxonomy Extension Definition Linkbase.
101.LAB	XBRL Taxonomy Extension Label Linkbase.
101.PRE	XBRL Taxonomy Extension Presentation Linkbase.

*  Previously filed.

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