424B4 1 d639957d424b4.htm 424B4 424B4
Table of Contents

Filed Pursuant to Rule 424(b)(4)
Registration No. 333-194899

 

PROSPECTUS

5,250,000 Shares

 

LOGO

COMMON STOCK

 

 

Arista Networks, Inc. is offering 5,250,000 shares of its common stock. This is our initial public offering and no public market currently exists for our shares.

 

 

We have been approved to list our common stock on the New York Stock Exchange under the symbol “ANET.”

 

 

We are an “emerging growth company” under the federal securities laws and are subject to reduced public company reporting requirements. Investing in our common stock involves risks. See “Risk Factors” beginning on page 12.

 

 

PRICE $43.00 A SHARE

 

 

 

      

Price to

Public

    

Underwriting

Discounts

and

Commissions(1)

    

Proceeds to

Arista Networks

Per Share

     $43.00      $2.58      $40.42

Total

     $225,750,000      $13,545,000      $212,205,000

 

(1) See section titled “Underwriting” for a description of the compensation payable to the underwriters.

We have granted the underwriters the right to purchase up to an additional 787,500 shares of common stock to cover over-allotments.

The Securities and Exchange Commission and state securities regulators have not approved or disapproved of these securities, or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

The underwriters expect to deliver the shares of common stock to purchasers on June 11, 2014.

 

 

 

MORGAN STANLEY   CITIGROUP

BofA MERRILL

LYNCH

          BARCLAYS   CREDIT SUISSE  

DEUTSCHE BANK

SECURITIES

  RBC CAPITAL MARKETS

WELLS FARGO

SECURITIES

  COWEN AND COMPANY   JMP SECURITIES   NEEDHAM & COMPANY   OPPENHEIMER & CO

PACIFIC CREST

SECURITIES

  STIFEL   THE JUDA GROUP   WILLIAM BLAIR

June 5, 2014


Table of Contents

TABLE OF CONTENTS

 

     Page  

Prospectus Summary

     1   

The Offering

     7   

Risk Factors

     12   

Special Note Regarding Forward-Looking Statements

     46   

Market and Industry Data

     47   

Use of Proceeds

     48   

Dividend Policy

     48   

Capitalization

     49   

Dilution

     51   

Selected Consolidated Financial Data

     53   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     58   

Business

     95   
     Page  

Management

     111   

Executive Compensation

     119   

Certain Relationships and Related Party Transactions

     130   

Principal Stockholders

     132   

Description of Capital Stock

     135   

Shares Eligible for Future Sale

     140   

Material U.S. Federal Income Tax Consequences to Non-U.S. Holders of Our Common Stock

     142   

Underwriters

     146   

Legal Matters

     154   

Experts

     154   

Additional Information

     154   

Index to Consolidated Financial Statements

     F-1   
 

 

 

Unless the context otherwise requires, the terms “Arista,” “Arista Networks,” “the company,” “we,” “us,” and “our” in this prospectus refer to Arista Networks, Inc. and its subsidiaries. Neither we nor the underwriters have authorized anyone to provide you with any information or make any representations other than those contained in this prospectus or in any free writing prospectus prepared by or on behalf of us or to which we have referred you. We take no responsibility for, and can provide no assurance as to the reliability of, any other information that others may give you. We are offering to sell, and seeking offers to buy, shares of common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of the common stock. Our business, financial condition, results of operations and prospects may have changed since that date.

Through and including June 30, 2014 (the 25th day after the date of this prospectus), all dealers effecting transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to a dealer’s obligation to deliver a prospectus when acting as an underwriter and with respect to an unsold allotment or subscription.

For investors outside of the United States: Neither we nor the underwriters have done anything that would permit this offering or possession or distribution of this prospectus in any jurisdiction where action for that purpose is required, other than in the United States. You are required to inform yourselves about and to observe any restrictions relating to this offering and the distribution of this prospectus outside of the United States.

 

-i-


Table of Contents

PROSPECTUS SUMMARY

This summary highlights information contained elsewhere in this prospectus. You should read the following summary together with the more detailed information appearing in this prospectus, including “Risk Factors,” “Selected Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and our consolidated financial statements and related notes before deciding whether to purchase shares of our common stock. Our year end is December 31, and our quarters end on March 31, June 30, September 30 and December 31. Our fiscal years ended December 31, 2010, 2011, 2012 and 2013 are referred to herein as 2010, 2011, 2012 and 2013, respectively.

ARISTA NETWORKS, INC.

Overview

We are a leading supplier of cloud networking solutions that use software innovations to address the needs of large-scale Internet companies, cloud service providers and next-generation data centers for enterprises, based on market share. Our cloud networking solutions consist of our Extensible Operating System, or EOS, a set of network applications and our 10/40/100 Gigabit Ethernet switches. Our cloud networking solutions deliver industry-leading performance, scalability, availability, programmability, automation and visibility. Since we began shipping our products, we have grown rapidly, and, according to Crehan Research, we have achieved the second largest market share in data center 10/40/100 Gigabit Ethernet switch ports, excluding blade switching, sold in 2013.

At the core of our cloud networking platform is EOS, which was purpose-built to be fully programmable and highly modular. The programmability of EOS has allowed us to create a set of software applications that address the requirements of cloud networking, including workflow automation, network visibility and analytics, and has also allowed us to rapidly integrate with a wide range of third-party applications for virtualization, management, automation, orchestration and network services.

EOS supports leading cloud and virtualization solutions, including VMware NSX, Microsoft System Center, OpenStack and other cloud management frameworks. We have worked with industry leaders to define new open protocols for the virtualized data center. We co-authored the VXLAN protocol specification with VMware and were the first to demonstrate VXLAN integration. We also co-authored the NVGRE protocol specification with Microsoft and support integration with Microsoft’s System Center.

We use standard Linux as our underlying operating system, providing customers with access to all Linux operating system facilities. This allows customers to extend our EOS software with off-the-shelf Linux applications and a growing number of open source management tools.

EOS has a highly modular architecture, which allows us to prevent network outages in deployments of our cloud networking solutions. This architecture also allows us to rapidly develop new features and protocols without compromising the quality of the existing code base. Because all of our switching products are powered by the same binary image of EOS, we are able to deliver these new innovations to our entire installed base with minimal disruption.

We sell our products through both our direct sales force and our channel partners. Since shipping our first products in 2008, our cumulative end-customer base has grown rapidly. Between December 31, 2010 and March 31, 2014, our cumulative end-customer base grew from approximately 570 to approximately 2,500. Our end customers span a range of industries and include large Internet companies, service providers, financial services organizations, government agencies, media and entertainment companies and others. Our customers

 

 

-1-


Table of Contents

include six of the largest cloud services providers based on annual revenue, including eBay, Facebook, Microsoft and Yahoo!, financial services organizations such as Barclays, Citigroup, and Morgan Stanley, and a number of media and service providers, including AOL, Comcast, Equinix, ESPN, Netflix, and Rackspace.

We have experienced rapid revenue growth over the last several years, increasing our revenue at a compound annual growth rate of 71.4% from 2010 to 2013. For 2010, 2011, 2012 and 2013, our revenue was $71.7 million, $139.8 million, $193.4 million and $361.2 million, respectively. Our 2013 revenue grew 86.8% when compared to 2012. Our revenue for the three months ended March 31, 2014 was $117.2 million, an increase of 91.1% when compared to the same period in 2013. For 2010, 2011, 2012 and 2013, our net income was $2.4 million, $34.0 million, $21.3 million and $42.5 million, respectively. For the three months ended March 31, 2013 and 2014, our net income was $6.6 million and $12.3 million, respectively.

Industry Background

Cloud computing is fundamentally changing the way IT infrastructure is built and how applications are delivered. In cloud computing, applications are distributed across thousands of servers. These servers are connected with high-speed network switches that, together, form a pool of resources that allows applications to be rapidly deployed and cost-effectively updated. Cloud computing enables ubiquitous and on-demand network access to these applications from Internet-connected devices including personal computers, tablets and smartphones.

Nearly all consumer applications today are delivered as cloud services. Enterprise applications are rapidly moving to the cloud as well, since cloud services are easier and more cost effective to deploy, scale and operate than traditional applications. Internet leaders like Amazon, eBay, Facebook, Google, Microsoft and Yahoo! pioneered the development of large-scale cloud data centers in order to meet the growing demands of their users, including business customers. These U.S.-based Internet leaders increased their capital spending from $8.9 billion in 2010 to $19.4 billion in 2013, representing a 29.6% compound annual growth rate.

The aggregate network bandwidth in the cloud can be orders of magnitude higher than typical legacy data center networks. Therefore, the networks in such cloud environments must be architected and built in a new way. We refer to these next-generation data center networks as cloud networks. Cloud networks must deliver high capacity, high availability and predictable performance and must be programmable to allow integration with third-party applications for virtualization, management, automation, orchestration and network services.

Requirements for Cloud Networking

Cloud networks differ in many aspects from legacy networks, including performance, capacity, scale, availability, programmability and automation. The requirements for cloud networking include the following:

 

    Capacity, Performance and Scalability. Cloud networks must have sufficient capacity to interconnect large numbers of servers, up to hundreds of thousands, with predictable network bandwidth.

 

    High Availability. Cloud networks must overcome hardware or software failures for customers to avoid network outages, which can result in lost revenue, dissatisfied customers and increased operational cost.

 

    Open and Programmable. Cloud networks must be based on open protocols and be programmable to enable integration with leading network applications and management and data analysis tools.

 

    Workflow Automation. Cloud networks must offer automated provisioning and configuration to enable fast service delivery and to minimize operational costs, avoiding time-consuming and error-prone manual processes for configuring, provisioning, monitoring and managing the network.

 

 

-2-


Table of Contents
    Network Visibility. Cloud networks must provide IT administrators with real-time in-depth visibility of network status to proactively monitor, detect and notify when issues arise.

 

    Cost Performance. Cloud networks must deliver high performance while lowering overall cost of ownership, including capital and operational costs.

These and other requirements drive the adoption of next-generation switches and cloud-optimized network designs.

Our Cloud Networking Solutions

We are a leading supplier of cloud networking solutions that use software innovations to address the needs of large-scale Internet companies, cloud service providers and next-generation enterprise data centers. Gartner has identified us as a “Visionary” in its 2014 “Magic Quadrant for Data Center Networking” based on our ability to execute and completeness of vision. Our cloud networking platform was purpose-built to address the functional and performance requirements of cloud networks. We deliver our solutions via our industry-leading 10/40/100 Gigabit Ethernet switches optimized for next-generation data center networks.

Our cloud networking solutions consist of our Extensible Operating System, or EOS, a set of network applications and our 10/40/100 Gigabit Ethernet switches. At the core of our cloud networking platform is EOS. EOS was architected to be fully programmable and highly modular. As a result, we are able to bring new features and applications to market rapidly, provide industry leading high availability and offer integration with leading third-party networking applications.

Our Market Opportunity

We compete primarily in the data center switching market for 10 Gigabit Ethernet and above, excluding blade switches. According to Crehan Research, this market will grow from approximately $6 billion in 2013 to $12 billion in 2017, representing a 18.9% compound annual growth rate.

We believe that cloud computing represents a fundamental shift from traditional legacy data centers and that cloud networking is the fastest growing segment within the data center switching market. As organizations of all sizes are adopting cloud architectures, spending on cloud and next-generation data centers has increased rapidly over the last several years, while traditional legacy IT spending has been growing more slowly.

Our Competitive Strengths

We believe the following strengths will allow us to maintain and extend our technology leadership position in cloud networking and next-generation data center Ethernet switching:

 

    Purpose-Built Cloud Networking Platform. We have developed a highly scalable cloud networking platform that uses software to address the needs of large-scale Internet companies, cloud service providers, financial services organizations, government agencies and media and entertainment companies.

 

    Broad and Differentiated Switch Portfolio. Using multiple silicon architectures, we deliver switches with industry-leading capacity, low latency, port density and power efficiency and have innovated in areas such as deep packet buffers, embedded optics and reversible cooling.

 

    Single Binary Image Software. The single binary image of our EOS software allows us to maintain feature consistency across our entire product portfolio and enables us to introduce new software innovations into the market that become available to our entire installed base without a “forklift upgrade” (i.e., a broad upgrade of the data center infrastructure).

 

 

-3-


Table of Contents
    Rapid Development of New Features and Applications. Our highly modular EOS software has allowed us to rapidly deliver new features and applications while preserving the structural integrity and quality of our network operating system.

 

    Deep Understanding of Customer Requirements. We have developed close working relationships with many of our largest customers that provide us with insights about their needs and future requirements. This has allowed us to rapidly develop and deliver products to market that meet customer demands and expectations as well as to rapidly grow sales to existing customers.

 

    Strong Management and Engineering Team with Significant Data Center Networking Expertise. Our management and engineering team consists of networking veterans with extensive data center networking expertise.

 

    Significant Technology Lead. We believe that our networking technology represents a fundamental advance in networking software. Our EOS software is the result of more than 1,000 man-years of research and development investment over a nine-year period.

Our Growth Strategy

We intend to grow our revenue and market share in cloud and next-generation data center Ethernet switching. Key elements of our growth strategy include:

 

    Continue to Innovate and Extend our Technology Leadership. We plan to increase our investment in research and development to expand and enhance the capabilities of our cloud networking solutions.

 

    Expand our Sales Organization and our Channel Partners. We intend to continue to invest in our global sales organization as we pursue relationships with large enterprise, service provider and government customers.

 

    Increase Penetration with our Existing Customer Base. As we successfully demonstrate the benefits of our solutions, we see a significant opportunity to sell additional products and services to our existing customers and to migrate additional workloads and applications onto our cloud networking platform.

 

    Expand Strategic Relationships. We have developed strategic relationships with a number of technology ecosystem participants including Aruba Networks, F5 Networks, Microsoft, Palo Alto Networks, Riverbed, Splunk and VMware, to allow integration of our cloud networking solutions with their offerings and enable an integrated experience for our customers.

Risks Associated With Our Business

Our business is subject to numerous risks and uncertainties, including those highlighted in the section titled “Risk Factors” immediately following this prospectus summary. These risks include, among others, the following:

 

    we have a limited operating history, which makes it difficult to evaluate our current business and future prospects and may increase the risks associated with your investment;

 

    our business and operations have experienced rapid growth, and, if we do not appropriately manage any future growth or are unable to improve our systems and processes, our business, financial condition, results of operations and prospects will be adversely affected;

 

    our results of operations are likely to vary significantly from period to period and be unpredictable, which could cause the market price of our common stock to decline;

 

    we expect large purchases by a limited number of end customers to continue to represent a substantial majority of our revenue, and any loss or delay of expected purchases could result in material quarter-to-quarter fluctuations of our revenue or otherwise adversely affect our results of operations;

 

 

-4-


Table of Contents
    our revenue growth in recent periods may not be indicative of our future performance;

 

    we face intense competition, especially from larger, well-established companies, and we may lack sufficient financial or other resources to maintain or improve our competitive position;

 

    if we do not successfully anticipate technological shifts, market needs and opportunities, and develop products and product enhancements that meet those technological shifts, needs and opportunities, or if those products are not made available in a timely manner or do not gain market acceptance, we may not be able to compete effectively, and our ability to generate revenue will suffer;

 

    we are currently involved in a license dispute with Optumsoft, Inc;

 

    product quality problems, defects, errors or vulnerabilities in our products or services could harm our reputation and adversely impact our business, financial condition, results of operations and prospects;

 

    the cloud networking market is still in its early stages and is rapidly evolving, and if this market does not evolve as we anticipate or our target end customers do not adopt our cloud networking solutions, we may not be able to compete effectively, and our ability to generate revenue will suffer;

 

    we identified a material weakness in our internal controls for the years ended December 31, 2010, 2011, 2012 and 2013 that, if not properly remediated, could result in material misstatements in our financial statements in future periods and impair our ability to comply with the accounting and reporting requirements applicable to public companies; and

 

    insiders, our directors, executive officers, and each of our stockholders who own greater than 5% of our stock, who will beneficially own approximately 59.5% of the outstanding shares of our common stock after this offering, based on shares outstanding as of April 30, 2014 as adjusted for the conversion into shares of common stock of principal and accrued interest through the anticipated completion of this offering of certain of our subordinated convertible promissory notes, will continue to have substantial control over us, which could limit your ability to influence the outcome of key transactions, including a change of control.

Corporate Information

We were incorporated in the State of California as Arastra, Inc. in October 2004. We reincorporated in the State of Nevada in March 2008, and we changed our name to Arista Networks, Inc. in October 2008. We reincorporated in the State of Delaware in March 2014. Our principal executive offices are located at 5453 Great America Parkway, Santa Clara, California 95054. Our main telephone number is (408) 547-5500. Our website address is www.arista.com. Information on or that can be accessed through our website is not part of this prospectus and should not be relied upon in determining whether to make an investment decision.

The Arista Networks design logo and the marks “ARISTA,” “EOS,” “CloudVision,” “CVX,” “Health Tracer,” “MapReduce Tracer,” “Path Tracer,” “MXP,” “RAIL” and “SPLINE” are our property. This prospectus contains additional trade names, trademarks and service marks of other companies. We do not intend our use or display of other companies’ trade names, trademarks or service marks to imply a relationship with, or endorsement or sponsorship of us by, these other companies.

Implications of Being an Emerging Growth Company

As a company with less than $1.0 billion in revenue during our last year, we qualify as an “emerging growth company” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. An emerging growth company may take advantage of specified reduced reporting requirements that are otherwise applicable generally to public companies. These reduced reporting requirements include:

 

    the requirement to present only two years of audited financial statements and only two years of related management’s discussion and analysis in this prospectus;

 

    an exemption from compliance with the auditor attestation requirement on the effectiveness of our internal controls over financial reporting;

 

 

-5-


Table of Contents
    an exemption from compliance with any requirement that the Public Company Accounting Oversight Board may adopt regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements;

 

    reduced disclosure about our executive compensation arrangements; and

 

    exemption from the requirements to obtain a non-binding advisory vote on executive compensation or shareholder approval of any golden parachute arrangements.

We will remain an emerging growth company until the earliest to occur of: (i) the first fiscal year following the fifth anniversary of our initial public offering; (ii) the first fiscal year after our annual gross revenue is $1 billion or more; (iii) the date on which we have, during the previous three-year period, issued more than $1 billion in non-convertible debt securities; or (iv) as of the end of any fiscal year in which the market value of our common stock held by non-affiliates exceeded $700 million as of the end of the second quarter of that fiscal year.

We may choose to take advantage of some, but not all, of the available benefits under the JOBS Act. We are choosing to irrevocably “opt out” of the extended transition periods available under the JOBS Act for complying with new or revised accounting standards, but we intend to take advantage of the other exemptions discussed above. Accordingly, the information contained herein may be different than the information you receive from other public companies in which you hold stock.

 

 

-6-


Table of Contents

THE OFFERING

 

Common stock offered by us

  

5,250,000 shares

Over-allotment option being offered by us

  

787,500 shares

Common stock to be outstanding after this offering

  


63,582,416 shares (64,369,916 shares, if the underwriters exercise their over-allotment option in full)

Use of proceeds

  

We estimate that the net proceeds from this offering will be approximately $206.9 million, or approximately $238.7 million if the underwriters exercise their over-allotment option in full, at the initial public offering price of $43.00 per share, after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

 

The principal purposes of this offering are to increase our capitalization and financial flexibility, to create a public market for our stock and thereby enable access to the public equity markets by our employees and stockholders, to obtain additional capital and to increase our visibility in the marketplace.

 

We intend to use approximately $23.6 million of the net proceeds we receive from this offering to prepay the principal and accrued interest of the Singtel Innov8 Pte. Ltd subordinated convertible promissory note, and the remaining net proceeds for general corporate purposes, including working capital, sales and marketing activities, product development, general and administrative matters and capital expenditures, although we do not currently have any specific or preliminary plans with respect to the use of proceeds for such purposes. We also may use a portion of the net proceeds to acquire complementary businesses, products, services or technologies. However, we do not have agreements or commitments for any specific acquisitions at this time. See “Use of Proceeds.”

Proposed NYSE trading symbol

  

“ANET”

 

 

-7-


Table of Contents

The number of shares of our common stock to be outstanding after this offering is based on 56,088,441 shares of our common stock outstanding as of March 31, 2014 and excludes:

 

    13,507,913 shares of common stock issuable upon the exercise of options outstanding with a weighted-average exercise price of $11.05 per share as of March 31, 2014;

 

    773,900 shares of common stock issuable upon the exercise of options granted prior to the date of this prospectus and subsequent to March 31, 2014 with an exercise price of $38.00 per share; and

 

    12,904,064 shares of common stock reserved for future issuance under our stock-based compensation plans, consisting of (i) 5,743,064 shares of common stock reserved for future issuance under our 2011 Equity Incentive Plan, which shares will be added to the shares to be reserved under our 2014 Equity Incentive Plan, which will become effective upon completion of this offering; (ii) 6,510,000 shares of common stock reserved for future issuance under our 2014 Equity Incentive Plan, which will become effective upon completion of this offering; and (iii) 651,000 shares of common stock reserved for future issuance under our 2014 Employee Stock Purchase Plan, which will become effective upon completion of this offering; as well as shares of common stock that become available under our 2014 Equity Incentive Plan and 2014 Employee Stock Purchase Plan, pursuant to provisions thereof that automatically increase the share reserves under the plans each year, as more fully described in “Executive Compensation—Employee Benefit and Stock Plans.”

Except as otherwise indicated, all information in this prospectus assumes:

 

    the effectiveness of our amended and restated certificate of incorporation in connection with the completion of this offering;

 

    the conversion of certain subordinated convertible promissory notes issued to certain noteholders in the aggregate principal amount of $80.0 million and accrued interest through the anticipated completion of this offering, into 2,243,975 shares of common stock (assuming conversion of the notes at the common stock price per share of $43.00 which is the initial public offering price of this offering). For a description of the subordinated convertible promissory notes, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Debt Obligations;”

 

    the automatic conversion of all outstanding shares of our convertible preferred stock into an aggregate of 24,000,000 shares of common stock immediately prior to the completion of this offering;

 

    no exercise of outstanding options subsequent to March 31, 2014; and

 

    no exercise of the underwriters’ over-allotment option.

Except for SingTel Innov8 Pte. Ltd, who holds $20.0 million in principal amount of our convertible promissory notes, the noteholders have agreed to convert the principal and interest amount outstanding under their convertible promissory notes into shares of our common stock at the initial offering price in conjunction with our initial public offering.

 

 

-8-


Table of Contents

SUMMARY CONSOLIDATED FINANCIAL DATA

The following table summarizes our consolidated financial data. The summary consolidated statements of operations data presented below for the years ended December 31, 2011, 2012 and 2013 have been derived from the audited consolidated financial statements that are included elsewhere in this prospectus. The summary consolidated statements of operations data for the three months ended March 31, 2013 and 2014, and the consolidated balance sheet data as of March 31, 2014 have been derived from the unaudited consolidated financial statements that are included elsewhere in this prospectus. The unaudited consolidated financial statements were prepared on the same basis as the audited consolidated financial statements contained in this prospectus and include, in the opinion of management, all adjustments necessary for a fair presentation of the financial information set forth in those statements. The following summary consolidated financial data should be read together with our audited and unaudited consolidated financial statements and the related notes, as well as the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus. Our historical results are not necessarily indicative of our results in any future period and our interim results are not necessarily indicative of results that should be expected for a full year or any other period.

 

     Year Ended December 31,     Three Months
Ended March 31,
 
     2011     2012     2013     2013     2014  
     (in thousands, except share and per-share data)  

Consolidated Statements of Operations Data:

          

Revenue

   $ 139,848      $ 193,408      $ 361,224      $ 61,348      $ 117,207   

Cost of revenue(1)

     43,366        61,252        122,686        19,220        35,893   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     96,482        132,156        238,538        42,128        81,314   

Operating expenses(1):

          

Research and development

     26,408        55,155        98,587       
19,514
  
    33,446   

Sales and marketing

     19,450        28,603        55,115        10,135        18,655   

General and administrative

     6,224        8,501        18,688        3,736        7,231   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     52,082        92,259        172,390        33,385        59,332   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     44,400        39,897        66,148        8,743        21,982   

Other income (expense), net:

          

Interest expense

     (6,417     (7,057     (7,119     (1,751     (1,771

Interest and other income (expense), net

     (357     135        (754     (99     (764
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other income (expense), net

     (6,774     (6,922     (7,873     (1,850     (2,535
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before provision for income taxes

     37,626        32,975        58,275        6,893        19,447   

Provision for income taxes

     3,591        11,626        15,815        282        7,118   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 34,035      $ 21,349      $ 42,460      $ 6,611      $ 12,329   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income attributable to common stockholders(2):

          

Basic

   $ 13,789      $ 9,622      $ 20,777      $ 3,127      $ 6,362   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

   $ 13,854      $ 9,662      $ 21,780      $ 3,233      $ 6,816   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income per share attributable to common stockholders(2):

          

Basic

   $ 0.65      $ 0.39      $ 0.76      $ 0.12      $ 0.22   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

   $ 0.65      $ 0.39      $ 0.72      $ 0.12      $ 0.20   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Weighted-average shares used in computing net income per share attributable to common stockholders (2):

          

Basic

     21,175,788        24,711,453        27,320,294        26,284,899        29,124,310   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

     21,345,641        24,901,005        30,051,290     

 

28,044,389

  

 

 

33,815,705

  

  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Pro forma net income per share attributable to common stockholders(2):

          

Basic

       $ 0.77        $ 0.22   
      

 

 

     

 

 

 

Diluted

       $ 0.73        $ 0.20   
      

 

 

     

 

 

 

Weighted-average shares used in computing pro forma net income per share attributable to common stockholders(2):

          

Basic

         51,320,294          53,124,310   
      

 

 

     

 

 

 

Diluted

         54,051,290          57,815,705   
      

 

 

     

 

 

 

 

 

-9-


Table of Contents

 

(1) Includes stock-based compensation expense as follows:

 

     Year Ended
December 31,
     Three Months Ended
March 31,
 
     2011      2012      2013      2013      2014  
     (in thousands)  

Cost of revenue

   $ 94       $ 270       $ 408       $ 67       $ 211   

Research and development

     992         2,590         5,464         996         2,467   

Sales and marketing

     554         1,078         2,985        
482
  
     1,428   

General and administrative

     334         765         1,302         197         676   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total stock-based compensation

   $ 1,974       $ 4,703       $ 10,159       $ 1,742       $ 4,782   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(2) See Notes 1 and 11 to our consolidated financial statements appearing elsewhere in this prospectus for an explanation of the calculations of our basic and diluted net income per share attributable to common stockholders and our basic and diluted pro forma net income per share attributable to common stockholders.

Our consolidated balance sheet as of March 31, 2014 is presented on:

 

    an actual basis;

 

    a pro forma basis, giving effect to the automatic conversion of all outstanding shares of our convertible preferred stock into 24,000,000 shares of common stock and the effectiveness of our amended and restated certificate of incorporation and amended and restated bylaws as of immediately prior to the completion of this offering, as if such conversion had occurred and our amended and restated certificate of incorporation had become effective on March 31, 2014; and

 

    a pro forma as adjusted basis, giving effect to the pro forma adjustments, the conversion of $80.0 million in principal amount of and accrued interest through the anticipated completion of this offering on our subordinated convertible promissory notes into 2,243,975 shares of common stock (assuming conversion of the notes at the common stock price per share of $43.00 which is the initial public offering price of this offering), the prepayment of $23.6 million principal and accrued interest through the anticipated completion of this offering of the Singtel Innov8 Pte. Ltd subordinated convertible promissory note with a portion of the net proceeds from this offering and the sale of 5,250,000 shares of common stock by us in this offering, based on the initial public offering price of $43.00 per share, after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

 

     March 31, 2014  
     Actual      Pro Forma      Pro Forma As
Adjusted
 
     (in thousands)  

Consolidated Balance Sheet Data:

  

Cash and cash equivalents

   $ 129,524       $ 129,524       $ 313,568   

Working capital

     93,033         93,033         397,216   

Total assets

     375,463         375,463         556,608   

Total indebtedness(1)

     162,308         162,308         44,293   

Total deferred revenue

     56,107         56,107         56,107   

Total stockholders’ equity

     96,428         96,428         397,712   

 

(1) Total indebtedness includes our subordinated convertible promissory notes payable to related parties, subordinated convertible promissory notes payable to third parties, accrued interest payable on the notes and our lease financing obligations.

 

 

-10-


Table of Contents

Non-GAAP Financial Measures

We use the financial measures set forth below, which are non-GAAP financial measures, to help us analyze our financial results, establish budgets and operational goals for managing our business and evaluate our performance. We also believe that the presentation of these non-GAAP financial measures in this prospectus provides an additional tool for investors to use in comparing our core business and results of operations over multiple periods with other companies in our industry, many of which present similar non-GAAP financial measures to investors.

 

     Year Ended December 31,     Three Months Ended
March 31,
 
     2011     2012     2013     2013     2014  
     (in thousands, except percentages)  

Non-GAAP gross profit

   $ 96,576      $ 132,426      $ 238,946      $ 42,195      $ 81,525   

Non-GAAP gross margin

     69.1     68.5     66.1     68.8     69.6

Non-GAAP income from operations

   $ 46,374      $ 44,600      $ 76,307      $ 10,485      $ 26,764   

Non-GAAP operating margin

     33.2     23.1     21.1     17.1     22.8

Adjusted EBITDA

   $ 47,667      $ 46,379      $ 81,351      $ 11,202      $ 29,049   

Adjusted EBITDA margin

     34.1     24.0     22.5     18.3     24.8

Non-GAAP gross profit and margin. We define non-GAAP gross profit as gross profit as reported on our consolidated statements of operations, excluding the impact of stock-based compensation, which is a non-cash charge. We define non-GAAP gross margin as non-GAAP gross profit divided by revenue. We have presented non-GAAP gross profit and margin because we believe that the exclusion of stock-based compensation allows for more accurate comparisons of our results of operations to other companies in our industry. Please see “Selected Consolidated Financial Data—Non-GAAP Financial Measures” for information regarding the limitations of using non-GAAP gross profit and gross margin as financial measures and for a reconciliation of non-GAAP gross profit to gross profit, the most directly comparable financial measure calculated in accordance with GAAP.

Non-GAAP income from operations and operating margin. We define non-GAAP income from operations as income from operations as reported on our consolidated statements of operations, excluding the impact of stock-based compensation. We define non-GAAP operating margin as non-GAAP income from operations divided by revenue. We have presented non-GAAP income from operations and operating margin because we believe that the exclusion of stock-based compensation allows for more accurate comparisons of our results of operations to other companies in our industry. Please see “Selected Consolidated Financial Data—Non-GAAP Financial Measures” for information regarding the limitations of using non-GAAP income from operations and operating margin as financial measures and for a reconciliation of non-GAAP income from operations to income from operations, the most directly comparable financial measure calculated in accordance with GAAP.

Adjusted EBITDA and adjusted EBITDA margin. We define adjusted EBITDA as our net income excluding: (i) stock-based compensation; (ii) interest expense; (iii) other income (expense), net, which primarily includes foreign exchange gains and losses; (iv) depreciation and amortization; and (v) our provision for income taxes. We define adjusted EBITDA margin as adjusted EBITDA divided by revenue. Depreciation includes depreciation expense associated with our leased building in Santa Clara, California. See Note 6 to our consolidated financial statements appearing elsewhere in this prospectus for an explanation of the accounting for our build-to-suit lease. We have presented adjusted EBITDA and adjusted EBITDA margin because they are key measures used by our management and board of directors to understand and evaluate our operating performance, to establish budgets and to develop operational goals for managing our business. In particular, we believe that the exclusion of the expenses eliminated in calculating adjusted EBITDA can provide a useful measure for period-to-period comparisons of our core operating performance. Please see “Selected Consolidated Financial Data—Non-GAAP Financial Measures” for information regarding the limitations of using adjusted EBITDA and adjusted EBITDA margin as financial measures and for a reconciliation of adjusted EBITDA to net income, the most directly comparable financial measure calculated in accordance with GAAP.

 

 

-11-


Table of Contents

RISK FACTORS

Investing in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below, together with all of the other information in this prospectus, including our consolidated financial statements and related notes, before investing in our common stock. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, may also become important factors that adversely affect our business. If any of the following risks occur, our business, financial condition, results of operations and prospects could be materially harmed. In that event, the market price of our common stock could decline, and you could lose part or all of your investment.

Risks Related to Our Business and Our Industry

Our limited operating history makes it difficult to evaluate our current business and future prospects and may increase the risk associated with your investment.

We were founded in 2004 and shipped our first products in 2008. The majority of our revenue growth has occurred since the beginning of 2010. Our limited operating history makes it difficult to evaluate our current business and our future prospects, including our ability to plan for and model future growth. We have encountered and will continue to encounter risks and difficulties frequently experienced by rapidly growing companies in constantly evolving industries, including the risks described in this prospectus. If we do not address these risks successfully, our business, financial condition, results of operations and prospects will be adversely affected, and the market price of our common stock could decline. Further, we have limited historic financial data, and we operate in a rapidly evolving market. As such, any predictions about our future revenue and expenses may not be as accurate as they would be if we had a longer operating history or operated in a more predictable market.

Our business and operations have experienced rapid growth, and if we do not appropriately manage any future growth or are unable to improve our systems and processes, our business, financial condition, results of operations and prospects will be adversely affected.

We have experienced rapid growth and increased demand for our products over the last several years, which has placed a strain on our management, administrative, operational and financial infrastructure. Our employee headcount and number of end customers have increased significantly. To handle the increase in end customers, we expect to continue to grow our headcount significantly over the next 12 months. For example, as of December 31, 2010 and March 31, 2014, our cumulative number of end customers increased from approximately 570 to approximately 2,500, and our headcount increased from over 100 to over 850 over the same period. As we have grown, we have had to manage an increasingly larger and more complex array of internal systems and processes to scale with all aspects of our business, including our hardware and software development, contract manufacturing and purchasing, logistics and fulfillment and maintenance and support. Our success will depend in part upon our ability to manage our growth effectively. To do so, we must continue to increase the productivity of our existing employees and continue to hire, train and manage new employees as needed. To manage domestic and international growth of our operations and personnel, we will need to continue to improve our operational, financial and management controls and our reporting processes and procedures and implement more extensive and integrated financial and business information systems. We may not be able to successfully implement these or other improvements to our systems and processes in an efficient or timely manner, and we may discover deficiencies in their capabilities or effectiveness. We may experience difficulties in managing improvements to our systems and processes or in connection with third-party technology. In addition, our systems and processes may not prevent or detect all errors, omissions or fraud. Our failure to improve our systems and processes, or their failure to operate effectively and in the intended manner, may result in disruption of our current operations and end-customer relationships, our inability to manage the growth of our business and our inability to accurately forecast our revenue, expenses and earnings and prevent certain losses.

 

-12-


Table of Contents

Our results of operations are likely to vary significantly from period to period and be unpredictable, which could cause the market price of our common stock to decline.

Our results of operations have historically varied from period to period, and we expect that this trend will continue. As a result, you should not rely upon our past financial results for any period as indicators of future performance. Our results of operations in any given period can be influenced by a number of factors, many of which are outside of our control and may be difficult to predict, including:

 

    our ability to attract and retain new end customers, including large end customers;

 

    the budgeting cycles and purchasing practices of end customers, including large end customers;

 

    the buying patterns of our large end customers in which large bulk purchases may or may not occur in certain quarters;

 

    changes in end-customer, distributor or reseller requirements or market needs;

 

    deferral or cancellation of orders from end customers, including in anticipation of new products or product enhancements announced by us or our competitors;

 

    changes in the growth rate of the networking market;

 

    the actual or rumored timing and success of new product and service introductions by us or our competitors or any other change in the competitive landscape of our industry, including consolidation among our competitors or end customers;

 

    our ability to successfully expand our business domestically and internationally;

 

    our ability to increase the size of our distribution channel;

 

    decisions by potential end customers to purchase cloud networking solutions from larger, more established vendors or from their primary network equipment vendors;

 

    price competition;

 

    insolvency or credit difficulties confronting our end customers, which could adversely affect their ability to purchase or pay for our products and services, or confronting our key suppliers, including our sole source suppliers, which could disrupt our supply chain;

 

    any disruption in our sales channel or termination of our relationship with important channel partners;

 

    our inability to fulfill our end customers’ orders due to supply chain delays, access to key commodities or technologies or events that impact our manufacturers or their suppliers;

 

    the cost and potential outcomes of existing and future litigation;

 

    seasonality or cyclical fluctuations in our markets;

 

    future accounting pronouncements or changes in our accounting policies;

 

    stock-based compensation expense;

 

    our overall effective tax rate, including impacts caused by any reorganization in our corporate structure, any changes in our valuation allowance for domestic deferred tax assets and any new legislation or regulatory developments;

 

    increases or decreases in our expenses caused by fluctuations in foreign currency exchange rates, as an increasing portion of our expenses are incurred and paid in currencies other than the U.S. dollar;

 

    general economic conditions, both domestically and in foreign markets; and

 

    other risk factors described in this prospectus.

 

-13-


Table of Contents

Any one of the factors above or the cumulative effect of several of the factors described above may result in significant fluctuations in our financial and other results of operations. This variability and unpredictability could result in our failure to meet our revenue, results of operations or other expectations or those of securities analysts or investors for a particular period. If we fail to meet or exceed such expectations for these or any other reasons, the market price of our common stock could decline substantially, and we could face costly lawsuits, including securities class action suits.

We expect large purchases by a limited number of end customers to continue to represent a substantial majority of our revenue, and any loss or delay of expected purchases could result in material quarter-to-quarter fluctuations of our revenue or otherwise adversely affect our results of operations.

Historically, large purchases by a relatively limited number of end customers have accounted for significant portion of our revenue. Many of these end customers make large purchases to complete or upgrade specific data center installations. These purchases are short-term in nature and are typically made on a purchase-order basis rather than pursuant to long-term contracts. During 2011, 2012 and 2013, sales to our 10 largest end customers accounted for approximately 32.4%, 39.3% and 43.0% of our revenue, respectively. During the three months ended March 31, 2013 and 2014, sales to our 10 largest end customers accounted for approximately 42.3% and 44.6% of our revenue, respectively. Revenue from sales to Microsoft, through our channel partner, World Wide Technology, Inc., accounted for 10.4% of our revenue for the year ended December 31, 2011, 15.3% of our revenue for the year ended December 31, 2012, 21.9% of our revenue for the year ended December 31, 2013, and 12.5% and 24.7% of our revenue for the three months ended March 31, 2013 and 2014, respectively.

As a consequence of the concentrated nature of our customer base and their purchasing behavior, our quarterly revenue and results of operations may fluctuate from quarter to quarter and are difficult to estimate. For example, any cancellation of orders or any acceleration or delay in anticipated product purchases or the acceptance of shipped products by our larger end customers could materially affect our revenue and results of operations in any quarterly period. We may be unable to sustain or increase our revenue from our large end customers or offset the discontinuation of concentrated purchases by our larger end customers with purchases by new or existing end customers. We expect that such concentrated purchases will continue to contribute materially to our revenue for the foreseeable future and that our results of operations may fluctuate materially as a result of such larger end customers’ buying patterns. In addition, we may see consolidation of our customer base, such as among Internet companies and cloud service providers, which could result in loss of end customers. The loss of such end customers, or a significant delay or reduction in their purchases, could materially harm our business, financial condition, results of operations and prospects.

Our revenue growth rate in recent periods may not be indicative of our future performance.

Our revenue growth rate in recent periods may not be indicative of our future performance. We experienced annual revenue growth rates of 95.0%, 38.3% and 86.8% in 2011, 2012 and 2013, respectively. We may not achieve similar revenue growth rates in future periods, especially as we enter and expand into the cloud services and application services provider markets. You should not rely on our revenue for any prior quarterly or annual period as any indication of our future revenue or revenue growth. If we are unable to maintain consistent revenue or revenue growth, our business, financial condition, results of operations and prospects could be materially adversely affected.

We face intense competition, especially from larger, well-established companies, and we may lack sufficient financial or other resources to maintain or improve our competitive position.

The market for data center networking, including the market for cloud networking, is intensely competitive, and we expect competition to increase in the future from established competitors and new market entrants. This competition could result in increased pricing pressure, reduced profit margins, increased sales and marketing expenses and our failure to increase, or the loss of, market share, any of which would likely seriously harm our business, financial condition, results of operations and prospects.

 

-14-


Table of Contents

We compete with large network equipment and system vendors, including Cisco Systems, Juniper Networks, Brocade Communications Systems, Hewlett-Packard and Dell. We also face competition from other companies and new market entrants, some of which may be our current technology partners and end customers. Many of our existing and potential competitors enjoy substantial competitive advantages, such as:

 

    greater name recognition and longer operating histories;

 

    larger sales and marketing budgets and resources;

 

    broader distribution and established relationships with channel partners and end customers;

 

    greater access to larger end-customer bases;

 

    greater end-customer support resources;

 

    greater manufacturing resources;

 

    the ability to leverage their sales efforts across a broader portfolio of products;

 

    the ability to bundle competitive offerings with other products and services;

 

    the ability to set more aggressive pricing policies;

 

    lower labor and development costs;

 

    greater resources to make acquisitions;

 

    larger intellectual property portfolios; and

 

    substantially greater financial, technical, research and development or other resources.

Our competitors also may be able to provide end customers with capabilities or benefits different from or greater than those we can provide in areas such as technical qualifications or geographic presence or may be able to provide end customers a broader range of products, services and prices. In addition, large competitors may have more extensive relationships with and within existing and potential end customers that provide them with an advantage in competing for business with those end customers. For example, certain large competitors encourage end customers of their other products and services to adopt their data networking solutions through discounted bundled product packages. Our ability to compete will depend upon our ability to provide a better solution than our competitors at a more competitive price. We may be required to make substantial additional investments in research, development, marketing and sales in order to respond to competition, and we cannot assure you that these investments will achieve any returns for us or that we will be able to compete successfully in the future.

We also expect increased competition if our market continues to expand. Conditions in our market could change rapidly and significantly as a result of technological advancements or other factors. Current or potential competitors may be acquired by third parties that have greater resources available than we do. Our current or potential competitors might take advantage of the greater resources of the larger organization resulting from these acquisitions to compete more vigorously or broadly with us. In addition, continued industry consolidation might adversely affect end customers’ perceptions of the viability of smaller and even medium-sized networking companies and, consequently, end customers’ willingness to purchase from those companies. Further, certain large end customers have explored developing network switches and cloud service solutions for internal use and/or to broaden their portfolio of products, which could allow these end customers to become new competitors in the market.

If we do not successfully anticipate technological shifts, market needs and opportunities, and develop products and product enhancements that meet those technological shifts, needs and opportunities, or if those products are not made available in a timely manner or do not gain market acceptance, we may not be able to compete effectively, and our ability to generate revenue will suffer.

The cloud networking market can be characterized by rapid technological shifts and increasingly complex end-customer requirements to achieve scalable and more programmable networks that facilitate virtualization,

 

-15-


Table of Contents

big data, public/private cloud and web scale computing. We must continue to develop new technologies and products that address emerging technological trends and changing end-customer needs. The process of developing new technology is complex and uncertain, and new offerings requires significant upfront investment that may not result in material design improvements to existing products or result in marketable new products or costs savings or revenue for an extended period of time, if at all. The success of new products depends on several factors, including appropriate new product definition, component costs, timely completion and introduction of these products, differentiation of new products from those of our competitors and market acceptance of these products.

In addition, new technologies could render our existing products obsolete or less attractive to end customers, and our business, financial condition, results of operations and prospects could be materially adversely affected if such technologies are widely adopted. For example, end customers may prefer to address their network switch requirements by licensing software operating systems separately and placing them on industry-standard servers or develop their own networking products rather than purchasing integrated hardware products as has occurred in the server industry.

We may not be able to successfully anticipate or adapt to changing technology or end-customer requirements on a timely basis, or at all. If we fail to keep up with technology changes or to convince our end customers and potential end customers of the value of our solutions even in light of new technologies, our business, financial condition, results of operations and prospects could be materially adversely affected.

We are currently involved in a license dispute with Optumsoft, Inc.

On April 4, 2014, Optumsoft filed a lawsuit against us in the Superior Court of California, Santa Clara County titled Optumsoft, Inc. v. Arista Networks, Inc., in which it asserts (i) ownership of certain components of our EOS network operating system pursuant to the terms of a 2004 agreement between the companies and (ii) breaches of certain confidentiality and use restrictions in that agreement. Under the terms of the 2004 agreement, Optumsoft provided us with a non-exclusive, irrevocable, royalty-free license to software delivered by Optumsoft comprising a software tool used to develop certain components of EOS and a runtime library that is incorporated into EOS. The 2004 agreement places certain restrictions on our use and disclosure of the Optumsoft software and gives Optumsoft ownership of improvements, modifications and corrections to, and derivative works of, the Optumsoft software that we develop. In its lawsuit, Optumsoft has asked the Court to order us to (i) give Optumsoft copies of certain components of our software for evaluation by Optumsoft, (ii) cease all conduct constituting the alleged confidentiality and use restriction breaches, (iii) secure the return or deletion of Optumsoft’s alleged intellectual property provided to third parties, including our customers, (iv) assign ownership to Optumsoft of Optumsoft’s alleged intellectual property currently owned by us, and (v) pay Optumsoft’s alleged damages, attorney’s fees, and costs of the lawsuit. David Cheriton, one of our founders and a former member of our board of directors who resigned from our board of directors on March 1, 2014 and has no continuing role with us, is a founder and, we believe, the largest stockholder and director of Optumsoft. The 2010 David R. Cheriton Irrevocable Trust dtd July 27, 2010, a trust for the benefit of the minor children of Mr. Cheriton, is our largest stockholder.

Optumsoft has identified in confidential filings certain software components it claims to own, which are generally applicable tools and utility subroutines and not networking specific code. We cannot assure which software components Optumsoft may ultimately claim to own in the litigation or whether such claimed components are material.

We intend to vigorously defend against Optumsoft’s lawsuit. However, we cannot be certain that, if litigated, any claims by Optumsoft would be resolved in our favor. For example, if it were determined that Optumsoft owned components of our EOS network operating system, we would be required to transfer ownership of those components and any related intellectual property to Optumsoft. If Optumsoft were the owner of those components, it could make them available to our competitors, such as through a sale or license. In addition, Optumsoft could assert additional or different claims against us, including claims that our license from Optumsoft is invalid.

 

-16-


Table of Contents

Additionally, the existence of this lawsuit could cause concern among our customers and potential customers and could adversely affect our business and results of operations. An adverse litigation ruling could also result in a significant damages award against us and the injunctive relief described above. In addition, if our license was ruled to have been terminated, and we were not able to negotiate a new license from Optumsoft on reasonable terms, we could be required to pay substantial royalties to Optumsoft or be prohibited from selling products that incorporate Optumsoft intellectual property. Any such adverse ruling could materially adversely affect our business, prospects, results of operation and financial condition. Whether or not we prevail in the lawsuit, we expect that the litigation will be expensive, time-consuming and a distraction to management in operating our business. See “Business— Legal Proceedings.”

Product quality problems, defects, errors or vulnerabilities in our products or services could harm our reputation and adversely affect our business, financial condition, results of operations and prospects.

We produce highly complex products that incorporate advanced technologies, including both hardware and software technologies. Despite testing prior to their release, our products may contain undetected defects or errors, especially when first introduced or when new versions are released. Product defects or errors could affect the performance of our products and could delay the development or release of new products or new versions of products. Allegations of unsatisfactory performance could cause us to lose revenue or market share, increase our service costs, cause us to incur substantial costs in redesigning the products, cause us to lose significant end customers, subject us to liability for damages and divert our resources from other tasks, any one of which could materially adversely affect our business, financial condition, results of operations and prospects.

From time to time, we have had to replace certain components of products that we had shipped and provide remediation in response to the discovery of defects or bugs, including failures in software protocols or defective component batches resulting in reliability issues, in such products, and we may be required to do so in the future. We may also be required to provide full replacements or refunds for such defective products. We cannot assure you that such remediation would not have a material effect on our business, financial condition, results of operations and prospects. Please see “—Our business is subject to the risks of warranty claims, product returns, product liability and product defects.”

The cloud networking market is still in its early stages and is rapidly evolving. If this market does not evolve as we anticipate or our target end customers do not adopt our cloud networking solutions, we may not be able to compete effectively, and our ability to generate revenue will suffer.

The cloud networking market is still in its early stages. The market demand for cloud networking solutions has increased in recent years as end customers have deployed larger networks and have increased the use of virtualization and cloud computing. Our success depends upon our ability to provide cloud networking solutions that address the needs of end customers more effectively and economically than those of other competitors or existing technologies.

If the cloud networking solutions market does not develop in the way we anticipate, if our solutions do not offer benefits compared to competing network switching products or if end customers do not recognize the benefits that our solutions provide, then our business, financial condition, results of operations and prospects could be materially adversely affected.

We identified a material weakness in our internal controls for the years ended December 31, 2010, 2011, 2012 and 2013 that, if not properly remediated, could result in material misstatements in our financial statements in future periods and impair our ability to comply with the accounting and reporting requirements applicable to public companies.

Our independent registered public accounting firm has not conducted an audit of our internal control over financial reporting. However, in connection with the audit of our consolidated financial statements for 2010 to

 

-17-


Table of Contents

2012 and 2013, we identified a material weakness in our internal control over financial reporting. As defined in the standards established by the Public Company Accounting Oversight Board of the U.S.A., a “material weakness” is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. The material weakness identified in 2013 includes certain controls related to our inventory process that were not designed and implemented during the year. As a result, we identified material errors requiring adjustment in order for the financial statements to be presented accurately in accordance with U.S. generally accepted accounting principles. Specifically, in conjunction with changes in our supply chain, we did not appropriately capitalize the cost of freight incurred related to product shipped from our contract manufacturers to the distribution centers and we also did not appropriately capitalize the purchase price variance for inventory. These errors were subsequently corrected and disclosed in our financial statements.

Our remediation efforts are still in process and have not yet been completed. Because of this material weakness, there is heightened risk that a material misstatement of our annual or quarterly financial statements will not be prevented or detected. In addition, the remediation steps we have taken, are taking and expect to take may not effectively remediate the material weakness, in which case our internal control over financial reporting would continue to be ineffective. We cannot guarantee that we will be able to complete our remedial actions successfully. Even if we are able to complete these actions successfully, these measures may not adequately address our material weakness. In addition, it is possible that we will discover additional material weaknesses in our internal control over financial reporting.

We will be required to disclose changes made in our internal control and procedures on a quarterly basis. However, our independent registered public accounting firm will not be required to attest to the effectiveness of our internal control over financial reporting pursuant to Section 404 until the later of the year following our first annual report required to be filed with the SEC or the date we are no longer an “emerging growth company” as defined in the JOBS Act, if we take advantage of the exemptions contained in the JOBS Act. At such time, our independent registered public accounting firm may issue a report that is adverse in the event that such firm is not satisfied with the level at which our controls are documented, designed or operating. As a result, we may need to undertake various actions, such as implementing new internal controls and procedures and hiring accounting or internal audit staff. Our remediation efforts may not enable us to avoid a material weakness in the future. Ensuring that we have adequate internal financial and accounting controls and procedures in place to help produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be evaluated frequently.

If we are unable to adequately remediate the foregoing material weakness or comply or continue to comply with the foregoing obligations, it could subject us to a variety of administrative sanctions, including the suspension or delisting of our common stock from the New York Stock Exchange and the inability of registered broker-dealers to make a market in our common stock, which could reduce the market price of our common stock. In addition, in the event that we do not adequately remediate this material weakness, or if we fail to maintain proper and effective internal controls in future periods, our business, results of operations and financial condition and our ability to run our business effectively could be adversely affected and investors could lose confidence in our financial reporting.

If we are unable to attract new large end customers or to sell additional products to our existing end customers, our revenue growth will be adversely affected and our revenue could decrease.

To increase our revenue, we must add new end customers and large end customers and sell additional products to existing end customers. For example, one of our sales strategies is to target specific projects at our current end customers because they are familiar with the operational and economic benefits of our solutions, thereby reducing the sales cycle into these customers. We believe this opportunity with current end customers to be significant given their existing infrastructure and expected future spend. If we fail to attract new large end customers or sell additional products to our existing end customers, our business, financial condition, results of operations and prospects will be harmed.

 

-18-


Table of Contents

Some of our large end customers require more favorable terms and conditions from their vendors and may request price concessions. As we seek to sell more products to these end customers, we may be required to agree to terms and conditions that may have an adverse effect on our business or ability to recognize revenue.

Our large end customers have significant purchasing power and, as a result, may receive more favorable terms and conditions than we typically provide to other end customers, including lower prices, bundled upgrades, extended warranties, acceptance terms and extended return policies and other contractual rights. As we seek to sell more products to these large end customers, an increased mix of our shipments may be subject to such terms and conditions, which may reduce our margins or affect the timing of our revenue recognition and thus may have an adverse effect on our business, financial condition, results of operations and prospects.

Reliance on shipments at the end of the quarter could cause our revenue for the applicable period to fall below expected levels.

As a result of end-customer buying patterns and the efforts of our sales force and channel partners to meet or exceed their sales objectives, we have historically received and fulfilled a substantial portion of sales orders and generated a substantial portion of revenue during the last few weeks of each quarter. This places significant pressure on order review and processing, supply chain management, manufacturing, inventory and quality control management, shipping and trade compliance to ensure that we have properly forecasted supply purchasing, manufacturing capacity, inventory and quality compliance and logistics. If there is any significant interruption in these critical functions, it could result in delayed order fulfillment, adversely affect our business, financial condition, results of operations and prospects and result in a decline in the market price of our common stock.

We base our inventory requirements on our forecasts of future sales. If these forecasts are materially inaccurate, we may procure inventory that we may be unable to use in a timely manner or at all.

Our contract manufacturers procure components and build our products based on our forecasts. These forecasts are based on estimates of future demand for our products, which are in turn based on historical trends and analyses from our sales and marketing organizations, adjusted for overall market conditions. To the extent our forecasts are materially inaccurate, we may under- or over-procure inventory, and such inaccuracies in our forecasts could materially adversely affect our business, financial condition and results of operations.

Managing the supply of our products and product components is complex. Insufficient supply and inventory may result in lost sales opportunities or delayed revenue, while excess inventory may harm our gross margins.

Managing the supply of our products and product components is complex, and our inventory management systems and related supply-chain visibility tools may not enable us to forecast accurately and manage effectively the supply of our products and product components. Insufficient supply and inventory may result in lost sales opportunities or delayed revenue, while excess inventory may harm our gross margins. In order to reduce manufacturing lead times and plan for adequate component supply, from time to time we may issue purchase orders for components and products that are non-cancelable and non-returnable. We establish a liability for non-cancelable, non-returnable purchase commitments with our third-party contract manufacturers for quantities in excess of our demand forecasts, or obsolete material charges. As of December 31, 2013 and March 31, 2014, our provision for non-cancelable, non-returnable purchase commitments was $1.8 million and $1.5 million, respectively. We did not have provisions for non-cancelable, non-returnable purchase commitments as of December 31, 2011 and 2012.

Supply management remains an increased area of focus as we balance the need to maintain sufficient supply levels to ensure competitive lead times against the risk of obsolescence or the end of life of certain products. If we ultimately determine that we have excess supply, we may have to reduce our prices and write down inventory, which in turn could result in lower gross margins. We record a provision when inventory is

 

-19-


Table of Contents

determined to be in excess of anticipated demand or obsolete to adjust inventory to its estimated realizable value. For the years ended December 31, 2011, 2012 and 2013 and the three months ended March 31, 2013 and 2014, we incurred inventory write-downs of $1.6 million, $3.2 million, $5.3 million, $0.3 million and $0.4 million, respectively.

Alternatively, insufficient supply levels may lead to shortages that result in delayed revenue or loss of sales opportunities altogether as potential end customers turn to competitors’ products that are readily available. Additionally, any increases in the time required to manufacture our products or ship products could result in supply shortfalls. If we are unable to effectively manage our supply and inventory, our business, financial condition, results of operations and prospects could be adversely affected.

Because some of the key components in our products come from sole limited sources of supply, we are susceptible to supply shortages or supply changes, which could disrupt or delay our scheduled product deliveries to our end customers and may result in the loss of sales and end customers.

Our products rely on key components, including integrated circuit components and power supplies that our contract manufacturers purchase on our behalf from a limited number of suppliers, including certain sole source providers. We do not have guaranteed supply contracts with any of our component suppliers, and our suppliers could delay shipments or cease manufacturing such products or selling them to us at any time. For example, in the past we have experienced shortages in inventory for dynamic random access memory integrated circuits and delayed releases of the next generation of chipset, which delayed our production and/or the release of our new products. The development of alternate sources for those components is time-consuming, difficult and costly. If we are unable to obtain a sufficient quantity of these components on commercially reasonable terms or in a timely manner, sales of our products could be delayed or halted entirely or we may be required to redesign our products. Any of these events could result in lost sales and damage to our end-customer relationships, which would adversely impact our business, financial condition, results of operations and prospects.

Our product development efforts are also dependent upon our continued collaboration with our key merchant silicon vendors such as Broadcom and Intel. As we develop our product roadmap and continue to expand our relationships with these and other merchant silicon vendors, it is critical that we work in tandem with our key merchant silicon vendors to ensure that their silicon includes improved features and that our products take advantage of such improved features. This enables us to focus our research and development resources on our software core competencies and to leverage the investments made by merchant silicon vendors to achieve cost-effective solutions.

If our key merchant silicon vendors do not continue to collaborate in such a fashion, if they do not continue to innovate or if there are delays in the release of their products, our own product launches could be delayed, which could have a material effect on revenue and business, financial condition, results of operations and prospects.

In the event of a shortage or supply interruption from our component suppliers, we may not be able to develop alternate or second sources in a timely manner. Further, long-term supply and maintenance obligations to end customers increase the duration for which specific components are required, which may increase the risk of component shortages or the cost of carrying inventory. In addition, our component suppliers change their selling prices frequently in response to market trends, including industry-wide increases in demand, and because we do not have contracts with these suppliers, we are susceptible to price fluctuations related to raw materials and components. If we are unable to pass component price increases along to our end customers or maintain stable pricing, our gross margins could be adversely affected and our business, financial condition, results of operations and prospects could suffer.

 

-20-


Table of Contents

Because we depend on third-party manufacturers to build our products, we are susceptible to manufacturing delays and pricing fluctuations that could prevent us from shipping end-customer orders on time, if at all, or on a cost-effective basis, which may result in the loss of sales and end customers.

We depend on third-party contract manufacturers, primarily Jabil Circuit and Foxconn, as our sole source manufacturers for our product lines. A significant portion of our cost of revenue consists of payments to these third-party contract manufacturers. Our reliance on these third-party contract manufacturers reduces our control over the manufacturing process, quality assurance, product costs and product supply and timing, which exposes us to risk. Any manufacturing disruption by these third-party manufacturers could severely impair our ability to fulfill orders on time, if at all, or on a cost-effective basis.

Our reliance on contract manufacturers also yields the potential for their infringement of third party intellectual property rights in the manufacturing of our products or misappropriation of our intellectual property rights in the manufacturing of other customers’ products. If we are unable to manage our relationships with our third-party contract manufacturers effectively, or if these third-party manufacturers suffer delays or disruptions for any reason, experience increased manufacturing lead times, capacity constraints or quality control problems in their manufacturing operations or fail to meet our future requirements for timely delivery, our ability to ship products to our end customers would be severely impaired, and our business, financial condition, results of operations and prospects would be seriously harmed.

Our contract manufacturers typically fulfill our supply requirements on the basis of individual orders. We do not have long-term contracts with our third-party manufacturers that guarantee capacity, the continuation of particular pricing terms or the extension of credit limits. Accordingly, they are not obligated to continue to fulfill our supply requirements, which could result in supply shortages, and the prices we are charged for manufacturing services could be increased on short notice. For example, a competitor could place large orders with the third-party manufacturer, thereby utilizing all or substantially all of such third-party manufacturer’s capacity and leaving the manufacturer little or no capacity to fulfill our individual orders without price increases or delays, or at all. Our contract with one of our contract manufacturers permits it to terminate the agreement for convenience, subject to prior notice requirements. We may not be able to develop alternate or second contract manufacturers in a timely manner. If we are required to change contract manufacturers, our ability to meet our scheduled product deliveries to our end customers could be adversely affected, which could cause the loss of sales to existing or potential end customers, delayed revenue or an increase in our costs which could adversely affect our gross margins. The addition of contract manufacturers or manufacturing locations also would increase the complexity of our supply chain management. Any production interruptions or disruptions for any reason, such as a natural disaster, epidemic, capacity shortages, adverse results from intellectual property litigation or quality problems, at one of our manufacturing partners would adversely affect sales of our product lines manufactured by that manufacturing partner and adversely affect our business, financial condition, results of operations and prospects.

If we are unable to increase market awareness of our company and our products, our revenue may not continue to grow or may decline.

We have not yet established broad market awareness of our products and services. Market awareness of our value proposition and products and services will be essential to our continued growth and our success, particularly for the service provider and large enterprise markets. If our marketing efforts are unsuccessful in creating market awareness of our company and our products and services, then our business, financial condition, results of operations and prospects will be adversely affected, and we will not be able to achieve sustained growth.

The sales prices of our products and services may decrease, which may reduce our gross profits and adversely affect our results of operations.

The sales prices for our products and services may decline for a variety of reasons, including competitive pricing pressures, discounts, a change in our mix of products and services, anticipation of the introduction of new products and services by us or by our competitors, promotional programs, product and related warranty costs or

 

-21-


Table of Contents

broader macroeconomic factors. In addition, we have provided, and may in the future provide, pricing discounts to large end customers, which may result in lower margins for the period in which such sales occur. Our gross margins may also fluctuate as a result of the timing of such sales to large end customers.

We have experienced declines in sales prices for our products, including our 10 Gigabit Ethernet modular and fixed switches. Competition continues to increase in the market segments in which we participate, and we expect competition to further increase in the future, thereby leading to increased pricing pressures. Larger competitors with more diverse product and service offerings may reduce the price of products and services that compete with ours or may bundle them with other products and services. Additionally, although we price our products worldwide in U.S. dollars, currency fluctuations in certain countries and regions may adversely affect actual prices that partners and end customers are willing to pay in those countries and regions. Furthermore, we anticipate that the sales prices and gross profits for our products will decrease over product life cycles. Decreased sales prices for any reason may reduce our gross profits and adversely affect our result of operations.

Seasonality may cause fluctuations in our revenue and results of operations.

We operate on a December 31 year end and believe that there are significant seasonal factors which may cause product revenue to be greater for the second and fourth quarters of our year than our first and third quarters. We believe that this seasonality results from a number of factors, including the procurement, budgeting and deployment cycles of many of our end customers. Our rapid historical growth may have reduced the impact of seasonal or cyclical factors that might have influenced our business to date. As our increasing size causes our growth rate to slow, seasonal or cyclical variations in our operations may become more pronounced over time and may materially affect our business, financial condition, results of operations and prospects.

If we are unable to hire, retain, train and motivate qualified personnel and senior management, our business, financial condition, results of operations and prospects could suffer.

Our future success depends, in part, on our ability to continue to attract and retain highly skilled personnel, particularly software engineering and sales personnel. Competition for highly skilled personnel is often intense, especially in the San Francisco Bay Area where we have a substantial presence and need for highly skilled personnel. Many of the companies with which we compete for experienced personnel have greater resources than we have to provide more attractive compensation packages and other amenities. Research and development personnel are aggressively recruited by startup and emerging growth companies, which are especially active in many of the technical areas and geographic regions in which we conduct product development. In addition, in making employment decisions, particularly in the high-technology industry, job candidates often consider the value of the stock-based compensation they are to receive in connection with their employment. Declines in the market price of our stock after this offering could adversely affect our ability to attract, motivate or retain key employees. If we are unable to attract or retain qualified personnel, or if there are delays in hiring required personnel, our business, financial condition, results of operations and prospects may be seriously harmed.

Also, to the extent we hire personnel from competitors, we may be subject to allegations that such personnel has been improperly solicited, that such personnel has divulged proprietary or other confidential information or that former employers own certain inventions or other work product. Such claims could result in litigation. Please see “—We may become involved in litigation that may materially adversely affect us.”

Our future performance also depends on the continued services and continuing contributions of our senior management to execute our business plan and to identify and pursue new opportunities and product innovations. Our employment arrangements with our employees do not require that they continue to work for us for any specified period, and therefore, they could terminate their employment with us at any time. The loss of our key personnel, including Jayshree Ullal, our Chief Executive Officer, Andy Bechtolsheim, our Founder and Chief Development Officer, and Kenneth Duda, our Founder, Chief Technology Officer and SVP Software Engineering or other members of our senior management team, sales and marketing team or engineering team, or

 

-22-


Table of Contents

any difficulty attracting or retaining other highly qualified personnel in the future, could significantly delay or prevent the achievement of our development and strategic objectives, which could adversely affect our business, financial condition, results of operations and prospects.

We are subject to a number of risks associated with the expansion of our international sales and operations.

Our ability to grow our business and our future success will depend to a significant extent on our ability to expand our operations and customer base worldwide. We have a limited history of marketing, selling and supporting our products and services internationally. Operating in a global marketplace, we are subject to risks associated with having an international reach and requirements such as compliance with applicable anticorruption laws.

One such applicable anticorruption law is the U.S. Foreign Corrupt Practices Act, or FCPA, which generally prohibits U.S. companies and its employees and intermediaries from making corrupt payments to foreign officials for the purpose of obtaining or keeping business, securing an advantage and directing business to another, and requires companies to maintain accurate books and records and a system of internal accounting controls. Under the FCPA, U.S. companies may be held liable for the corrupt actions taken by directors, officers, employees, agents, or other strategic or local partners or representatives. As such, if we or our intermediaries fail to comply with the requirements of the FCPA or similar legislation, governmental authorities in the U.S. and elsewhere could seek to impose civil and/or criminal fines and penalties which could have a material adverse effect on our business, results of operations and financial conditions. We are currently in the early stages of implementing an anticorruption compliance program. Failure to comply with anti-corruption and anti-bribery laws, such as the FCPA and the United Kingdom Bribery Act of 2010, or the United Kingdom Bribery Act, and similar laws associated with our activities outside the United States, could subject us to penalties and other adverse consequences. We intend to increase our international sales and business and, as such, the risk of violating laws such as the FCPA and United Kingdom Bribery Act increases.

Additionally, as a result of our international reach, we must hire and train experienced personnel to staff and manage our foreign operations. To the extent that we experience difficulties in recruiting, training, managing and retaining an international staff, and specifically staff related to sales management and sales personnel, we may experience difficulties in sales productivity in foreign markets. We also enter into strategic distributor and reseller relationships with companies in certain international markets where we do not have a local presence. If we are not able to maintain successful strategic distributor relationships internationally or to recruit additional companies to enter into strategic distributor relationships, our future success in these international markets could be limited. Business practices in the international markets that we serve may differ from those in the United States and may require us in the future to include terms other than our standard terms in end-customer contracts, although to date we generally have not done so. To the extent that we may enter into end-customer contracts in the future that include non-standard terms related to payment, warranties or performance obligations, our results of operations may be adversely affected.

Additionally, our international sales and operations are subject to a number of risks, including the following:

 

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

 

    increased expenses incurred in establishing and maintaining our international operations;

 

    fluctuations in exchange rates between the U.S. dollar and foreign currencies where we do business;

 

    greater difficulty and costs in recruiting local experienced personnel;

 

    wage inflation in certain growing economies;

 

    general economic and political conditions in these foreign markets;

 

    economic uncertainty around the world as a result of sovereign debt issues;

 

    communication and integration problems resulting from cultural and geographic dispersion;

 

-23-


Table of Contents
    limitations on our ability to access cash resources in our international operations;

 

    ability to establish necessary business relationships and to comply with local business requirements;

 

    risks associated with trade restrictions and foreign legal requirements, including the importation, certification and localization of our products required in foreign countries;

 

    greater risk of unexpected changes in regulatory practices, tariffs and tax laws and treaties;

 

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

 

    greater risk of a failure of foreign employees to comply with both U.S. and foreign laws, including antitrust regulations, the FCPA and any trade regulations ensuring fair trade practices; and

 

    heightened risk of unfair or corrupt business practices in certain geographies and of improper or fraudulent sales arrangements that may impact financial results and result in restatements of, or irregularities in, financial statements.

These and other factors could harm our ability to gain future international revenue and, consequently, materially affect our business, financial condition, results of operations and prospects. Expanding our existing international operations and entering into additional international markets will require significant management attention and financial commitments. Our failure to successfully manage our international operations and the associated risks effectively could limit our future growth or materially adversely affect our business, financial condition, results of operations and prospects.

Our ability to sell our products is highly dependent on the quality of our support and services offerings, and our failure to offer high-quality support and services could have a material adverse effect on our business, financial condition, results of operations and prospects.

Once our products are deployed within our end customers’ networks, our end customers depend on our support organization and our channel partners to resolve any issues relating to our products. High-quality support is critical for the successful marketing and sale of our products. If we or our channel partners do not assist our end customers in deploying our products effectively, do not succeed in helping our end customers resolve post-deployment issues quickly or do not provide adequate ongoing support, it could adversely affect our ability to sell our products to existing end customers and could harm our reputation with potential end customers. In addition, as we expand our operations internationally, our support organization will face additional challenges, including those associated with delivering support, training and documentation in languages other than English. Our failure or the failure of our channel partners to maintain high-quality support and services could have a material adverse effect on our business, financial condition, results of operations and prospects.

We may become involved in litigation that may materially adversely affect us.

From time to time, we may become involved in various legal proceedings relating to matters incidental to the ordinary course of our business, including patent, commercial, product liability, employment, class action, whistleblower and other litigation and claims, and governmental and other regulatory investigations and proceedings. Such matters can be time-consuming, divert management’s attention and resources, cause us to incur significant expenses or liability and/or require us to change our business practices. Because of the potential risks, expenses and uncertainties of litigation, we may, from time to time, settle disputes, even where we have meritorious claims or defenses, by agreeing to settlement agreements. Because litigation is inherently unpredictable, we cannot assure you that the results of any of these actions will not have a material adverse effect on our business, financial condition, results of operations and prospects.

 

-24-


Table of Contents

Adverse economic conditions or reduced information technology and network infrastructure spending may adversely affect our business, financial condition, results of operations and prospects.

Our business depends on the overall demand for information technology, network connectivity and access to data and applications. Weak domestic or global economic conditions, fear or anticipation of such conditions or a reduction in information technology and network infrastructure spending even if economic conditions improve, could adversely affect our business, financial condition, results of operations and prospects in a number of ways, including longer sales cycles, lower prices for our products and services, higher default rates among our distributors, reduced unit sales and lower or no growth. For example, the ongoing debt concerns in many countries in Europe have caused, and are likely to continue to cause, uncertainty and instability in local economies and in global financial markets, particularly if any future sovereign debt defaults or significant bank failures or defaults occur. Market uncertainty and instability in Europe could intensify or spread further, particularly if ongoing stabilization efforts prove insufficient. Concerns have been raised as to the financial, political and legal ineffectiveness of measures taken to date. Continuing or worsening economic instability in Europe and elsewhere could adversely affect spending for IT, network infrastructure, systems and tools. Continued turmoil in the geopolitical environment in many parts of the world may also affect the overall demand for our products. Although we do not believe that our business, financial condition, results of operations and prospects have been significantly adversely affected by economic and political uncertainty in Europe and other countries, deterioration of such conditions may harm our business, financial condition, results of operations and prospects in the future. A prolonged period of economic uncertainty or a downturn may also significantly affect financing markets, the availability of capital and the terms and conditions of financing arrangements, including the overall cost of financing as well as the financial health or creditworthiness of our end customers. Circumstances may arise in which we need, or desire, to raise additional capital, and such capital may not be available on commercially reasonable terms, or at all.

Assertions by third parties of infringement or other violations by us of their intellectual property rights, or other lawsuits asserted against us, could result in significant costs and substantially harm our business, financial condition, results of operations and prospects.

Patent and other intellectual property disputes are common in the network infrastructure industry and have resulted in protracted and expensive litigation for many companies. Many companies in the network infrastructure industry, including our competitors and other third parties, as well as non-practicing entities, own large numbers of patents, copyrights, trademarks and trade secrets, which they may use to assert claims of patent infringement, misappropriation or other violations of intellectual property rights against us. From time to time, they have or may in the future also assert such claims against us, our end customers or channel partners whom we typically indemnify against claims that our products infringe, misappropriate or otherwise violate the intellectual property rights of third parties. As the number of products and competitors in our market increases and overlaps occur, claims of infringement, misappropriation and other violations of intellectual property rights may increase. Any claim of infringement, misappropriation or other violations of intellectual property rights by a third party, even those without merit, could cause us to incur substantial costs defending against the claim, distract our management from our business and require us to cease use of such intellectual property.

The patent portfolios of most of our competitors are larger than ours. This disparity may increase the risk that our competitors may sue us for patent infringement and may limit our ability to counterclaim for patent infringement or settle through patent cross-licenses. In addition, future assertions of patent rights by third parties, and any resulting litigation, may involve patent holding companies or other adverse patent owners who have no relevant product revenue and against whom our own patents may therefore provide little or no deterrence or protection. We cannot assure you that we are not infringing or otherwise violating any third-party intellectual property rights.

The third-party asserters of intellectual property claims may be unreasonable in their demands, or may simply refuse to settle, which could lead to expensive settlement payments, prolonged periods of litigation and

 

-25-


Table of Contents

related expenses, additional burdens on employees or other resources, distraction from our business, supply stoppages and lost sales.

An adverse outcome of a dispute may require us to pay substantial damages including treble damages if we are found to have willfully infringed a third party’s patents; cease making, licensing or using solutions that are alleged to infringe or misappropriate the intellectual property of others; expend additional development resources to attempt to redesign our products or services or otherwise to develop non-infringing technology, which may not be successful; enter into potentially unfavorable royalty or license agreements in order to obtain the right to use necessary technologies or intellectual property rights; and indemnify our partners and other third parties. Any damages or royalty obligations we may become subject to as a result of an adverse outcome, and any third-party indemnity we may need to provide, could harm our business, financial condition, results of operations and prospects. Royalty or licensing agreements, if required or desirable, may be unavailable on terms acceptable to us, or at all, and may require significant royalty payments and other expenditures. Further, there is little or no information publicly available concerning market or fair values for license fees, which can lead to overpayment of license or settlement fees. In addition, some licenses may be non-exclusive, and therefore our competitors may have access to the same technology licensed to us. Suppliers subject to third-party intellectual property claims also may choose or be forced to discontinue or alter their arrangements with us, with little or no advance notice to us. Any of these events could seriously harm our business, financial condition, results of operations and prospects.

Our standard sales contracts contain indemnification provisions requiring us to defend our end customers against third-party claims, including against infringement of certain intellectual property rights, that could expose us to losses which could seriously harm our business, financial conditions, results of operations and prospects.

Under the indemnification provisions of our standard sales contracts, we agree to defend our end customers against third-party claims asserting infringement of certain intellectual property rights, which may include patents, copyrights, trademarks or trade secrets, and to pay judgments entered on such claims. Our exposure under these indemnification provisions is generally limited to the total amount paid by our end customer under the agreement. However, certain agreements include indemnification provisions that could potentially expose us to losses in excess of the amount received under the agreement. Any of these events, including claims for indemnification, could seriously harm our business, financial condition, results of operations and prospects.

If we are unable to protect our intellectual property rights, our competitive position could be harmed or we could be required to incur significant expenses to enforce our rights.

We depend on our ability to protect our proprietary technology. We rely on trade secret, patent, copyright and trademark laws and confidentiality agreements with employees and third parties, all of which offer only limited protection. We have not registered our trademarks in all geographic markets. Failure to secure those registrations could adversely affect our ability to enforce and defend our trademark rights and result in indemnification claims. Further, any claim of infringement by a third party, even those claims without merit, could cause us to incur substantial costs defending against such claim, could divert management attention from our business and could require us to cease use of such intellectual property in certain geographic markets.

Despite our efforts, the steps we have taken to protect our proprietary rights may not be adequate to preclude misappropriation of our proprietary information or infringement of our intellectual property rights, and our ability to police such misappropriation or infringement is uncertain, particularly in countries outside of the United States. Further, with respect to patent rights, we do not know whether any of our pending patent applications will result in the issuance of patents or whether the examination process will require us to narrow our claims. To the extent that additional patents are issued from our patent applications, which is not certain, they may be contested, circumvented or invalidated in the future. Moreover, the rights granted under any issued patents may not provide us with proprietary protection or competitive advantages, and, as with any technology,

 

-26-


Table of Contents

competitors may be able to develop similar or superior technologies to our own now or in the future. In addition, we rely on confidentiality or license agreements with third parties in connection with their use of our products and technology. There is no guarantee that such parties will abide by the terms of such agreements or that we will be able to adequately enforce our rights, in part because we rely on “shrink-wrap” licenses in some instances.

Detecting and protecting against the unauthorized use of our products, technology and proprietary rights is expensive, difficult and, in some cases, impossible. Litigation may be necessary in the future to enforce or defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Such litigation could result in substantial costs and diversion of management resources, either of which could harm our business, financial condition, results of operations and prospects, and there is no guarantee that we would be successful. Furthermore, many of our current and potential competitors have the ability to dedicate substantially greater resources to protecting their technology or intellectual property rights than we do. Accordingly, despite our efforts, we may not be able to prevent third parties from infringing upon or misappropriating our intellectual property, which could result in a substantial loss of our market share.

We rely on the availability of licenses to third-party software and other intellectual property.

Many of our products and services include software or other intellectual property licensed from third parties, and we otherwise use software and other intellectual property licensed from third parties in our business. This exposes us to risks over which we may have little or no control. For example, a licensor may have difficulties keeping up with technological changes or may stop supporting the software or other intellectual property that it licenses to us. Also, it will be necessary in the future to renew licenses, expand the scope of existing licenses or seek new licenses, relating to various aspects of these products and services or otherwise relating to our business, which may result in increased license fees. These licenses may not be available on acceptable terms, if at all. In addition, a third party may assert that we or our end customers are in breach of the terms of a license, which could, among other things, give such third party the right to terminate a license or seek damages from us, or both. The inability to obtain or maintain certain licenses or other rights or to obtain or maintain such licenses or rights on favorable terms, or the need to engage in litigation regarding these matters, could result in delays in releases of products and services and could otherwise disrupt our business, until equivalent technology can be identified, licensed or developed, if at all, and integrated into our products and services or otherwise in the conduct of our business. Moreover, the inclusion in our products and services of software or other intellectual property licensed from third parties on a nonexclusive basis may limit our ability to differentiate our products from those of our competitors. Any of these events could have a material adverse effect on our business, financial condition, results of operations and prospects.

Our products contain third-party open source software components, and failure to comply with the terms of the underlying open source software licenses could restrict our ability to sell our products.

Our products contain software modules licensed to us by third-party authors under “open source” licenses. Use and distribution of open source software may entail greater risks than use of third-party commercial software, as open source licensors generally do not provide warranties or other contractual protections regarding infringement claims or the quality of the code. Some open source licenses contain requirements that we make available source code for modifications or derivative works we create based upon the type of open source software that we use. If we combine our software with open source software in a certain manner, we could, under certain open source licenses, be required to release portions of the source code of our software to the public. This would allow our competitors to create similar products with lower development effort and time and ultimately could result in a loss of product sales for us.

Although we monitor our use of open source software to avoid subjecting our products to conditions we do not intend, the terms of many open source licenses have not been interpreted by U.S. courts, and these licenses could be construed in a way that could impose unanticipated conditions or restrictions on our ability to commercialize our products. Moreover, we cannot assure you that our processes for controlling our use of open

 

-27-


Table of Contents

source software in our products will be effective. If we are held to have breached the terms of an open source software license, we could be required to seek licenses from third parties to continue offering our products on terms that are not economically feasible, to re-engineer our products, to discontinue the sale of our products if re-engineering could not be accomplished on a timely basis or to make generally available, in source code form, our proprietary code, any of which could adversely affect our business, financial condition, results of operations and prospects.

Sales of our 7000 Series of switches generate most of our product revenue, and if we are unable to continue to grow sales of these products, our business, financial condition, results of operations and prospects will suffer.

Historically, we have derived substantially all of our product revenue from sales of our 7000 Series of switches, and we expect to continue to do so for the foreseeable future. A decline in the price of these products and related services, or our inability to increase sales of these products, would harm our business, financial condition, results of operations and prospects more seriously than if we derived significant revenue from a larger variety of product lines and services. Our future financial performance will also depend upon successfully developing and selling next-generation versions of our 7000 Series of switches. If we fail to deliver new products, new features, or new releases that end customers want and that allow us to maintain leadership in what will continue to be a competitive market environment, our business, financial condition, results of operations and prospects will be harmed.

We expect our gross margins to vary over time and to be adversely affected by numerous factors.

We expect our gross margins to vary over time and to be affected by numerous factors, including:

 

    changes in end-customer or product mix, including mix of configurations within each product group;

 

    introduction of new products, including products with price-performance advantages;

 

    our ability to reduce production costs;

 

    entry into new markets or growth in lower margin markets;

 

    entry in markets with different pricing and cost structures;

 

    pricing discounts;

 

    increases in material, labor or other manufacturing-related costs, which could be significant especially during periods of supply constraints;

 

    excess inventory and inventory holding charges;

 

    obsolescence charges;

 

    changes in shipment volume;

 

    the timing of revenue recognition and revenue deferrals;

 

    increased cost, loss of cost savings or dilution of savings due to changes in component pricing or charges incurred due to inventory holding periods if parts ordering does not correctly anticipate product demand or if the financial health of either contract manufacturers or suppliers deteriorates;

 

    lower than expected benefits from value engineering;

 

    increased price competition;

 

    changes in distribution channels;

 

    increased warranty costs; and

 

    how well we execute our strategy and operating plans.

 

-28-


Table of Contents

Our sales cycles can be long and unpredictable, and our sales efforts require considerable time and expense. As a result, our sales and revenue are difficult to predict and may vary substantially from period to period, which may cause our results of operations to fluctuate significantly.

The timing of our sales and revenue recognition is difficult to predict because of the length and unpredictability of our products’ sales cycles. A sales cycle is the period between initial contact with a prospective end customer and any sale of our products. End-customer orders often involve the purchase of multiple products. These orders are complex and difficult to complete because prospective end customers generally consider a number of factors over an extended period of time before committing to purchase the products and solutions we sell. End customers, especially in the case of our large end customers, often view the purchase of our products as a significant and strategic decision and require considerable time to evaluate, test and qualify our products prior to making a purchase decision and placing an order. The length of time that end customers devote to their evaluation, contract negotiation and budgeting processes varies significantly. Our products’ sales cycles can be lengthy in certain cases, especially with respect to our prospective large end customers. During the sales cycle, we expend significant time and money on sales and marketing activities and make investments in evaluation equipment, all of which lower our operating margins, particularly if no sale occurs. Even if an end customer decides to purchase our products, there are many factors affecting the timing of our recognition of revenue, which makes our revenue difficult to forecast. For example, there may be unexpected delays in an end customer’s internal procurement processes, particularly for some of our larger end customers for which our products represent a very small percentage of their total procurement activity. There are many other factors specific to end customers that contribute to the timing of their purchases and the variability of our revenue recognition, including the strategic importance of a particular project to an end customer, budgetary constraints and changes in their personnel.

Even after an end customer makes a purchase, there may be circumstances or terms relating to the purchase that delay our ability to recognize revenue from that purchase. For example, the sale of our products may be subject to acceptance testing. In addition, the significance and timing of our product enhancements, and the introduction of new products by our competitors, may also affect end customers’ purchases. For all of these reasons, it is difficult to predict whether a sale will be completed, the particular period in which a sale will be completed or the period in which revenue from a sale will be recognized. If our sales cycles lengthen, our revenue could be lower than expected, which would have an adverse effect on our business, financial condition, results of operations and prospects.

Our business depends on end customers renewing their maintenance and support contracts. Any decline in maintenance renewals could harm our future business, financial condition, results of operations and prospects.

We typically sell our products with maintenance and support as part of the initial purchase, and a portion of our annual revenue comes from renewals of maintenance and support contracts. Our end customers have no obligation to renew their maintenance and support contracts after the expiration of the initial period, and they may elect not to renew their maintenance and support contracts, to renew their maintenance and support contracts at lower prices through alternative channel partners or to reduce the product quantity under their maintenance and support contracts, thereby reducing our future revenue from maintenance and support contracts. If our end customers, especially our large end customers, do not renew their maintenance and support contracts or if they renew them on terms that are less favorable to us, our revenue may decline and our business, financial condition, results of operations and prospects will suffer.

Industry consolidation may lead to increased competition and may harm our business, financial condition, results of operations and prospects.

Most of our competitors have made acquisitions and/or have entered into or extended partnerships or other strategic relationships to offer more comprehensive product lines, including cloud networking solutions. For example, in the last few years alone Dell acquired Force10, IBM acquired Blade Network Technology, Hewlett Packard acquired 3Com, Brocade acquired Foundry Networks, Juniper acquired Contrail and VMware acquired Nicira.

 

-29-


Table of Contents

Moreover, large system vendors are increasingly seeking to deliver top-to-bottom cloud networking solutions to end customers that combine cloud-focused hardware and software solutions to provide an alternative to our products.

We expect this trend to continue as companies attempt to strengthen their market positions in an evolving industry and as companies are acquired or are unable to continue operations. Companies that are strategic alliance partners in some areas of our business may acquire or form alliances with our competitors, thereby reducing their business with us. Industry consolidation may result in stronger competitors that are better able to compete with us, including any competitors that seek to become sole source vendors for end customers. This could lead to more variability in our results of operations and could have a material adverse effect on our business, financial condition, results of operations and prospects.

Our business is subject to the risks of warranty claims, product returns, product liability and product defects.

Real or perceived errors, failures or bugs in our products could result in claims by end customers for losses that they sustain. If end customers make these types of claims, we may be required, or may choose, for end-customer relations or other reasons, to expend additional resources in order to address the problem. We may also be required to repair or replace such products or provide a refund for the purchase price for such products. Liability provisions in our standard terms and conditions of sale, and those of our resellers and distributors, may not be enforceable under some circumstances or may not fully or effectively protect us from end-customer claims and related liabilities and costs, including indemnification obligations under our agreements with end customers, resellers and distributors. The sale and support of our products also entail the risk of product liability claims. We maintain insurance to protect against certain types of claims associated with the use of our products, but our insurance coverage may not adequately cover any such claims. In addition, even claims that ultimately are unsuccessful could result in expenditures of funds in connection with litigation and divert management’s time and other resources.

For example, in 2012, we and one of our major end customers determined that one model of our switches sold to them during 2011 and 2012 did not fully support a certain protocol feature. We reached an agreement with our end customer that we would replace defective linecards with linecards incorporating next-generation switch chips, which corrected the protocol issue. We recorded an accrued warranty liability in our accompanying balance sheet and cost of revenue in the accompanying consolidated income statement for the years ended December 31, 2011, 2012 and 2013 and the three months ended March 31, 2013, of $1.8 million, $3.3 million, $0.4 million and $0.2 million for the estimated costs of these replacement programs. The majority of the replacement effort occurred during 2013. There was no specific product warranty reserve recorded for the three months ended March 31, 2014. In addition, we accrued $0.1 million, $0.1 million, $3.9 million, $1.1 million and $0.5 million, for general accrued warranty liabilities during the year ended December 31, 2011, 2012 and 2013 and the three months ended March 31, 2013 and 2014, respectively. For the years ended December 31, 2011, 2012 and 2013 and the three months ended March 31, 2013 and 2014, our provisions for warranty expense were $1.9 million, $3.4 million, $4.3 million, $1.3 million and $0.5 million, respectively. Further, as a result of reliability issues in particular component batches, certain products have, in the past, failed at higher than expected rates, and no assurances can be given that such failures won’t occur in the future. In such cases, we proactively replace the affected products and record a specific warranty reserve.

In addition to our own direct sales force, we rely on distributors, systems integrators and value-added resellers to sell our products, and our failure to effectively develop, manage or prevent disruptions to our distribution channels and the processes and procedures that support them could cause a reduction in the number of end customers of our products.

Our future success is highly dependent upon maintaining our relationships with distributors, systems integrators and value-added resellers and establishing additional sales channel relationships. We anticipate that sales of our products to a limited number of channel partners will continue to account for a material portion of our total product revenue for the foreseeable future. We provide our channel partners with specific training and programs to assist them in selling our products, but these steps may not be effective. In addition, our channel

 

-30-


Table of Contents

partners may be unsuccessful in marketing, selling and supporting our products and services. If we are unable to develop and maintain effective sales incentive programs for our channel partners, we may not be able to incentivize these partners to sell our products to end customers. These partners may have incentives to promote our competitors’ products to the detriment of our own or may cease selling our products altogether. One of our channel partners could elect to consolidate or enter into a strategic partnership with one of our competitors, which could reduce or eliminate our future opportunities with that channel partner. Our agreements with our channel partners may generally be terminated for any reason by either party with advance notice. We may be unable to retain these channel partners or secure additional or replacement channel partners. The loss of one or more of our significant channel partners requires extensive training, and any new or expanded relationship with a channel partner may take several months or more to achieve productivity.

Where we rely on the channel partners for sales of our products, we may have little or no contact with the ultimate users of our products that purchase through such channel partners, thereby making it more difficult for us to establish brand awareness, ensure proper delivery and installation of our products, service ongoing end-customer requirements, estimate end-customer demand and respond to evolving end-customer needs. In addition, our channel partner sales structure could subject us to lawsuits, potential liability and reputational harm if, for example, any of our channel partners misrepresent the functionality of our products or services to end customers or violate laws or our corporate policies. If we fail to effectively manage our existing sales channels, or if our channel partners are unsuccessful in fulfilling the orders for our products, if we are unable to enter into arrangements with, and retain a sufficient number of, high-quality channel partners in each of the regions in which we sell products and keep them motivated to sell our products, our ability to sell our products and our business, financial condition, results of operations and prospects will be harmed.

An increasing portion of our revenue is generated by sales to government entities, which are subject to a number of challenges and risks.

We anticipate increasing our sales efforts to U.S. and foreign, federal, state and local governmental end customers in the future. Sales to government entities are subject to a number of risks. Selling to government entities can be highly competitive, expensive and time consuming, often requiring significant upfront time and expense without any assurance that these efforts will generate a sale. The substantial majority of our sales to date to government entities have been made indirectly through our channel partners. Government certification requirements for products like ours may change and, in doing so, restrict our ability to sell into the government sector until we have attained revised certifications. Government demand and payment for our products and services may be affected by public sector budgetary cycles and funding authorizations, with funding reductions or delays adversely affecting public sector demand for our products and services. Government entities may have statutory, contractual or other legal rights to terminate contracts with our distributors and resellers for convenience or due to a default, and any such termination may adversely impact our future business, financial condition, results of operations and prospects. Selling to government entities may also require us to comply with various regulations that are not applicable to sales to non-government entities, including regulations that may relate to pricing, classified material and other matters. Complying with such regulations may also require us to put in place controls and procedures to monitor compliance with the applicable regulations that may be costly or not possible. We are not currently certified to perform work under classified contracts with government entities. Failure to comply with any such regulations could adversely affect our business, prospects, results of operations and financial condition. Governments routinely investigate and audit government contractors’ administrative processes, and any unfavorable audit could result in the government ceasing to buy our products and services, a reduction of revenue, fines or civil or criminal liability if the audit uncovers improper or illegal activities, any of which could materially adversely affect our business, financial condition, results of operations and prospects. The U.S. government may require certain products that it purchases to be manufactured in the United States and other relatively high-cost manufacturing locations, and we may not manufacture all products in locations that meet these requirements. Any of these and other circumstances could have a material adverse effect on our business, financial condition, results of operations and prospects.

 

-31-


Table of Contents

Our products must interoperate with operating systems, software applications and hardware that is developed by others, and if we are unable to devote the necessary resources to ensure that our products interoperate with such software and hardware, we may lose or fail to increase market share and experience a weakening demand for our products.

Generally, our products comprise only a part of the data center and must interoperate with our end customers’ existing infrastructure, specifically their networks, servers, software and operating systems, which may be manufactured by a wide variety of vendors and original equipment manufacturers, or OEMs. Our products must comply with established industry standards in order to interoperate with the servers, storage, software and other networking equipment in the data center such that all systems function efficiently together. We depend on the vendors of servers and systems in a data center to support prevailing industry standards. Often, these vendors are significantly larger and more influential in driving industry standards than we are. Also, some industry standards may not be widely adopted or implemented uniformly, and competing standards may emerge that may be preferred by our end customers.

In addition, when new or updated versions of these software operating systems or applications are introduced, we must sometimes develop updated versions of our software so that our products will interoperate properly. We may not accomplish these development efforts quickly, cost-effectively or at all. These development efforts require capital investment and the devotion of engineering resources. If we fail to maintain compatibility with these systems and applications, our end customers may not be able to adequately utilize our products, and we may lose or fail to increase market share and experience a weakening in demand for our products, among other consequences, which would adversely affect our business, financial condition, results of operations and prospects.

We are subject to governmental export and import controls that could impair our ability to compete in international markets or subject us to liability if we violate these controls.

Our products may be subject to various export controls and because we incorporate encryption technology into certain of our products, certain of our products may be exported from various countries only with the required export license or through an export license exception. If we were to fail to comply with the applicable export control laws, customs regulations, economic sanctions or other applicable laws, we could be subject to monetary damages or the imposition of restrictions which could be material to our business, operating results and prospects and could also harm our reputation. Further, there could be criminal penalties for knowing or willful violations, including incarceration for culpable employees and managers. Obtaining the necessary export license or other authorization for a particular sale may be time-consuming and may result in the delay or loss of sales opportunities. Furthermore, certain export control and economic sanctions laws prohibit the shipment of certain products, technology, software and services to embargoed countries and sanctioned governments, entities, and persons. Even though we take precautions to ensure that our channel partners comply with all relevant regulations, any failure by our channel partners to comply with such regulations could have negative consequences, including reputational harm, government investigations and penalties.

As our company grows we also continue developing procedures and controls to comply with export control and other applicable laws. Historically, we have had some instances where we inadvertently have not fully complied with certain export control laws, but we have disclosed them to, and implemented corrective actions with, the appropriate government agencies.

In addition, various countries regulate the import of certain encryption technology, including through import permit and license requirements, and have enacted laws that could limit our ability to distribute our products or could limit our end customers’ ability to implement our products in those countries. Any change in export or import regulations, economic sanctions or related legislation, shift in the enforcement or scope of existing regulations or change in the countries, governments, persons or technologies targeted by such regulations could result in decreased use of our products by, or in our decreased ability to export or sell our products to, existing or

 

-32-


Table of Contents

potential end customers with international operations or create delays in the introduction of our products into international markets. Any decreased use of our products or limitation on our ability to export or sell our products could adversely affect our business, financial condition, results of operations and prospects.

Failure to comply with governmental laws and regulations could harm our business, financial condition, results of operations and prospects.

Our business is subject to regulation by various federal, state, local and foreign governmental agencies, including agencies responsible for monitoring and enforcing employment and labor laws, workplace safety, product safety, environmental laws, consumer protection laws, anti-bribery laws, import/export controls, federal securities laws and tax laws and regulations. In certain jurisdictions, these regulatory requirements may be more stringent than those in the United States. Noncompliance with applicable government regulations or requirements could subject us to investigations, sanctions, mandatory product recalls, enforcement actions, disgorgement of profits, fines, damages, civil and criminal penalties or injunctions. If any governmental sanctions are imposed, or if we do not prevail in any possible civil or criminal litigation, our business, financial condition, results of operations and prospects could be materially adversely affected. In addition, responding to any action will likely result in a significant diversion of management’s attention and resources and an increase in professional fees. Enforcement actions and sanctions could harm our business, financial condition, results of operations and prospects.

We may acquire other businesses which could require significant management attention, disrupt our business, dilute stockholder value and adversely affect our business, financial condition, results of operations and prospects.

As part of our business strategy, we may make investments in complementary companies, products or technologies. However, we have not made any significant acquisitions to date, and as a result, our ability as an organization to acquire and integrate other companies, products or technologies in a successful manner is unproven. We may not be able to find suitable acquisition candidates, and we may not be able to complete such acquisitions on favorable terms, if at all. If we do complete acquisitions, we may not ultimately strengthen our competitive position or achieve our goals, and any acquisitions we complete could be viewed negatively by our end customers, investors and securities analysts. In addition, if we are unsuccessful at integrating such acquisitions or retaining key talent from those acquisitions, or the technologies associated with such acquisitions, into our company, the business, financial condition, results of operations and prospects of the combined company could be adversely affected. Any integration process may require significant time and resources, and we may not be able to manage the process successfully. We may not successfully evaluate or utilize the acquired technology or personnel or accurately forecast the financial effects of an acquisition transaction, including accounting charges. We may have to pay cash, incur debt or issue equity securities to pay for any such acquisition, each of which could adversely affect our financial condition or the market price of our common stock. The sale of equity or issuance of debt to finance any such acquisitions could result in dilution to our stockholders. The incurrence of indebtedness would result in increased fixed obligations and could also include covenants or other restrictions that would impede our ability to manage our operations.

If we needed to raise additional capital to expand our operations and invest in new products, our failure to do so on favorable terms could reduce our ability to compete and could harm our business, financial condition, results of operations and prospects.

We expect that our existing cash and cash equivalents, together with our net proceeds from this offering, will be sufficient to meet our anticipated cash needs for the foreseeable future. If we did need to raise additional funds to expand our operations and invest in new products, we may not be able to obtain additional debt or equity financing on favorable terms, if at all. If we raise additional equity financing, our stockholders may experience significant dilution of their ownership interests, and the market price of our common stock could decline. Furthermore, if we engage in debt financing, the holders of such debt would have priority over the holders of common stock, and we may be required to accept terms that restrict our ability to incur additional indebtedness

 

-33-


Table of Contents

or impose other restrictions on our business. We may also be required to take other actions that would otherwise be in the interests of the debt holders, including maintaining specified liquidity or other ratios, any of which could harm our business, financial condition, results of operations and prospects. If we need additional capital and cannot raise it on acceptable terms, if at all, we may not be able to, among other things:

 

    evolve or enhance our products and services;

 

    continue to expand our sales and marketing and research and development organizations;

 

    acquire complementary technologies, products or businesses;

 

    expand operations, in the United States or internationally;

 

    hire, train and retain employees; or

 

    respond to competitive pressures or unanticipated working capital requirements.

Our failure to do any of these things could seriously harm our business, financial condition, results of operations and prospects.

If our estimates or judgments relating to our critical accounting policies are based on assumptions that change or prove to be incorrect, our results of operations could fall below expectations of securities analysts and investors, resulting in a decline in the market price of our common stock.

The preparation of financial statements in conformity with generally accepted accounting principles in the United States, or GAAP, requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, as described in the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the results of which form the basis for making judgments about the carrying values of assets, liabilities, equity, revenue and expenses that are not readily apparent from other sources. Significant assumptions and estimates used in preparing our consolidated financial statements include those related to revenue recognition, stock-based compensation, contract manufacturing liabilities and income taxes. If our assumptions change or if actual circumstances differ from those in our assumptions, our results of operations may be adversely affected and may fall below the expectations of securities analysts and investors, resulting in a decline in the market price of our common stock.

We are exposed to the credit risk of our channel partners and some of our end customers, which could result in material losses.

Most of our sales are on an open credit basis, with standard payment terms of 30 days in the United States and, because of local customs or conditions, longer in some markets outside the United States. We monitor individual end-customer payment capability in granting such open credit arrangements, seek to limit such open credit to amounts we believe the end customers can pay and maintain reserves we believe are adequate to cover exposure for doubtful accounts. We are unable to recognize revenue from shipments until the collection of those amounts becomes reasonably assured. Any significant delay or default in the collection of significant accounts receivable could result in an increased need for us to obtain working capital from other sources, possibly on worse terms than we could have negotiated if we had established such working capital resources prior to such delays or defaults. Any significant default could adversely affect our results of operations and delay our ability to recognize revenue.

A material portion of our sales is derived through our distributors, systems integrators and value-added resellers. Some of our distributors, systems integrators and value-added resellers may experience financial difficulties, which could adversely affect our collection of accounts receivable. Distributors tend to have more limited financial resources than other systems integrators, value-added resellers and end customers. Distributors represent potential sources of increased credit risk because they may be less likely to have the reserve resources

 

-34-


Table of Contents

required to meet payment obligations. Our exposure to credit risks of our channel partners may increase if our channel partners and their end customers are adversely affected by global or regional economic conditions. One or more of these channel partners could delay payments or default on credit extended to them, either of which could materially adversely affect our business, financial condition, results of operations and prospects.

If we or our partners fail to comply with environmental requirements, our business, financial condition, results of operations, prospects and reputation could be adversely affected.

We and our partners, including our contract manufacturers, are subject to various local, state, federal and international environmental laws and regulations, including laws governing the hazardous material content of our products and laws relating to the collection, recycling and disposal of electrical and electronic equipment. Examples of these laws and regulations include the European Union, or EU, Restrictions on the use of Hazardous Substances Directive, or RoHS Directive, and the EU Waste Electrical and Electronic Equipment Directive, or WEEE Directive, as well as the implementing legislation of the EU member states. Similar laws and regulations have been passed or are pending in China, South Korea, Norway and Japan and may be enacted in other regions, including in the United States, and we or our partners, including our contract manufacturers, are, or may in the future be, subject to these laws and regulations.

The EU RoHS Directive and the similar laws of other jurisdictions limit the content of certain hazardous materials such as lead, mercury and cadmium in the manufacture of electrical equipment, including our products. Our products currently comply with the RoHS Directive; however, if there are future changes to this directive, we may be required to re-engineer our products to use components compatible with these regulations. This re-engineering and component substitution could result in additional costs to us or disrupt our operations or logistics.

We are also subject to environmental laws and regulations governing the management and disposal of hazardous materials and wastes. Our failure, or the failure of our partners, including our contract manufacturers, to comply with past, present and future environmental laws could result in fines, penalties, third-party claims, reduced sales of our products, substantial product inventory write-offs and reputational damage, any of which could harm our business, financial condition, results of operations and prospects. We also expect that our business will be affected by new environmental laws and regulations on an ongoing basis applicable to us and our partners, including our contract manufacturers. To date, our expenditures for environmental compliance have not had a material effect on our results of operations or cash flows. Although we cannot predict the future effect of such laws or regulations, they will likely result in additional costs or require us to change the content or manufacturing of our products, which could have a material adverse effect on our business, financial condition, results of operations and prospects.

We are exposed to fluctuations in currency exchange rates, which could adversely affect our business, financial condition, results of operations and prospects.

Our sales contracts are primarily denominated in U.S. dollars, and therefore substantially all of our revenue is not subject to foreign currency risk. However, a strengthening U.S. dollar could increase the real cost of our products to our end customers outside of the United States, which could adversely affect our business, financial condition, results of operations and prospects. In addition, a decrease in the value of the U.S. dollar relative to foreign currencies could increase our product and operating costs in foreign locations. Further, an increasing portion of our operating expenses is incurred outside the United States, is denominated in foreign currencies and is subject to fluctuations due to changes in foreign currency exchange rates. If we are not able to successfully hedge against the risks associated with the currency fluctuations, our business, financial condition, results of operations and prospects could be adversely affected.

 

-35-


Table of Contents

Our business is subject to the risks of earthquakes, fire, power outages, floods and other catastrophic events and to interruption by manmade problems such as terrorism.

Our corporate headquarters and the operations of our key manufacturing vendors, logistics providers and partners, as well as many of our customers, are located in areas exposed to risks of natural disasters such as earthquakes and tsunamis, including the San Francisco Bay area, Japan and Taiwan. A significant natural disaster, such as an earthquake, tsunami, fire or a flood, or other catastrophic event such as a disease outbreak, could have a material adverse effect on our or their business, which could in turn materially affect our financial condition, results of operations and prospects. For example, in the event our service providers’ information technology systems or manufacturing or logistics abilities are hindered by any of the events discussed above, shipments could be delayed, which could result in missed financial targets, such as revenue and shipment targets, for a particular quarter. Further, if a natural disaster occurs in a region from which we derive a significant portion of our revenue, end customers in that region may delay or forego purchases of our products, which may materially and adversely affect our business, financial condition, results of operations and prospects. In addition, acts of terrorism could cause disruptions in our business or the business of our manufacturer, logistics providers, partners or end customers or the economy as a whole. Given our typical concentration of sales at each quarter end, any disruption in the business of our manufacturer, logistics providers, partners or end customers that affects sales at the end of our quarter could have a particularly significant adverse effect on our quarterly results. All of the aforementioned risks may be augmented if our disaster recovery plans and those of our manufacturers, logistics providers or partners prove to be inadequate. To the extent that any of the above results in delays or cancellations of end-customer orders, or delays in the manufacture, deployment or shipment of our products, our business, financial condition, results of operations and prospects would be adversely affected.

Breaches of our cybersecurity systems could degrade our ability to conduct our business operations and deliver products and services to our customers, delay our ability to recognize revenue, compromise the integrity of our software products, result in significant data losses and the theft of our intellectual property, damage our reputation, expose us to liability to third parties and require us to incur significant additional costs to maintain the security of our networks and data.

We increasingly depend upon our IT systems to conduct virtually all of our business operations, ranging from our internal operations and product development activities to our marketing and sales efforts and communications with our customers and business partners. Computer programmers may attempt to penetrate our network security, or that of our website, and misappropriate our proprietary information or cause interruptions of our service. Because the techniques used by such computer programmers to access or sabotage networks change frequently and may not be recognized until launched against a target, we may be unable to anticipate these techniques. In addition, sophisticated hardware and operating system software and applications that we produce or procure from third parties may contain defects in design or manufacture, including “bugs” and other problems that could unexpectedly interfere with the operation of the system. We have also outsourced a number of our business functions to third-party contractor, including our manufacturers and logistics providers, and our business operations also depend, in part, on the success of our contractors’ own cybersecurity measures. Similarly, we rely upon distributors, resellers and system integrators to sell our products and our sales operations depend, in part, on the reliability of their cybersecurity measures. Additionally, we depend upon our employees to appropriately handle confidential data and deploy our IT resources in safe and secure fashion that does not expose our network systems to security breaches and the loss of data. Accordingly, if our cybersecurity systems and those of our contractors fail to protect against unauthorized access, sophisticated cyberattacks and the mishandling of data by our employees and contractors, our ability to conduct our business effectively could be damaged in a number of ways, including:

 

    sensitive data regarding our business, including intellectual property and other proprietary data, could be stolen;

 

    our electronic communications systems, including email and other methods, could be disrupted, and our ability to conduct our business operations could be seriously damaged until such systems can be restored;

 

-36-


Table of Contents
    our ability to process customer orders and electronically deliver products and services could be degraded, and our distribution channels could be disrupted, resulting in delays in revenue recognition;

 

    defects and security vulnerabilities could be introduced into our software, thereby damaging the reputation and perceived reliability and security of our products and potentially making the data systems of our customers vulnerable to further data loss and cyberincidents; and

 

    personally identifiable data of our customers, employees and business partners could be compromised.

Should any of the above events occur, we could be subject to significant claims for liability from our customers and regulatory actions from governmental agencies. In addition, our ability to protect our intellectual property rights could be compromised and our reputation and competitive position could be significantly harmed. Also, the regulatory and contractual actions, litigations, investigations, fines, penalties and liabilities relating to data breaches that result in losses of personally identifiable or credit card information of users of our services can be significant in terms of fines and reputational impact and necessitate changes to our business operations that may be disruptive to us. Additionally, we could incur significant costs in order to upgrade our cybersecurity systems and remediate damages. Consequently, our financial performance and results of operations could be adversely affected.

We believe our long-term value as a company will be greater if we focus primarily on growth instead of profitability.

Our business strategy is to focus primarily on our long-term growth. As a result, our profitability in any given period may be lower than it would be if our strategy was to maximize short-term profitability. Expenditures on research and development, sales and marketing, infrastructure and other such investments may not ultimately grow our business, prospects or cause long term profitability. For example, in order to support our strong growth, we have accelerated our investment in infrastructure, such as enterprise resource planning software and other technologies to improve the efficiency of our operations. As a result, we expect our levels of operating profit could decline in the short to medium term. If we are ultimately unable to achieve profitability at the level anticipated by analysts and our stockholders, the market price of our common stock may decline.

We may not generate positive returns on our research and development investments.

Developing our products is expensive, and the investment in product development may involve a long payback cycle. In 2011, 2012 and 2013, our research and development expenses were $26.4 million, or approximately 18.9% of our revenue, $55.2 million, or approximately 28.5% of our revenue, and $98.6 million, or approximately 27.3% of our revenue, respectively. In the three months ended March 31, 2013 and 2014, our research and development expenses were $19.5 million, or approximately 31.8% of our revenue, and $33.4 million, or approximately 28.5% of our revenue, respectively. We expect to continue to invest heavily in software development in order to expand the capabilities of our cloud networking platform, introduce new products and features and build upon our technology leadership. We believe one of our greatest strengths lies in the speed of our product development efforts. By investing in research and development, we believe we will be well positioned to continue our rapid growth and take advantage of our large market opportunity. We expect that our results of operations will be impacted by the timing and size of these investments. These investments may take several years to generate positive returns, if ever.

We provide access to our software and other selected source code to certain partners, which creates additional risk that our competitors could develop products that are similar to or better than ours.

Our success and ability to compete depend substantially upon our internally developed technology, which is incorporated in the source code for our products. We seek to protect the source code, design code, documentation and other information relating to our software, under trade secret, patent and copyright laws. However, we have chosen to provide access to selected source code of our software to several of our partners for co-development, as

 

-37-


Table of Contents

well as for open application programming interfaces, or APIs, formats and protocols. Though we generally control access to our source code and other intellectual property and enter into confidentiality or license agreements with such partners as well as with our employees and consultants, this combination of procedural and contractual safeguards may be insufficient to protect our trade secrets and other rights to our technology. Our protective measures may be inadequate, especially because we may not be able to prevent our partners, employees or consultants from violating any agreements or licenses we may have in place or abusing their access granted to our source code. Improper disclosure or use of our source code could help competitors develop products similar to or better than ours.

Changes in our provision for income taxes or our effective tax rate, the enactment of new tax laws or changes in the application of existing tax laws of various jurisdictions or adverse outcomes resulting from examination of our income tax returns could adversely affect our results.

Our provision for income taxes is subject to volatility and could be adversely affected by several factors, many of which are outside of our control, including earnings that are lower than anticipated in countries that have lower tax rates and higher than anticipated in countries that have higher tax rates; our ability to generate and use tax attributes; changes in the valuation of our deferred tax assets and liabilities; expiration of or lapses in the R&D tax credit laws; transfer pricing adjustments, including the effect of acquisitions on our inter-company R&D cost sharing arrangement and legal structure; tax effects of nondeductible compensation, including certain stock-based compensation; tax costs related to inter-company realignments; changes in accounting principles; adverse tax consequences, including imposition of withholding or other taxes on payments by subsidiaries or customers; a change in our decision to indefinitely reinvest foreign earnings or changes in tax laws and regulations, including possible U.S. changes to the taxation of earnings of our foreign subsidiaries, the deductibility of expenses attributable to foreign income or the foreign tax credit rules.

Significant judgment is required to evaluate our tax positions and determine our provision for income taxes. The accounting guidance for uncertainty in income taxes applies to all income tax positions, including the potential recovery of previously paid taxes, which if settled unfavorably could adversely affect our provision for income taxes or additional paid-in capital. In addition, tax laws are dynamic and subject to change as new laws are passed and new interpretations of the law are issued or applied. Recent changes to U.S. tax laws, including limitations on the ability of taxpayers to claim and utilize foreign tax credits and the deferral of certain tax deductions until earnings outside of the United States are repatriated to the United States, as well as changes to U.S. tax laws that may be enacted in the future, could impact the tax treatment of our foreign earnings, as well as cash and cash equivalent balances we currently maintain outside of the United States.

Further, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. Audits by the Internal Revenue Service or other tax authorities are subject to inherent uncertainties and could result in unfavorable outcomes, including potential fines or penalties. As we operate in numerous taxing jurisdictions, the application of tax laws can be subject to diverging and sometimes conflicting interpretations by tax authorities of these jurisdictions. The expense of defending and resolving such an audit may be significant. The amount of time to resolve an audit is also unpredictable and may divert management’s attention from our business operations. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. We cannot assure you that fluctuations in our provision for income taxes or our effective tax rate, the enactment of new tax laws or changes in the application or interpretation of existing tax laws or adverse outcomes resulting from examination of our tax returns by tax authorities will not have an adverse effect on our business, financial condition, results of operations and prospects.

If we do not effectively expand and train our direct sales force, we may be unable to add new end customers or increase sales to our existing end customers, and our business will be adversely affected.

We depend on our direct sales force to obtain new end customers and increase sales with existing end customers. As such, we have invested and will continue to invest substantially in our sales organization. In recent

 

-38-


Table of Contents

periods, we have been adding personnel and other resources to our sales function as we focus on growing our business, entering new markets and increasing our market share, and we expect to incur significant additional expenses in expanding our sales personnel in order to achieve revenue growth. There is significant competition for sales personnel with the skills and technical knowledge that we require. Our ability to achieve significant revenue growth will depend, in large part, on our success in recruiting, training, retaining and integrating sufficient numbers of sales personnel to support our growth, particularly in international markets. New hires require significant training and may take significant time before they achieve full productivity. Our recent hires and planned hires may not become productive as quickly as we expect, and we may be unable to hire, retain or integrate into our corporate culture sufficient numbers of qualified individuals in the markets where we do business or plan to do business. In addition, because we continue to grow rapidly, a large percentage of our sales force is new to our company. If we are unable to hire, integrate and train a sufficient number of effective sales personnel, or the sales personnel we hire are not successful in obtaining new end customers or increasing sales to our existing end-customer base, our business, financial condition, results of operations and prospects will be adversely affected.

New regulations related to conflict minerals may cause us to incur additional expenses and could limit the supply and increase the costs of certain metals used in the manufacturing of our products.

As a public company, we will be subject to new requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, that will require us to perform diligence, and disclose and report whether or not our products contain conflict minerals. The implementation of these new requirements could adversely affect the sourcing, availability and pricing of the materials used in the manufacture of components used in our products. In addition, we will incur additional costs to comply with these disclosure requirements, including costs related to conducting diligence procedures and, if applicable, potential changes to products, processes or sources of supply as a consequence of such verification activities. We may also face reputational harm if we determine that certain of our products contain minerals not determined to be conflict-free or if we are unable to alter our products, processes or sources of supply to avoid such materials.

Risks Related to this Offering, the Securities Markets and Ownership of Our Common Stock

The market price of our common stock may be volatile, and the value of your investment could decline.

Technology stocks have historically experienced high levels of volatility. The market price of our common stock following this offering may fluctuate substantially. Following the completion of this offering, the market price of our common stock may be higher or lower than the price you pay in the offering, depending on many factors, some of which are beyond our control and may not be related to our operating performance. These fluctuations could cause you to lose all or part of your investment in our common stock. Factors that could cause fluctuations in the market price of our common stock include the following:

 

    actual or anticipated announcements of new products, services or technologies, commercial relationships, acquisitions or other events by us or our competitors;

 

    price and volume fluctuations in the overall stock market from time to time;

 

    significant volatility in the market price and trading volume of technology companies in general and of companies in the IT security industry in particular;

 

    fluctuations in the trading volume of our shares or the size of our public float;

 

    actual or anticipated changes or fluctuations in our results of operations;

 

    adverse changes to our relationships with any of our channel partners;

 

    manufacturing, supply or distribution shortages;

 

    whether our results of operations meet the expectations of securities analysts or investors;

 

-39-


Table of Contents
    actual or anticipated changes in the expectations of investors or securities analysts;

 

    litigation involving us, our industry, or both;

 

    regulatory developments in the United States, foreign countries or both;

 

    general economic conditions and trends;

 

    major catastrophic events;

 

    sales of large blocks of our common stock; or

 

    departures of key personnel.

In addition, if the market for technology stocks or the stock market in general experiences a loss of investor confidence, the market price of our common stock could decline for reasons unrelated to our business, financial condition, results of operations and prospects. The market price of our common stock might also decline in reaction to events that affect other companies in our industry even if these events do not directly affect us. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been brought against that company. If the market price of our common stock is volatile, we may become the target of securities litigation. Securities litigation could result in substantial costs and divert our management’s attention and resources from our business and prospects. This could have a material adverse effect on our business, financial condition, results of operations and prospects.

Sales of substantial amounts of our common stock in the public markets, or the perception that such sales might occur, could reduce the market price that our common stock might otherwise attain and may dilute your voting power and your ownership interest in us.

Sales of a substantial number of shares of our common stock in the public market after this offering, or the perception that such sales could occur, could adversely affect the market price of our common stock and may make it more difficult for you to sell your common stock at a time and price that you deem appropriate. Based on the total number of outstanding shares of our common stock as of April 30, 2014, as adjusted for the conversion into shares of common stock of principal and accrued interest through the anticipated completion of this offering of certain of our subordinated convertible promissory notes upon completion of this offering, we will have 63,593,966 shares of common stock outstanding, assuming no exercise of our outstanding options after April 30, 2014 and no exercise of the underwriters’ overallotment option.

All of the shares of common stock sold in this offering will be freely tradable without restrictions or further registration under the Securities Act of 1933, as amended, or the Securities Act, except for any shares held by our affiliates as defined in Rule 144 under the Securities Act.

Subject to certain exceptions described in the section titled “Underwriters,” we, all of our directors and officers and holders of substantially all of our common stock, or securities exercisable for or convertible into our common stock outstanding immediately prior to this offering, have agreed not to offer, sell or agree to sell, directly or indirectly, any shares of common stock without the permission of each of Morgan Stanley & Co. LLC and Citigroup Global Markets, Inc. on behalf of the underwriters, for a period of 180 days from the date of this prospectus, subject to potential extension in the event we release earnings results or material news or a material event relating to us occurs near the end of the lock-up period. When the applicable lock-up period expires, we and our locked-up securityholders will be able to sell our shares in the public market. In addition, the underwriters may, in their sole discretion, release all or some portion of the shares subject to lock-up agreements prior to the expiration of the lock-up period. See “Shares Eligible for Future Sale” for more information. Sales of a substantial number of such shares upon expiration, or the perception that such sales may occur, or early release of the lock-up, could cause our share price to decline or make it more difficult for you to sell your common stock at a time and price that you deem appropriate.

Based on shares outstanding as of April 30, 2014, upon completion of this offering, holders of up to approximately 28,118,975 shares, or 44.2%, of our common stock will have rights, subject to some conditions, to

 

-40-


Table of Contents

require us to file registration statements covering the sale of their shares or to include their shares in registration statements that we may file for ourselves or other stockholders. We also intend to register the offer and sale of all shares of common stock that we may issue under our equity compensation plans.

We may issue our shares of common stock or securities convertible into our common stock from time to time in connection with a financing, acquisition, investments or otherwise. Any such issuance could result in substantial dilution to our existing stockholders and cause the trading price of our common stock to decline.

Insiders will continue to have substantial control over us after this offering, which could limit your ability to influence the outcome of key transactions, including a change of control.

Our directors, executive officers and each of our stockholders who own greater than 5% of our outstanding common stock together with their affiliates, in the aggregate, will beneficially own approximately 59.5% of the outstanding shares of our common stock after this offering, based on shares outstanding as of April 30, 2014 as adjusted for the conversion into shares of common stock of principal and accrued interest through the anticipated completion of this offering of certain of our subordinated convertible promissory notes upon completion of this offering, and after giving effect to the exercise and exercisability of options. As a result, these stockholders, if acting together, will be able to influence or control matters requiring approval by our stockholders, including the election of directors and the approval of mergers, acquisitions or other extraordinary transactions. They may also have interests that differ from yours and may vote in a way with which you disagree and which may be adverse to your interests. This concentration of ownership may also discourage a potential investor from acquiring our common stock due to the limited voting power of such stock or otherwise may have the effect of delaying, preventing or deterring a change of control of our company, could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale of our company and might ultimately affect the market price of our common stock.

We cannot assure you that a market will develop for our common stock or what the market price of our common stock will be.

We have been approved to list our common stock on the New York Stock Exchange under the symbol “ANET.” However, we cannot assure you that an active trading market for our common stock will develop on such exchange or elsewhere or, if developed, that any market will be sustained. The lack of an active market may impair your ability to sell your shares at the time you wish to sell them or at a price that you consider reasonable. An inactive market may also impair our ability to raise capital by selling shares and may impair our ability to acquire other businesses, applications or technologies using our shares as consideration. We cannot predict the prices at which our common stock will trade. The initial public offering price of our common stock was determined by negotiations with the underwriters and may not bear any relationship to the market price at which our common stock will trade after this offering or to any other established criteria of the value of our business and prospects.

We have broad discretion in the use of the net proceeds that we receive in this offering and may use them in ways that may not enhance our results of operations or the market price of our common stock.

The principal purposes of this offering are to raise additional capital, to create a public market for our common stock and to facilitate our future access to the public equity markets. We have not yet determined the specific allocation of the net proceeds that we receive in this offering other than the prepayment of the Singtel Innov8 Pte. Ltd subordinated convertible promissory note. We intend to use approximately $23.6 million of the net proceeds that we receive in this offering to prepay the principal and accrued interest of the Singtel Innov8 Pte. Ltd subordinated convertible promissory note, and the remaining net proceeds for working capital and general corporate purposes, including expansion of our sales and marketing organization, further development and expansion of our product offerings and possible acquisitions of, or investments in, businesses, technologies or other assets. Accordingly, our management will have broad discretion over the specific use of the net proceeds that we receive in this offering and might not be able to obtain a significant return, if any, on investment of these net proceeds. Investors in this offering will need to rely upon the judgment of our management with respect to

 

-41-


Table of Contents

the use of proceeds. If we do not use the net proceeds that we receive in this offering effectively, our business, financial condition, results of operations and prospects could be harmed, and the market price of our common stock could decline.

We do not intend to pay dividends for the foreseeable future.

We have never declared nor paid any dividends on our common stock. We intend to retain any earnings to finance the operation and expansion of our business and prospects, and we do not anticipate paying any cash dividends in the future. As a result, you may only receive a return on your investment in our common stock if the market price of our common stock increases.

The requirements of being a public company may strain our resources, divert management’s attention and affect our ability to attract and retain qualified board members.

As a public company, we are subject to the reporting and corporate governance requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act, the listing requirements of the New York Stock Exchange and other applicable securities rules and regulations, including the Sarbanes-Oxley Act and the Dodd-Frank Act. 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, particularly after we are no longer an “emerging growth company” as defined in the JOBS Act. Among other things, the Exchange Act requires that we file annual, quarterly and current reports with respect to our business and results of operations and maintain effective disclosure controls and procedures and internal control over financial reporting. In order to 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, financial condition, results of operations and prospects. Although we have already hired additional employees to help comply with these requirements, we may need to further expand our legal and finance departments in the future, which will increase our costs and expenses.

In addition, changing laws, regulations, and standards relating to corporate governance and public disclosure are creating uncertainty for public companies, increasing legal and financial compliance costs and making some activities more time consuming. These laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We intend to invest resources to comply with evolving laws, regulations, and standards, and this investment may result in increased general and administrative expense and a diversion of management’s time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new laws, regulations and standards differ from the activities intended by regulatory or governing bodies, regulatory authorities may initiate legal proceedings against us and our business and prospects may be harmed. As a result of disclosure of information in the filings required of a public company and in this prospectus, our business and financial condition will become more visible, which may result in threatened or actual litigation, including by competitors and other third parties. If such claims are successful, our business, financial condition, results of operations and prospects could be harmed, and even if the claims do not result in litigation or are resolved in our favor, these claims, and the time and resources necessary to resolve them, could divert the resources of our management and harm our business, financial condition, results of operations and prospects.

We also expect that being a public company and these new rules and regulations will make it more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These factors could also make it more difficult for us to attract and retain qualified executive officers and members of our board of directors, particularly to serve on our Audit Committee and Compensation Committee.

 

-42-


Table of Contents

In addition, as a result of our disclosure obligations as a public company, we will have reduced strategic flexibility and will be under pressure to focus on short-term results, which may adversely affect our ability to achieve long-term profitability.

We are an “emerging growth company,” and we cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make our common stock less attractive to investors.

For so long as we remain an “emerging growth company” as defined in the JOBS Act, we may take advantage of certain exemptions from various requirements that are applicable to public companies that are not “emerging growth companies,” including reduced disclosure obligations regarding executive compensation in our registration statements, periodic reports and proxy statements and exemptions from the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We may take advantage of these exemptions until we are no longer an emerging growth company. We would cease to be an emerging growth company upon the earliest to occur of: (i) the first fiscal year following the fifth anniversary of our initial public offering; (ii) the first fiscal year after our annual gross revenue is $1 billion or more; (iii) the date on which we have, during the previous three-year period, issued more than $1 billion in non-convertible debt securities; or (iv) as of the end of any fiscal year in which the market value of our common stock held by non-affiliates exceeded $700 million as of the end of the second quarter of that fiscal year.

In addition, Section 107 of the JOBS Act also provides that an “emerging growth company” may take advantage of an extended transition period for complying with new or revised accounting standards. However, we have chosen to “opt out” of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable.

Because the initial public offering price of our common stock will be substantially higher than the pro forma net tangible book value per share of our outstanding common stock following this offering, new investors will experience immediate and substantial dilution.

The initial public offering price of our common stock will be substantially higher than the pro forma as adjusted net tangible book value per share of our common stock immediately following this offering based on the total value of our tangible assets less our total liabilities. Therefore, if you purchase shares of our common stock in this offering, you will experience immediate dilution of $36.75 per share, the difference between the price per share you pay for our common stock and the pro forma as adjusted net tangible book value per share of our common stock as of March 31, 2014, after giving effect to the issuance of shares of our common stock in this offering. Furthermore, if the underwriters exercise their over-allotment option, if outstanding options and warrants are exercised, if we issue awards to our employees under our equity incentive plans, or if we otherwise issue additional shares of our common stock, you could experience further dilution. See “Dilution” below.

If securities or industry analysts do not publish research or reports about our business, or publish inaccurate or unfavorable research reports about our business or prospects, the market price of our common stock and trading volume could decline.

The trading market for our common stock, to some extent, depends on the research and reports that securities or industry analysts publish about us or our business or prospects. We do not have any control over these analysts. If one or more of the analysts who cover us should downgrade our shares or change their opinion of our shares, the market price of our common stock would likely decline. If one or more of these analysts should cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which could cause the market price of our common stock or trading volume to decline.

 

-43-


Table of Contents

Our charter documents and Delaware law could discourage takeover attempts and lead to management entrenchment.

Our amended and restated certificate of incorporation and amended and restated bylaws that will be in effect upon completion of this offering contain provisions that could delay or prevent a change in control of our company. These provisions could also make it difficult for stockholders to elect directors that are not nominated by the current members of our board of directors or take other corporate actions, including effecting changes in our management. These provisions include:

 

    a classified board of directors with three-year staggered terms, which could delay the ability of stockholders to change the membership of a majority of our board of directors;

 

    the ability of our board of directors to issue shares of preferred stock and to determine the price and other terms of those shares, including preferences and voting rights, without stockholder approval, which could be used to significantly dilute the ownership of a hostile acquirer;

 

    the exclusive right of our board of directors to elect a director to fill a vacancy created by the expansion of our board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors;

 

    a prohibition on stockholder action by written consent, which forces stockholder action to be taken at an annual or special meeting of our stockholders;

 

    the requirement that a special meeting of stockholders may be called only by the chairman of our board of directors, our president, our secretary or a majority vote of our board of directors, which could delay the ability of our stockholders to force consideration of a proposal or to take action, including the removal of directors;

 

    the requirement for the affirmative vote of holders of at least 66 23% of the voting power of all of the then outstanding shares of the voting stock, voting together as a single class, to amend the provisions of our amended and restated certificate of incorporation relating to the issuance of preferred stock and management of our business or our amended and restated bylaws, which may inhibit the ability of an acquirer to effect such amendments to facilitate an unsolicited takeover attempt;

 

    the ability of our board of directors, by majority vote, to amend the bylaws, which may allow our board of directors to take additional actions to prevent an unsolicited takeover and inhibit the ability of an acquirer to amend the bylaws to facilitate an unsolicited takeover attempt; and

 

    advance notice procedures with which stockholders must comply to nominate candidates to our board of directors or to propose matters to be acted upon at a stockholders’ meeting, which may discourage or deter a potential acquirer from conducting a solicitation of proxies to elect the acquirer’s own slate of directors or otherwise attempting to obtain control of us.

In addition, as a Delaware corporation, we are subject to Section 203 of the Delaware General Corporation Law. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging or combining with us for a certain period of time.

The issuance of additional stock in connection with financings, acquisitions, investments, our stock incentive plans or otherwise will dilute all other stockholders.

Our amended and restated certificate of incorporation, as it will be in effect upon the completion of this offering, will authorize us to issue up to 1,000,000,000 shares of common stock and up to 100,000,000 shares of preferred stock with such rights and preferences as may be determined by our board of directors. Subject to compliance with applicable rules and regulations, we may issue our shares of common stock or securities convertible into our common stock from time to time in connection with a financing, acquisition, investment, our stock incentive plans or otherwise. We may from time to time issue additional shares of common stock at a

 

-44-


Table of Contents

discount from the then market price of our common stock. Any issuance of stock could result in substantial dilution to our existing stockholders and cause the market price of our common stock to decline.

We may have contingent liability arising out of possible violations of the Securities Act of 1933 in connection with communications to potential participants in a previously planned directed share program.

As part of the offering, up to 112,200 shares were reserved for sale at the initial public offering price in connection with a previously planned directed share program which has subsequently been terminated. In March, April and May 2014, certain officers and directors and employees acting at the request of such officers communicated with certain potential participants in the directed share program. The potential directed share program participants consisted of personal friends or family members of officers or directors, customers, suppliers or partners with long-term commercial relationships with us, and three journalists and three industry researchers who had covered us over time. In total, over 150 persons were contacted in person or by telephone, email or text message regarding the planned directed share program. Such communications were intended only to determine their interest in, and ability under their applicable corporate policies to participate in, the planned directed share program and, in some cases, to obtain contact information to provide to the underwriter managing such program. Certain of such communications regarding the directed share program may have constituted a violation of Section 5 of the Securities Act. We could have a contingent liability arising out of the possible violations of the Securities Act in connection with such communications. Any liability would depend upon the number of shares purchased by the recipients of such communications that may have constituted a violation of Section 5 of the Securities Act. If a claim were brought by any such recipients of such communications who purchased shares in the offering and a court were to conclude that these communications constituted a violation of Section 5 of the Securities Act, we could be required to repurchase the shares sold to the potential participants who received such communications at the original purchase price, plus statutory interest from the date of purchase, for claims brought during a period of one year from the date of their purchase of common stock. We could also incur considerable expense in contesting any such claim.

 

-45-


Table of Contents

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus, including the sections entitled “Prospectus Summary,” “Risk Factors,” “Use of Proceeds,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and “Compensation Discussion and Analysis,” contains forward-looking statements. The words “believe,” “may,” “will,” “potentially,” “estimate,” “continue,” “anticipate,” “intend,” “could,” “would,” “project,” “plan,” “predict,” “expect” and similar expressions that convey uncertainty of future events or outcomes are intended to identify forward-looking statements.

These forward-looking statements include, but are not limited to, statements concerning the following:

 

    our ability to maintain an adequate rate of revenue growth and our future financial performance, including our expectations regarding our cost of revenue, gross profit or gross margin and operating expenses;

 

    our business plan and our ability to effectively manage our growth;

 

    costs associated with defending intellectual property infringement and other claims, such as those claims discussed in “Business—Legal Proceedings;”

 

    our ability to attract and retain end customers;

 

    our ability to further penetrate our existing customer base;

 

    our ability to displace existing products in established markets;

 

    our ability to expand our leadership position in the network switch industry, including the areas of mobility, virtualization, cloud computing and cloud networks;

 

    our ability to timely and effectively scale and adapt our existing technology;

 

    our ability to successfully anticipate technological shifts and market needs, innovate new products and bring them to market in a timely manner;

 

    our ability to expand internationally;

 

    the effects of increased competition in our market and our ability to compete effectively;

 

    the effects of seasonal and cyclical trends on our results of operations;

 

    our expectations concerning relationships with third parties;

 

    the attraction and retention of qualified employees and key personnel;

 

    our ability to maintain, protect and enhance our brand and intellectual property;

 

    economic and industry trends;

 

    estimates and estimate methodologies used in preparing our financial statements and determining option exercise prices;

 

    future trading prices of our common stock; and

 

    future acquisitions of or investments in complementary companies, products, services or technologies.

These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in the section titled “Risk Factors” and elsewhere in this prospectus. Moreover, we operate in a very competitive and rapidly changing environment, and new risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this prospectus may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements.

 

-46-


Table of Contents

You should not rely upon forward-looking statements as predictions of future events. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee that the future results, levels of activity, performance or events and circumstances reflected in the forward-looking statements will be achieved or occur. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. We undertake no obligation to update publicly any forward-looking statements for any reason after the date of this prospectus to conform these statements to actual results or to changes in our expectations, except as required by law.

You should read this prospectus and the documents that we reference in this prospectus and have filed with the SEC as exhibits to the registration statement of which this prospectus is a part with the understanding that our actual future results, levels of activity, performance and events and circumstances may be materially different from what we expect.

MARKET AND INDUSTRY DATA

Unless otherwise indicated, information contained in this prospectus concerning our industry and the markets in which we operate, including our general expectations and market position, market opportunity and market size, is based on information from various sources, including the “Datacenter Switch Market Share & Forecast Tables up to Calendar 4Q14—Vendor Market Shares up to Calendar 4Q13—” dated March 5, 2014 published by Crehan Research, Inc. or Crehan Research and Gartner, Inc., or Gartner, on assumptions that we have made that are based on those data and other similar sources and on our knowledge of the markets for our products and services. This information involves a number of assumptions and limitations, and you are cautioned not to give undue weight to such estimates. Estimates of third parties, particularly as they relate to projections, involve numerous assumptions and estimates of our future performance and the future performance of the industry in which we operate are necessarily subject to a high degree of uncertainty and risk due to a variety of factors, including those described in the section titled “Risk Factors” and elsewhere in this prospectus. These and other factors could cause results to differ materially from those expressed in the estimates made by the independent parties and by us.

The Gartner Report described herein (the “Gartner Report”), represents data, research opinion or viewpoints published as part of a syndicated subscription service, by Gartner, and are not representations of fact. The Gartner Report speaks as of its original publication date (and not as of the date of this Registration Statement) and the opinions expressed in the Gartner Report are subject to change without notice. The Gartner Report consists of Gartner, Magic Quadrant for Data Center Networking, dated April 24, 2014, by Mark Fabbi, Tim Zimmerman and Andrew Lerner.

Gartner does not endorse any vendor, product or service depicted in its research publications, and does not advise technology users to select only those vendors with the highest ratings. Gartner research publications consist of the opinions of Gartner’s research organization and should not be construed as statements of fact. Gartner disclaims all warranties, expressed or implied, with respect to this research, including any warranties of merchantability or fitness for a particular purpose.

 

-47-


Table of Contents

USE OF PROCEEDS

We estimate that the net proceeds from our sale of 5,250,000 shares of common stock in this offering at the initial public offering price of $43.00 per share, after deducting underwriting discounts and commissions and estimated offering expenses payable by us, will be approximately $206.9 million, or $238.7 million if the underwriters’ over-allotment option is exercised in full.

The principal purposes of this offering are to increase our capitalization and financial flexibility, to create a public market for our stock and thereby enable access to the public equity markets by our employees and stockholders, to obtain additional capital and to increase our visibility in the marketplace. As of the date of this prospectus, we have no specific plans for the use of the net proceeds we receive from this offering other than the prepayment of the Singtel Innov8 Pte. Ltd subordinated convertible promissory note. We intend to use approximately $23.6 million of the net proceeds we receive from this offering to prepay the principal and accrued interest of the Singtel Innov8 Pte. Ltd subordinated convertible promissory note, and the remaining net proceeds for general corporate purposes, including working capital, sales and marketing activities, product development, general and administrative matters and capital expenditures, although we do not currently have any specific or preliminary plans with respect to the use of proceeds for such purposes. We also may use a portion of the net proceeds to acquire complementary businesses, products, services or technologies. However, we do not have agreements or commitments for any specific acquisitions at this time. We will have broad discretion over the uses of the net proceeds of this offering. Pending these uses, we intend to invest the net proceeds from this offering in short-term, investment-grade interest-bearing securities such as money market accounts, certificates of deposit, commercial paper and guaranteed obligations of the U.S. government as well as equity investment in marketable securities.

The Singtel Innov8 Pte. Ltd subordinated convertible promissory note bears interest at the rate of 6% per annum and matures on December 31, 2014.

DIVIDEND POLICY

We have never declared or paid cash dividends on our common stock. We currently intend to retain all available funds and any future earnings for use in the operation of our business and do not anticipate paying any dividends on our common stock in the foreseeable future. Any future determination to declare dividends will be made at the discretion of our board of directors and will depend on our financial condition, results of operations, capital requirements, general business conditions and other factors that our board of directors may deem relevant.

 

-48-


Table of Contents

CAPITALIZATION

The following table sets forth our cash and cash equivalents and capitalization as of March 31, 2014 on:

 

    an actual basis;

 

    a pro forma basis, giving effect to the automatic conversion of all outstanding shares of our convertible preferred stock into 24,000,000 shares of common stock and the effectiveness of our amended and restated certificate of incorporation and amended and restated bylaws as of immediately prior to the completion of this offering, as if such conversions had occurred and our amended and restated certificate of incorporation had become effective on March 31, 2014; and

 

    a pro forma as adjusted basis, giving effect to the pro forma adjustments, the conversion of $80.0 million in principal amount of and accrued interest through the anticipated completion of this offering on our subordinated convertible promissory notes into 2,243,975 shares of common stock (assuming conversion of the notes at the common stock price per share of $43.00, which is the initial public offering price of this offering), the prepayment of $23.6 million principal and accrued interest through the anticipated completion of this offering of the Singtel Innov8 Pte. Ltd subordinated convertible promissory note with a portion of the net proceeds from this offering and the sale of 5,250,000 shares of common stock by us in this offering, based on the initial public offering price of $43.00 per share, after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

You should read this table together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited and unaudited consolidated financial statements and related notes included elsewhere in this prospectus.

 

     March 31, 2014  
     Actual      Pro
Forma
     Pro Forma
as Adjusted
 
     (in thousands, except share and per-
share data)
 

Cash and cash equivalents

   $ 129,524       $ 129,524       $ 313,568   
  

 

 

    

 

 

    

 

 

 

Convertible notes payable to related parties and related accrued interest, net of discount

   $ 29,658       $ 29,658       $   

Convertible notes payable to third parties and related accrued interest, net of discount

     88,357         88,357           

Stockholders’ equity:

        

Preferred stock, par value $0.0001; no shares authorized, issued and outstanding, actual; 100,000,000 shares authorized, no shares issued and outstanding, pro forma and pro forma as adjusted

                       

Convertible preferred stock, $0.0001 par value; 24,000,000 shares authorized, issued and outstanding, actual; no shares authorized, issued and outstanding, pro forma and pro forma as adjusted

     5,992                   

Common stock, $0.0001 par value; 176,000,000 shares authorized, 32,088,441 shares issued and outstanding, actual; 1,000,000,000 shares authorized, 56,088,441 shares issued and outstanding, pro forma; 1,000,000,000 shares authorized, 63,582,416 shares issued and outstanding, pro forma as adjusted

     3         6         7   

Additional paid-in capital

     35,137         41,126         344,521   

Accumulated other comprehensive income

     3         3         3   

Retained earnings

     55,293         55,293         53,181   
  

 

 

    

 

 

    

 

 

 

Total stockholders’ equity

     96,428         96,428         397,712   
  

 

 

    

 

 

    

 

 

 

Total capitalization

   $ 214,443       $ 214,443       $ 397,712   
  

 

 

    

 

 

    

 

 

 

 

-49-


Table of Contents

The number of shares of our common stock to be outstanding after this offering is based on 56,088,441 shares of our common stock outstanding as of March 31, 2014 and excludes:

 

    13,507,913 shares of common stock issuable upon the exercise of options outstanding with a weighted-average exercise price of $11.05 per share as of March 31, 2014;

 

    773,900 shares of common stock issuable upon the exercise of options granted prior to the date of this prospectus and subsequent to March 31, 2014 with an exercise price of $38.00 per share; and

 

    12,904,064 shares of common stock reserved for future issuance under our stock-based compensation plans, consisting of (i) 5,743,064 shares of common stock reserved for future issuance under our 2011 Equity Incentive Plan, which shares will be added to the shares to be reserved under our 2014 Equity Incentive Plan, which will become effective upon completion of this offering; (ii) 6,510,000 shares of common stock reserved for future issuance under our 2014 Equity Incentive Plan, which will become effective upon completion of this offering; and (iii) 651,000 shares of common stock reserved for future issuance under our 2014 Employee Stock Purchase Plan, which will become effective upon completion of this offering; as well as shares of common stock that become available under our 2014 Equity Incentive Plan and 2014 Employee Stock Purchase Plan, pursuant to provisions thereof that automatically increase the share reserves under the plans each year, as more fully described in “Executive Compensation—Employee Benefit and Stock Plans.”

 

-50-


Table of Contents

DILUTION

If you invest in our common stock, your interest will be diluted to the extent of the difference between the amount per share paid by purchasers of shares of common stock in this initial public offering and the pro forma as adjusted net tangible book value per share of common stock immediately after this offering.

As of March 31, 2014, our pro forma net tangible book value was approximately $93.4 million, or $1.66 per share of common stock. Our pro forma net tangible book value per share represents the amount of our total tangible assets reduced by the amount of our total liabilities and divided by the total number of shares of our common stock outstanding as of March 31, 2014, assuming the conversion of all outstanding shares of our convertible preferred stock.

After giving effect to our sale in this offering of 5,250,000 shares of our common stock, at the initial public offering price of $43.00 per share, after deducting underwriting discounts and commissions and estimated offering expenses payable by us, and assuming the conversion of $80.0 million in principal amount of and accrued interest through the anticipated completion of this offering on our subordinated convertible promissory notes into 2,243,975 shares of common stock based upon $43.00 per share, the initial public offering price of this offering, and payment of $23.6 million of net proceeds received in this offering to prepay principal and accrued interest of the Singtel Innov8 Pte. Ltd subordinated convertible promissory note incurred through the anticipated completion of this offering, our pro forma as adjusted net tangible book value as of March 31, 2014 would have been approximately $397.5 million, or $6.25 per share of our common stock. This represents an immediate increase in pro forma as adjusted net tangible book value of $4.59 per share to our existing stockholders and an immediate dilution of $36.75 per share to holders of our subordinated convertible promissory notes and investors purchasing shares of common stock in this offering.

The following table illustrates this dilution:

 

Initial public offering price per share

      $ 43.00   

Pro forma net tangible book value per share as of March 31, 2014

   $ 1.66      

Increase per share attributable to this offering

     3.28      

Increase per share attributable to the conversion of our subordinated convertible promissory notes

     1.31      
  

 

 

    

Pro forma net tangible book value, as adjusted to give effect to conversion of our subordinated convertible promissory notes and this offering

      $ 6.25   
     

 

 

 

Dilution in pro forma net tangible book value per share to holders of our subordinated convertible promissory notes and new investors in this offering

      $ 36.75   
     

 

 

 

If the underwriters exercise their over-allotment option in full, the pro forma as adjusted net tangible book value per share of our common stock after giving effect to this offering would be $6.67 per share, and the immediate dilution in net tangible book value per share to holders of our subordinated convertible promissory notes (excluding SingTel Innov8 Pte. Ltd, who holds $20.0 million in principal amount of subordinated convertible promissory notes and has informed us it does not intend to convert the interest and principal outstanding under its subordinated convertible promissory notes into shares of our common stock at the initial offering price in conjunction with this offering) and investors in this offering would be $36.33 per share.

 

-51-


Table of Contents

The following table summarizes, on a pro forma as adjusted basis as of March 31, 2014 after giving effect to (i) the automatic conversion of all of our convertible preferred stock into common stock and the effectiveness of our amended and restated certificate of incorporation and amended and restated bylaws and (ii) the conversion of $80.0 million in principal amount of and accrued interest on our subordinated convertible promissory notes into common stock (assuming conversion of the notes at the common stock price per share of $43.00, which is the initial public offering price of this offering) and this offering at the initial public offering price of $43.00 per share, the difference between existing stockholders and holders of our subordinated convertible promissory notes and new investors with respect to the number of shares of common stock, purchased from us, the total consideration paid to us, and the average price per share paid, before deducting underwriting discounts and commissions and estimated offering expenses:

 

     Shares Purchased     Total Consideration     Average Price
Per Share
 
     Number      Percent     Amount      Percent    

Existing stockholders

     56,088,441         88.2   $ 22,719,912         6.6   $ 0.41   

Holders of our subordinated convertible promissory notes and new public investors

     7,493,975         11.8        322,240,959         93.4        43.00   
  

 

 

    

 

 

   

 

 

    

 

 

   

Total

     63,582,416         100.0   $ 344,960,871         100.0  
  

 

 

    

 

 

   

 

 

    

 

 

   

To the extent that any outstanding options are exercised, investors will experience further dilution. In addition, we may choose to raise additional capital in the future due to market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the issuance of these securities could result in further dilution to our stockholders.

Except as otherwise indicated, the above discussion and tables assume no exercise of the underwriters’ over-allotment option. If the underwriters exercise their over-allotment option in full, our existing stockholders would own 87.1% and holders of our subordinated convertible promissory notes and our new investors would own 12.9% of the total number of shares of our common stock outstanding upon the completion of this offering.

The number of shares of our common stock to be outstanding after this offering is based on 56,088,441 shares of our common stock outstanding as of March 31, 2014 and excludes:

 

    13,507,913 shares of common stock issuable upon the exercise of options outstanding with a weighted-average exercise price of $11.05 per share as of March 31, 2014;

 

    773,900 shares of common stock issuable upon the exercise of options granted prior to the date of this filing and subsequent to March 31, 2014 with an exercise price of $38.00 per share; and

 

    12,904,064 shares of common stock reserved for future issuance under our stock-based compensation plans, consisting of (i) 5,743,064 shares of common stock reserved for future issuance under our 2011 Equity Incentive Plan, which shares will be added to the shares to be reserved under our 2014 Equity Incentive Plan, which will become effective upon completion of this offering; (ii) 6,510,000 shares of common stock reserved for future issuance under our 2014 Equity Incentive Plan, which will become effective upon completion of this offering; and (iii) 651,000 shares of common stock reserved for future issuance under our 2014 Employee Stock Purchase Plan, which will become effective upon completion of this offering; as well as shares of common stock that become available under our 2014 Equity Incentive Plan and 2014 Employee Stock Purchase Plan, pursuant to provisions thereof that automatically increase the share reserves under the plans each year, as more fully described in “Executive Compensation—Employee Benefit and Stock Plans.”

 

-52-


Table of Contents

SELECTED CONSOLIDATED FINANCIAL DATA

The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes included elsewhere in this prospectus. We derived the selected consolidated statements of operations data for the years ended December 31, 2011, 2012 and 2013 and the selected consolidated balance sheet data as of December 31, 2012 and 2013 from our audited consolidated financial statements included elsewhere in this prospectus. We derived the selected consolidated statements of operations data for the year ended December 31, 2010 and the selected consolidated balance sheet data as of December 31, 2010 and 2011 from our audited consolidated financial statements not included in this prospectus. We derived the unaudited selected consolidated statements of operations data for the three months ended March 31, 2013 and 2014 and the unaudited select consolidated balance sheet data as of March 31, 2014 from our unaudited consolidated financial statements included elsewhere in this prospectus. The unaudited consolidated financial statements were prepared on the same basis as the audited consolidated financial statements contained in this prospectus and include, in the opinion of management, all adjustments necessary for a fair presentation of the financial information set forth in those statements. Our historical results presented below are not necessarily indicative of financial results to be achieved in future periods, and our interim results are not necessarily indicative of results that should be expected for a full year or any other period.

 

-53-


Table of Contents
    Year Ended December 31,     Three Months Ended
March 31,
 
    2010     2011     2012     2013     2013     2014  
   

(in thousands, except share and per share data)

 

Consolidated Statements of Operations Data:

           

Revenue

  $ 71,719      $ 139,848      $ 193,408      $ 361,224      $ 61,348      $ 117,207   

Cost of revenue(1)

    27,173        43,366        61,252        122,686        19,220        35,893   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

    44,546        96,482        132,156        238,538        42,128        81,314   

Operating expenses(1):

           

Research and development

    16,285        26,408        55,155        98,587        19,514        33,446   

Sales and marketing

    9,944        19,450        28,603        55,115        10,135        18,655   

General and administrative

    2,248        6,224        8,501        18,688        3,736        7,231   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

    28,477        52,082        92,259        172,390        33,385        59,332   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

    16,069        44,400        39,897        66,148        8,743        21,982   

Other income (expense), net:

           

Interest expense

    (12,606     (6,417     (7,057     (7,119     (1,751     (1,771

Interest and other income (expense), net

    (143     (357     135        (754     (99     (764
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other income (expense), net

    (12,749     (6,774     (6,922     (7,873     (1,850     (2,535
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before provision for income taxes

    3,320        37,626        32,975        58,275        6,893        19,447   

Provision for income taxes

    924        3,591        11,626        15,815        282        7,118   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

  $ 2,396      $ 34,035      $ 21,349      $ 42,460      $ 6,611      $ 12,329   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income attributable to common stockholders(2):

           

Basic

  $ 715      $ 13,789      $ 9,622      $ 20,777      $ 3,127      $ 6,362   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

  $ 726      $ 13,854      $ 9,662      $ 21,780      $ 3,233      $ 6,816   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income per share attributable to common stockholders(2):

           

Basic

  $ 0.04      $ 0.65      $ 0.39      $ 0.76      $ 0.12      $ 0.22   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

  $ 0.04      $ 0.65      $ 0.39      $ 0.72      $ 0.12      $ 0.20   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Weighted-average shares used in computing net income per share attributable to common stockholders(2):

           

Basic

    15,994,362        21,175,788        24,711,453        27,320,294        26,284,899        29,124,310   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

    16,373,838        21,345,641        24,901,005        30,051,290        28,044,389        33,815,705   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Pro forma net income per share attributable to common stockholders (unaudited)(2):

           

Basic

        $ 0.77        $ 0.22   
       

 

 

     

 

 

 

Diluted

        $ 0.73        $ 0.20   
       

 

 

     

 

 

 

Weighted-average shares used in computing pro forma net income per share attributable to common stockholders (unaudited)(2):

           

Basic

          51,320,294          53,124,310   
       

 

 

     

 

 

 

Diluted

          54,051,290          57,815,705   
       

 

 

     

 

 

 

 

(1) Includes stock-based compensation expense as follows:

 

     Year Ended December 31,      Three Months
Ended
March 31,
 
     2010      2011      2012      2013      2013      2014  
    

(in thousands)

 

Cost of revenue

   $ 5       $ 94       $ 270       $ 408       $ 67       $ 211   

Research and development

     62         992         2,590         5,464         996         2,467   

Sales and marketing

     94         554         1,078         2,985         482         1,428   

General and administrative

     19         334         765         1,302         197         676   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total stock-based compensation

   $ 180       $ 1,974       $ 4,703       $ 10,159       $ 1,742       $ 4,782   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

-54-


Table of Contents
(2) See Notes 1 and 11 to our consolidated financial statements appearing elsewhere in this prospectus for an explanation of the calculations of our basic and diluted net income per share attributable to common stockholders and our basic and diluted pro forma net income per share attributable to common stockholders.

 

     Year Ended December 31,      As of
March 31,
 
     2010     2011     2012      2013      2014  
    

(in thousands)

 

Consolidated Balance Sheet Data:

       

Cash and cash equivalents

   $ 14,578      $ 70,725      $ 88,655       $ 113,664       $ 129,524   

Working capital

     30,530        98,282        130,808         76,179         93,033   

Total assets

     48,216        127,642        220,168         364,520         375,463   

Total indebtedness(1)

     80,938        102,068        134,377         160,213         162,308   

Total deferred revenue

     5,189        11,326        24,777         58,904         56,107   

Total stockholders’ equity (deficit)

     (48,609     (8,194     18,910         77,732         96,428   

 

(1) Total indebtedness includes our subordinated convertible promissory notes payable to related parties, subordinated convertible promissory notes payable to third parties, accrued interest payable on the notes and our lease financing obligations.

Non-GAAP Financial Measures

We use the financial measures set forth below, which are non-GAAP financial measures, to help us analyze our financial results, establish budgets and operational goals for managing our business and evaluate our performance. We also believe that the presentation of these non-GAAP financial measures in this prospectus provides an additional tool for investors to use in comparing our core business and results of operations over multiple periods with other companies in our industry, many of which present similar non-GAAP financial measures to investors.

 

     Year Ended December 31,     Three Months Ended
March 31,
 
         2010             2011             2012             2013         2013     2014  
    

(in thousands, except percentages)

 

Non-GAAP gross profit

   $ 44,551      $ 96,576      $ 132,426      $ 238,946      $ 42,195      $ 81,525   

Non-GAAP gross margin

     62.1     69.1     68.5     66.1     68.8     69.6

Non-GAAP income from operations

     16,249      $ 46,374      $ 44,600      $ 76,307      $ 10,485      $ 26,764   

Non-GAAP operating margin

     22.7     33.2     23.1     21.1     17.1     22.8

Adjusted EBITDA

     17,643      $ 47,667      $ 46,379      $ 81,351      $ 11,202      $ 29,049   

Adjusted EBITDA margin

     24.6     34.1     24.0     22.5     18.3     24.8

Non-GAAP gross profit and margin. We define non-GAAP gross profit as gross profit as reported on our consolidated statements of operations, excluding the impact of stock-based compensation, which is a non-cash charge. We define non-GAAP gross margin as non-GAAP gross profit divided by revenue. We have presented non-GAAP gross profit and margin because we believe that the exclusion of stock-based compensation allows for more accurate comparisons of our results of operations to other companies in our industry.

Non-GAAP income from operations and operating margin. We define non-GAAP income from operations as income from operations as reported on our consolidated statements of operations, excluding the impact of stock-based compensation. We define non-GAAP operating margin as non-GAAP income from operations divided by revenue. We have presented non-GAAP income from operations and operating margin because we believe that the exclusion of stock-based compensation allows for more accurate comparisons of our results of operations to other companies in our industry.

Adjusted EBITDA and adjusted EBITDA margin. We define adjusted EBITDA as our net income excluding: (i) stock-based compensation; (ii) interest expense; (iii) other income (expense), net, which primarily includes foreign exchange gains and losses; (iv) depreciation and amortization; and (v) our provision for income taxes. We define

 

-55-


Table of Contents

adjusted EBITDA margin as adjusted EBITDA divided by revenue. Depreciation includes depreciation expense associated with our leased building in Santa Clara, California. See Note 6 to our consolidated financial statements appearing elsewhere in this prospectus for an explanation of the accounting for our build-to-suit lease. We have presented adjusted EBITDA and adjusted EBITDA margin because they are key measures used by our management and board of directors to understand and evaluate our operating performance, to establish budgets and to develop operational goals for managing our business. In particular, we believe that the exclusion of the expenses eliminated in calculating adjusted EBITDA can provide a useful measure for period-to-period comparisons of our core operating performance.

Reconciliation of Non-GAAP Financial Measures

Our non-GAAP measures have limitations as analytical tools and you should not consider them in isolation or as a substitute for an analysis of our results under GAAP. There are a number of limitations related to the use of these non-GAAP financial measures versus their nearest GAAP equivalents. First, non-GAAP gross profit and gross margin and income from operations and operating margin are not substitutes for gross profit, gross margin, income from operations and operating margin. Second, other companies may calculate non-GAAP financial measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of our non-GAAP financial measures as tools for comparison. Finally, adjusted EBITDA and adjusted EBITDA margin exclude some costs, namely, non-cash stock-based compensation, interest expense and provision for income taxes, which are recurring. Therefore, adjusted EBITDA and adjusted EBITDA margin do not reflect the non-cash impact of stock-based compensation or working capital needs that will continue for the foreseeable future.

The following tables reconcile the most directly comparable GAAP financial measure to each of these non-GAAP financial measures.

 

     Year Ended
December 31,
    Three Months Ended
March 31,
 
     2010     2011     2012     2013     2013     2014  
    

(in thousands, except percentages)

             

Non-GAAP Gross Profit and Margin:

            

Revenue

   $ 71,719      $ 139,848      $ 193,408      $ 361,224      $ 61,348      $ 117,207   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

   $ 44,546      $ 96,482      $ 132,156      $ 238,538      $ 42,128      $ 81,314   

Stock-based compensation—cost of revenue

     5        94        270        408        67        211   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Non-GAAP gross profit

   $ 44,551      $ 96,576      $ 132,426      $ 238,946      $ 42,195      $ 81,525   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Non-GAAP gross margin

     62.1     69.1     68.5     66.1     68.8     69.6

 

     Year Ended
December 31,
    Three Months Ended
March 31,
 
     2010     2011     2012     2013     2013     2014  
    

(in thousands, except percentages)

             

Non-GAAP Income from Operations and Operating Margin:

            

Revenue

   $ 71,719      $ 139,848      $ 193,408      $ 361,224      $ 61,348      $ 117,207   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

   $ 16,069      $ 44,400      $ 39,897      $ 66,148      $ 8,743      $ 21,982   

Stock-based compensation

     180        1,974        4,703        10,159        1,742        4,782   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Non-GAAP income from operations

   $ 16,249      $ 46,374      $ 44,600      $ 76,307      $ 10,485      $ 26,764   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Non-GAAP operating margin

     22.7     33.2     23.1     21.1     17.1     22.8

 

-56-


Table of Contents
     Year Ended
December 31,
    Three Months Ended
March 31,
 
     2010     2011     2012     2013     2013     2014  
    

(in thousands, except percentages)

             

Adjusted EBITDA and adjusted EBITDA Margin:

            

Revenue

   $ 71,719      $ 139,848      $ 193,408      $ 361,224      $ 61,348      $ 117,207   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 2,396      $ 34,035      $ 21,349      $ 42,460      $ 6,611      $ 12,329   

Stock-based compensation

     180        1,974        4,703        10,159        1,742        4,782   

Interest expense

     12,606        6,417        7,057        7,119        1,751        1,771   

Interest and other expense (income), net

     143        357        (135     754        99        764   

Depreciation and amortization

     1,394        1,293        1,779        5,044        717        2,285   

Provision for income taxes

     924        3,591        11,626        15,815        282        7,118   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted EBITDA

   $ 17,643      $ 47,667      $ 46,379      $ 81,351      $ 11,202      $ 29,049   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Adjusted EBITDA margin

     24.6     34.1     24.0     22.5     18.3     24.8

 

-57-


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

You should read the following discussion and analysis of our financial condition and results of operations together with the consolidated financial statements and related notes that are included elsewhere in this prospectus. This discussion contains forward-looking statements based upon current plans, expectations and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and in other parts of this prospectus.

Overview

We are a leading supplier of cloud networking solutions that use software innovations to address the needs of large-scale Internet companies, cloud service providers and next-generation data centers for enterprises, based on market share. Our cloud networking solutions consist of our Extensible Operating System, or EOS, a set of network applications and our 10/40/100 Gigabit Ethernet switches. Our cloud networking solutions deliver industry-leading performance, scalability, availability, programmability, automation and visibility. Since we began shipping our products, we have grown rapidly, and, according to Crehan Research, we have achieved the second largest market share in data center 10/40/100 Gigabit Ethernet switch ports, excluding blade switching, sold in 2013.

At the core of our cloud networking platform is EOS, which was purpose-built to be fully programmable and highly modular. The programmability of EOS has allowed us to create a set of software applications that address the requirements of cloud networking, including workflow automation, network visibility and analytics, and has also allowed us to rapidly integrate with a wide range of third-party applications for virtualization, management, automation, orchestration and network services.

We were founded in 2004 to address the limitations of legacy networking products and to create a cloud networking platform that is open and programmable. From 2004 to 2008, our activities were focused on the development of our software, which resulted in the commercial release of our first product, the 7100 Series switches based on our EOS software, in 2008. Since then, we have continued to introduce new products utilizing EOS, including our 7500 Series switch and our 7050 Series switch in 2010, the second generation of our 7500 Series switch, called the 7500E modular switch, in May 2013 and our 7300 Series switch in November 2013. As of March 31, 2014, we have shipped more than two million switch ports. As we have grown our portfolio of products, our business has also grown from over 100 employees as of December 31, 2010 to more than 850 employees as of March 31, 2014.

We have experienced rapid revenue growth over the last several years, increasing our revenue at a compound annual growth rate of 71.4% from 2010 to 2013. As we have grown the functionality of our EOS software, expanded the range of our switching portfolio and increased the size of our sales force, our revenue has continued to grow rapidly. To support revenue growth, we have increased our international presence to include offices in nine countries as of March 31, 2014, including Canada, China, India, Ireland, Japan, South Korea, Malaysia, Singapore and Taiwan. Our 2013 revenue grew 86.8% when compared to 2012. Our revenue for the three months ended March 31, 2014 was $117.2 million, an increase of 91.1% when compared to the same period in 2013. We have been profitable and cash flow positive for each year since 2010.

We believe that our cloud networking platform addresses the large and growing cloud networking segment of data center switching, which remains in the early stage of adoption. We expect to continue rapidly growing our organization to meet the needs of new and existing customers as they increasingly realize the performance and cost benefits of our cloud networking solutions and as they expand their cloud networks. We intend to continue to invest in our research and development organization to enhance the functionality of our existing cloud networking platform, introduce new products and features and build upon our technology leadership. We believe one of our greatest strengths lies in our rapid development of new features and applications. By investing in research and development, we believe we will be well positioned to continue our rapid growth and take

 

-58-


Table of Contents

advantage of our large market opportunity. We also intend to continue to expand our sales and marketing teams and programs, with a particular focus on expanding our network of international channel partners and carrying out associated marketing activities in key geographies. In order to support our strong growth, we have accelerated our investment in infrastructure, such as enterprise resource planning software and other technologies to improve the efficiency of our operations. As a result, we expect our levels of operating profit could decline in the short to medium term. For a description of factors that may impact our future performance, see the disclosure in the section titled “—Factors Affecting Our Performance” below.

For 2011, 2012 and 2013, our revenue was $139.8 million, $193.4 million and $361.2 million, respectively, and our net income was $34.0 million, $21.3 million and $42.5 million, respectively. For the three months ended March 31, 2013 and 2014, our revenue was $61.3 million and $117.2 million, respectively, and our net income was $6.6 million and $12.3 million, respectively.

Our Business Model

We derive revenue from sales of products and services. We generate revenue primarily from sales of our switching products which incorporate our EOS software. We also generate services revenue from post contract support, or PCS, which end customers typically purchase in conjunction with our products.

Since shipping our first products in 2008, our cumulative end-customer base has grown rapidly. Between December 31, 2010 and March 31, 2014, our cumulative end-customer base grew from approximately 570 to approximately 2,500. Our end customers span a range of industries and include large Internet companies, service providers, financial services organizations, government agencies, media and entertainment companies and others.

To continue to grow our revenue, it is important that we both obtain new customers and sell additional products to existing customers. For example during the year ended December 31, 2013, approximately 85.2% of our revenue was received from our existing end customers.

Our development model is focused on the development of new products based on our EOS software and enhancements to EOS. We engineer our products to be agnostic to the underlying merchant silicon architecture. Today, we combine our EOS software with merchant silicon into a family of switching products. This enables us to focus our research and development resources on our software core competencies and to leverage the investments made by merchant silicon vendors to achieve cost-effective solutions. We currently procure certain merchant silicon components from multiple vendors, and we continue to expand our relationships with these and other vendors. We work closely with third parties to manufacture and deliver our products. Our third-party silicon vendors deliver these components directly to our contract manufacturers, who manufacture and assemble our products and deliver them to us for labeling, quality assurance testing, final configuration and shipment to our customers.

We market and sell our products through our direct sales force and in partnership with channel partners, including distributors, value-added resellers, systems integrators, original equipment manufacturer, or OEM, partners and in conjunction with various technology partners, depending on the application. To facilitate channel coordination and increase productivity, we have created a partner program, the Arista Partner Program, to engage partners who provide value-added services and extend our reach into the marketplace. Authorized training partners provide technical training to our channel partners. Our partners commonly receive an order from an end customer prior to placing an order with us, and we confirm the identification of the end customer prior to accepting such orders. Our partners generally do not stock inventory received from us. Our sales organization is supported by systems engineers with deep technical expertise and responsibility for pre-sales technical support and engineering for our end customers. Each sales team is responsible for a geographic territory, has responsibility for a number of major direct end-customer accounts or has assigned accounts in a specific vertical market. During the year ended December 31, 2013 and for the three months ended March 31, 2014, 83.8% and 83.0% of our revenue was generated from the Americas, substantially all from the United States, 10.8% and 9.9% from Europe, the Middle East and Africa and 5.4% and 7.1% from the Asia-Pacific region, respectively.

 

-59-


Table of Contents

Non-GAAP Financial Measures

We use the financial measures set forth below, which are non-GAAP financial measures, to help us analyze our financial results, establish budgets and operational goals for managing our business and evaluate our performance. We also believe that the presentation of these non-GAAP financial measures provides an additional tool for investors to use in comparing our core business and results of operations over multiple periods with other companies in our industry, many of which present similar non-GAAP financial measures to investors.

 

     Year Ended December 31,     Three Months Ended
March 31,
 
     2011     2012     2013     2013     2014  
     (in thousands, except percentages)  

Non-GAAP gross profit

   $ 96,576      $ 132,426      $ 238,946      $ 42,195      $ 81,525   

Non-GAAP gross margin

     69.1     68.5     66.1     68.8     69.6

Non-GAAP income from operations

   $ 46,374      $ 44,600      $ 76,307      $ 10,485      $ 26,764   

Non-GAAP operating margin

     33.2     23.1     21.1     17.1     22.8

Adjusted EBITDA

   $ 47,667      $ 46,379      $ 81,351      $ 11,202      $ 29,049   

Adjusted EBITDA margin

     34.1     24.0     22.5     18.3     24.8

Non-GAAP gross profit and margin. We define non-GAAP gross profit as gross profit as reported on our consolidated statements of operations, excluding the impact of stock-based compensation, which is a non-cash charge. We define non-GAAP gross margin as non-GAAP gross profit divided by revenue. We have presented non-GAAP gross profit and margin because we believe that the exclusion of stock-based compensation allows for more accurate comparisons of our results of operations to other companies in our industry. Please see “Selected Consolidated Financial Data—Non-GAAP Financial Measures” for information regarding the limitations of using non-GAAP gross profit and gross margin as financial measures and for a reconciliation of non-GAAP gross profit to gross profit, the most directly comparable financial measure calculated in accordance with GAAP.

Non-GAAP income from operations and operating margin. We define non-GAAP income from operations as income from operations as reported on our consolidated statements of operations, excluding the impact of stock-based compensation. We define non-GAAP operating margin as non-GAAP income from operations divided by revenue. We have presented non-GAAP income from operations and operating margin because we believe that the exclusion of stock-based compensation allows for more accurate comparisons of our results of operations to other companies in our industry. Please see “Selected Consolidated Financial Data—Non-GAAP Financial Measures” for information regarding the limitations of using non-GAAP income from operations and operating margin as financial measures and for a reconciliation of non-GAAP income from operations to income from operations, the most directly comparable financial measure calculated in accordance with GAAP.

Adjusted EBITDA and adjusted EBITDA margin. We define adjusted EBITDA as our net income excluding: (i) stock-based compensation; (ii) interest expense; (iii) other income (expense), net, which primarily includes foreign exchange gains and losses; (iv) depreciation and amortization; and (v) our provision for income taxes. We define adjusted EBITDA margin as adjusted EBITDA divided by revenue. Depreciation includes depreciation expense associated with our leased building in Santa Clara, California. See Note 6 to our consolidated financial statements appearing elsewhere in this prospectus for an explanation of the accounting for our build-to-suit lease. We have presented adjusted EBITDA and adjusted EBITDA margin because they are key measures used by our management and board of directors to understand and evaluate our operating performance, to establish budgets and to develop operational goals for managing our business. In particular, we believe that the exclusion of the expenses eliminated in calculating adjusted EBITDA can provide a useful measure for period-to-period comparisons of our core operating performance. Please see “Selected Consolidated Financial Data—Non-GAAP Financial Measures” for information regarding the limitations of using adjusted EBITDA and adjusted EBITDA margin as financial measures and for a reconciliation of adjusted EBITDA to net income, the most directly comparable financial measure calculated in accordance with GAAP.

 

-60-


Table of Contents

Factors Affecting Our Performance

We believe that our future success will depend on many factors, including our ability to expand sales to our existing customers as well as to add new end customers. While these areas present significant opportunity, they also present risks that we must manage to ensure successful results. See the section titled “Risk Factors.” Additionally, we face intense competition especially from larger, well-established companies, and we must continue to expand the capabilities of our cloud networking platform to succeed in our market. If we are unable to address these challenges, our business could be adversely affected.

Increasing Adoption of Cloud Networks. Networks are subject to increasing performance requirements due to growing numbers of connected devices as well as new enterprise and consumer applications. Computing architectures are evolving to meet the need for constant connectivity and access to data and applications. We believe that cloud networks will continue to replace legacy network technologies. Our business and results of operations will be significantly affected by the speed with which organizations implement cloud networks.

Expanding Sales to Existing Customer Base. We expect that a substantial portion of our future sales will be follow-on sales to existing end customers. As noted above, one of our sales strategies is to target specific projects at our current end customers because they are familiar with the operational and economic benefits of our cloud networking solutions, thereby reducing the sales cycle into these customers. We believe this opportunity with current end customers to be significant given their existing and expected infrastructure spend. As of December 31, 2013, our end customers that have been with us for at least 2 years, on average made additional purchases that were approximately 9.3x more than the initial dollar amount of purchases made in the first two quarters of their purchasing history. The first 2 quarters of purchasing are typically the beginning of switch procurement for a given deployment and typically do not include time spent during initial customer testing, as most customer testing is done prior to initial purchase. Although the additional purchases for our Top 10 end customers were significantly more than our overall average, the remainder of the end customer base also showed a propensity to continue purchasing with average additional purchases of 5.2x the initial dollar purchases made in the first two quarters of their purchasing history. This analysis is based on billings, which represent amounts invoiced to customers for products shipped, or for services rendered or to be rendered, and that the vast majority of billings for any given period represent revenue, and to a far lesser extent deferred revenue. Our business and results of operations will depend on our ability to sell additional products to our growing base of customers.

Adding New End Customers. We believe that the cloud networking market is still in the early stages of adoption. We intend to target new end customers by continuing to invest in our field sales force and extending our relationships with channel partners. To date, we have primarily targeted end customers with the largest cloud data centers. A typical initial order involves the education of prospective customers about the technical merits and capabilities and potential cost savings of our products as compared to our competitors’ products. Our results of operations will depend on our ability to continue to add new customers. We believe that customer references have been, and will continue to be, an important factor in winning new business.

Selling More Complex and Higher-Performance Configurations. Our results of operations have been, and we believe will continue to be, affected by our ability to sell more complex and higher-performance configurations of our products. Going forward, we aim to grow our revenue by enabling end customers to transition from previously deployed 1 Gigabit Ethernet switches to 10, 40 and eventually 100 Gigabit Ethernet switches. Our ability to sustain our revenue growth will depend, in part, upon our continued sales of more robust configurations of our products, and quarterly results of operations can be significantly impacted by the mix of products and product configurations sold during the period.

Leveraging Channel Partners. We expect to continue to derive a growing portion of our sales through our channel partners as they develop new end customers and expand sales to our existing end customers. We plan to continue to invest in our network of channel partners to empower them to reach new end customers more effectively, increase sales to existing customers and provide services and support effectively. We believe that

 

-61-


Table of Contents

increasing channel leverage will extend and improve our engagement with a broad set of customers. Our business and results of operations will be materially affected by our success in leveraging our channel partners.

Investing in Research and Development for Growth. We believe that the market for cloud networking is still in the early stages of adoption and we intend to continue investing for long-term growth. We expect to continue to invest heavily in software development in order to expand the capabilities of our cloud networking platform, introduce new products including new releases and upgrades to our EOS software and new applications and build upon our technology leadership. We believe one of our greatest strengths lies in the speed of our product development efforts. By investing in research and development, we believe we will be well positioned to continue our rapid growth and take advantage of our large market opportunity. We expect that our results of operations will be impacted by the timing and size of these investments.

Customer Concentration and Timing of Large Orders. During the years ended December 31, 2011, 2012 and 2013, and the three months ended March 31, 2013 and 2014, sales to our 10 largest end customers accounted for approximately 32.4%, 39.3%, 43.0%, 42.3% and 44.6% of our revenue, respectively. During the years ended December 31, 2011, 2012 and 2013, and the three months ended March 31, 2013 and 2014, our largest end customer accounted for 10.4%, 15.3%, 21.9%, 12.5% and 24.7% of our revenue, respectively. We have also experienced and continue to experience customer concentration on a quarterly basis. In addition, we have experienced increases in the size of our orders, including orders from existing customers, which could result in future increased customer concentration, depending on the timing of the fulfillment of those orders. We have also experienced unpredictability in the timing of large orders, especially with respect to our large end customers, due to the complexity of orders, the time it takes end customers to evaluate, test and qualify our products and factors specific to our end customers. Due to these factors, we expect continued variability in our customer concentration and timing of sales on a quarterly and annual basis. In addition, we have provided, and may in the future provide, pricing discounts to large end customers, which may result in lower margins for the period in which such sales occur. Our gross margins may also fluctuate as a result of the timing of such sales to large end customers.

Basis of Presentation

Revenue

We generate revenue primarily from sales of our switching products which incorporate our EOS software. We also derive a small but growing portion of our revenue from sales of PCS. We generate PCS revenue from sales of technical support services contracts that are typically purchased in conjunction with our products and subsequent renewals of those contracts. We offer PCS services under renewable, fee-based contracts, which include 24-hour technical support, hardware repair and replacement parts, bug fixes, patches and unspecified upgrades on a when-and-if available basis. We expect our revenue may vary from period to period based on, among other things, the timing and size of orders and delivery of products, the impact of significant transactions with unique terms and conditions that may require deferral of revenue and cyclicality of orders being placed by our customers. Additionally, we expect our PCS revenue to increase in absolute dollars as we expand our installed base. Our ability to expand our installed base and increase our revenue is subject to numerous risks and uncertainties. See the section titled “Risk Factors.” We report revenue net of sales taxes.

Cost of Revenue

Cost of revenue primarily consists of amounts paid to our third-party contract manufacturers and merchant silicon vendors, warranty expenses, excess inventory write-offs and personnel and other costs in our manufacturing operations department. Our cost of product revenue also includes product testing costs, allocated costs and shipping costs. We expect our cost of product revenue to increase as our product revenue increases. Cost of providing PCS services consists of personnel costs for our global customer support organization. We expect our cost of service revenue to increase as our PCS revenue increases.

 

-62-


Table of Contents

Gross Margin

Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including sales to large end customers who generally receive lower pricing, the average sales price of our offerings, manufacturing costs, merchant silicon costs and the mix of products sold. We expect our gross margins to fluctuate over time, depending on the factors described above and others. See the section titled “Risk Factors.”

Operating Expenses

Our operating expenses consist of research and development, sales and marketing and general and administrative expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of wages, benefits, bonuses and, with respect to sales and marketing expenses, sales commissions. Personnel costs also include stock-based compensation and travel expenses. We expect operating expenses to continue to increase in absolute dollars as well as a percentage of revenue in the near term as we continue to invest in the growth of our business.

Research and Development Expenses

Research and development expenses consist primarily of personnel costs, with the remainder being prototype expenses, third-party engineering and contractor support costs, an allocated portion of facility and IT costs and depreciation. Our research and development efforts are focused on maintaining and developing additional functionality for our existing products and on new product development, including new releases and upgrades to our EOS software and applications. We expense research and development costs as incurred. We expect our research and development expenses to increase in absolute dollars as well as a percentage of revenue as we continue to invest heavily in software development in order to expand the capabilities of our cloud networking platform, introduce new products and features and build upon our technology leadership.

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of personnel costs and also include costs related to marketing and promotional activities, with the remainder being an allocated portion of facility and IT costs and depreciation. We expect our sales and marketing expenses to increase in absolute dollars and may fluctuate as a percentage of revenue from period to period as we expand our sales and marketing efforts worldwide and expand our relationships with current and future channel partners and end customers.

General and Administrative Expenses

General and administrative expenses consist primarily of personnel costs, professional fees, an allocated portion of facility and IT costs and depreciation. General and administrative personnel costs include those for our executive, finance, IT, human resources and legal functions. Our professional fees consist primarily of accounting, external legal and IT and other consulting costs. We expect our general and administrative expenses to increase in absolute dollars as well as a percentage of revenue to support our growing infrastructure needs and as we assume the reporting requirements and compliance obligations of a public company.

Other Income (Expense), Net

Interest Expense

Interest expense consists of interest expense on our convertible promissory notes, including our related party convertible promissory notes.

 

-63-


Table of Contents

Other Income (Expense), net

Other income (expense), net consists primarily of foreign currency exchange gains and losses. Our foreign currency exchange gains and losses relate to transactions and asset and liability balances denominated in currencies other than the U.S. dollar. We expect our foreign currency gains and losses to continue to fluctuate in the future due to changes in foreign currency exchange rates.

Provision for Income Taxes

We operate in a number of tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may be subject to U.S. income tax. Generally, the U.S. taxes are reduced by a credit for foreign income taxes paid on these earnings which avoids double taxation. Our tax expense to date consists of federal, state and foreign current and deferred income taxes. As we expand internationally, our marginal tax rate may decrease; however, there can be no certainty that our marginal tax rate will decrease, and we may experience changes in tax rates that are not reflective of actual changes in our business or operations.

We account for income taxes under the liability approach for deferred income taxes, which requires recognition of deferred income tax assets and liabilities for the expected future tax consequences of events that have been recognized in our consolidated financial statements but have not been reflected in our taxable income. Estimates and judgments occur in the calculation of certain tax liabilities and in the determination of the recoverability of certain deferred income tax assets, which arise from temporary differences and carryforwards. We measure deferred income tax assets and liabilities using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. We regularly assess the likelihood that our deferred income tax assets will be realized based on the positive and negative evidence available. We record a valuation allowance to reduce the deferred tax assets to the amount that we are more likely than not to realize.

We believe that we have adequately reserved for our uncertain tax positions, although we can provide no assurance that the final tax outcome of these matters will not be materially different. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made and could have a material impact on our financial condition and results of operations. The provision for income taxes includes the effects of any reserves that we believe are appropriate, as well as the related net interest and penalties.

 

-64-


Table of Contents

Results of Operations

The following table summarizes historical results of operations for the periods presented and as a percentage of revenue for those periods. We have derived the data for the years ended December 31, 2011, 2012 and 2013 from our audited consolidated financial statements included elsewhere in this prospectus. We have derived the data for the three months ended March 31, 2013 and 2014 from our unaudited consolidated financial statements included elsewhere in this prospectus.

 

     Year Ended December 31,     Three Months Ended
March 31,
 
            2011                   2012            2013     2013     2014  
            
    

(in thousands)

 

Consolidated Statements of Operations Data:

          

Revenue

   $ 139,848      $ 193,408      $ 361,224      $ 61,348      $ 117,207   

Cost of revenue(1)

     43,366        61,252        122,686        19,220        35,893   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     96,482        132,156        238,538        42,128        81,314   

Operating expenses(1):

          

Research and development

     26,408        55,155        98,587        19,514        33,446   

Sales and marketing

     19,450        28,603        55,115        10,135        18,655   

General and administrative

     6,224        8,501        18,688        3,736        7,231   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     52,082        92,259        172,390        33,385        59,332   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     44,400        39,897        66,148        8,743        21,982   

Other income (expense), net:

          

Interest expense

     (6,417     (7,057     (7,119     (1,751     (1,771

Other income (expense), net

     (357     135        (754     (99     (764
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other income (expense), net

     (6,774     (6,922     (7,873     (1,850     (2,535
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before provision for income taxes

     37,626        32,975        58,275        6,893        19,447   

Provision for income taxes

     3,591        11,626        15,815        282        7,118   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 34,035      $ 21,349      $ 42,460      $ 6,611      $ 12,329   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

-65-


Table of Contents
     Year Ended December 31,     Three Months
Ended
March 31,
 
     2011     2012     2013     2013     2014  
     (as a percentage of revenue)  

Revenue

     100.0     100.0     100.0     100.0     100.0

Cost of revenue

     31.0        31.7        34.0        31.3        30.6   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross margin

     69.0        68.3        66.0        68.7        69.4   

Operating expenses:

          

Research and development

     18.9        28.5        27.3        31.8        28.5   

Sales and marketing

     13.9        14.8        15.2        16.5        15.9   

General and administrative

     4.5        4.4        5.2        6.1        6.2   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     37.3        47.7        47.7        54.4        50.6   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) from operations

     31.7        20.6        18.3        14.3        18.8   

Other income (expense), net:

          

Interest expense

     (4.6     (3.6     (2.0     (2.9     (1.5

Other income (expense), net

     (0.2            (0.2     (0.2     (0.7
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other income (expense), net

     (4.8     (3.6     (2.2     (3.1     (2.2
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before provision for income taxes

     26.9        17.0        16.1        11.2        16.6   

Provision for income taxes

     2.6        6.0        4.4        0.4        6.1   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     24.3     11.0     11.7     10.8     10.5
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Includes stock-based compensation expense as follows:

 

     Year Ended December 31,      Three Months
Ended March 31,
 
         2011              2012          2013      2013      2014  
     (in thousands)  

Stock-Based Compensation Expense:

        

Cost of revenue

   $ 94       $ 270       $ 408       $ 67       $ 211   

Research and development

     992         2,590         5,464         996        
2,467
  

Sales and marketing

     554         1,078         2,985         482         1,428   

General and administrative

     334         765         1,302         197         676   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total stock-based compensation expense

   $ 1,974       $ 4,703       $ 10,159         1,742         4,782   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Three Months Ended March 31, 2013 Compared to Three Months Ended March 31, 2014

Revenue, Cost of Revenue and Gross Profit

 

     Three Months Ended March 31,               
     2013     2014     Change in  
     $     % of
revenue
    $     % of
revenue
    $      %  
     (in thousands, except percentages)  

Revenue

   $ 61,348        100.0   $ 117,207        100.0   $ 55,859         91.1

Cost of revenue

     19,220        31.3        35,893        30.6        16,673         86.8   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Gross profit

   $ 42,128        68.7   $ 81,314        69.4   $ 39,186         93.0
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Gross margin

     68.7       69.4       

 

-66-


Table of Contents

Revenue. Revenue increased $55.9 million, or 91.1%, for the three months ended March 31, 2014 compared to the same period in 2013. The increase in revenue predominantly included an increase in sales of switch products and related accessories of $48.5 million, or 85.1%, primarily to existing customers, and, to a lesser extent, new customers. The increase in product revenue was largely driven by the number of switch ports shipped which increased by 69.5% during the three months ended March 31, 2014 compared to the same period in 2013, as well as an increase of $8.1 million from the recognition of a large order that we previously recorded as deferred revenue. Our cumulative number of customers grew approximately 40.7% from March 31, 2013 to March 31, 2014.

Cost of revenue. Cost of revenue increased $16.7 million, or 86.8%, for the three months ended March 31, 2014 compared to the same period in 2013. The increase in cost of revenue was primarily due to the corresponding increase in revenue as our shipment volume significantly increased during the three months ended March 31, 2014 resulting in an increase in product costs of $15.4 million in the three months ended March 31, 2014 compared to the same period in 2013.

Gross margin. Gross margin increased from 68.7% for the three months ended March 31, 2013 to 69.4% compared to the same period in 2014. Gross margins were favorably impacted in the three months ended March 31, 2014 by a $2.2 million benefit resulting from a cash settlement received from one of our suppliers due to a product defect issue. The positive impact to gross margin was mostly offset by an increase in manufacturing overhead costs of $1.2 million to support the growth in production, and, to a lesser extent, an increase in the size of contracts with large end customers having lower margins.

Operating Expenses

 

     Three Months Ended,               
     2013     2014     Change in  
     $      % of
revenue
    $      % of
revenue
    $      %  
     (in thousands, except percentages)  

Operating expenses:

               

Research and development

   $ 19,514         31.8   $ 33,446         28.5   $ 13,932         71.4

Sales and marketing

     10,135         16.5        18,655         15.9        8,520         84.1   

General and administrative

     3,736         6.1        7,231         6.2        3,495         93.6   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

Total operating expenses

   $ 33,385         54.4   $ 59,332         50.6   $ 25,947         77.7
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

Research and development. Research and development expenses increased $13.9 million, or 71.4%, for the three months ended March 31, 2014 compared to the same period in 2013. The increase was primarily due to an increase in personnel costs of $8.6 million, resulting from an increase of 177 employees, or 52.5%, and the introduction of a corporate bonus plan in 2014. The increase was also due to a $2.4 million increase in development-related facilities and IT infrastructure expenses, a $2.0 million increase in prototype expenses and a $1.1 million increase in third-party engineering costs as we continued to expand our research and development activities.

Sales and marketing. Sales and marketing expenses increased $8.5 million, or 84.1%, for the three months ended March 31, 2014 compared to the same period in 2013. The increase was primarily due to an increase in personnel costs of $6.8 million, resulting from an increase of 88 employees, or 65.2%. The increase was also due to an increase of $1.0 million related to costs associated with pre-sale and proof of concept activities, product demonstrations and other marketing activities, and a $0.6 million increase in sales and marketing-related facilities and IT infrastructure expenses.

General and administrative. General and administrative expenses increased $3.5 million, or 93.6%, for the three months ended March 31, 2014 compared to the same period in 2013. The increase was primarily due to an increase in professional service fees of $1.9 million related to outside legal, accounting, consulting and IT

 

-67-


Table of Contents

services to support increased business activity and preparations for becoming a public company. The increase was also due to a $1.6 million increase in personnel costs, resulting from an increase of 34 employees, or 94.4%.

Other Income (Expense), Net

 

     Three Months Ended
March 31,
    Change in  
     2013     2014     $     %  
     (in thousands, except percentages)  

Other income (expense), net:

        

Interest expense

   $ (1,751   $ (1,771   $ (20     1.1

Other income (expense), net

     (99     (764     (665     NM   
  

 

 

   

 

 

   

 

 

   

Total other income (expense), net

   $ (1,850   $ (2,535   $ (685     37.0
  

 

 

   

 

 

   

 

 

   

Interest expense. Interest expense was consistent for the three months ended March 31, 2014 compared to the same period in 2013.

Other income (expense), net. Other income (expense), net decreased $0.7 million for the three months ended 2014, compared to the same period in 2013.

Provision for Income Taxes

 

     Three Months
Ended March 31,
    Change in  
     2013     2014     $      %  
     (in thousands, except percentages)  

Provision for income taxes

   $ 282      $ 7,118      $ 6,836         NM   

Effective tax rate

     4.1     36.6     

Provision for income taxes. Provision for income taxes increased $6.8 million, for the three months ended March 31, 2014 compared to the same period in 2013, and our effective tax rate increased 32.5 percentage points to 36.6%. The increase in the effective tax rate was primarily due to the beneficial impact of the passage of the American Tax Relief Act of 2012 signed into law on January 2, 2013, which reinstated the federal research and development credit. The prior year impact of the 2012 federal research and development tax credit benefit was recorded in the three months ended March 31, 2013. The federal research and development credit lapsed at the beginning of 2014, which led to a higher effective tax rate during the three months ended March 31, 2014, compared to the same period in 2013.

Year Ended December 31, 2013 Compared to Year Ended December 31, 2012

Revenue, Cost of Revenue and Gross Profit

 

     Year Ended December 31,        
     2012     2013     Change in  
     $     % of
revenue
    $     % of
revenue
    $      %  
     (in thousands, except percentages)  

Revenue

   $ 193,408        100.0   $ 361,224        100.0   $ 167,816         86.8

Cost of revenue

     61,252        31.7        122,686        34.0        61,434         100.3   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

Gross profit

   $ 132,156        68.3   $ 238,538        66.0   $ 106,382         80.5
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

Gross margin

     68.3       66.0       

 

-68-


Table of Contents

Revenue. Revenue increased $167.8 million, or 86.8%, for the year ended December 31, 2013 compared to 2012. The increase in revenue predominantly included an increase in sales of switch products and related accessories of $153.2 million, or 85.3%, primarily to existing customers as these customers purchased our newer products to further evolve their data centers. Our revenue also increased to a lesser extent due to sales to new customers. The increase in product revenue was largely driven by number of switch ports shipped which increased by 109.2%, during 2013 compared to the prior year. This increase was partially offset by a reduction of 10% in the average selling price per port shipped. The decrease in the average selling price per port was primarily attributable to lower pricing terms for sales to our large end customers. Our cumulative number of customers grew approximately 43.2% from December 31, 2012 to December 31, 2013 as we continued to broaden our market penetration.

Cost of revenue. Cost of revenue increased $61.4 million, or 100.3%, for the year ended December 31, 2013 compared to 2012. The increase in cost of revenue was primarily due to the corresponding increase in revenue as our shipment volume significantly increased during the year ended December 31, 2013 resulting in an increase in product costs of $46.5 million in 2013 compared to 2012. The increase was also due to an increase of $1.8 million in excess and obsolete material charges for non-cancelable and non-returnable purchase commitments by our third-party contract manufacturers, as well as an increase in write-downs of excess and obsolete inventory of $2.1 million from the introduction of new products and product enhancements We also experienced an increase in manufacturing overhead costs of $4.3 million to support the growth in production during the year ended 2013.

Gross margin. Gross margin decreased approximately two percentage points from 68.3% for the year ended December 31, 2012 to 66.0% for 2013. The decrease in gross margin was primarily due to an increase in excess and obsolete inventory and material charges noted above totaling $3.9 million, and an increase in manufacturing overhead costs of $4.3 million. The decrease was also due, to a lesser extent, to an increase in the size of contracts with large end customers with lower margins, which was partially offset by cost reductions primarily due to more favorable component pricing from our contract manufacturers as we increased volume.

Operating Expenses

 

     Year Ended December 31,        
     2012     2013     Change in  
     $      % of
revenue
    $      % of
revenue
    $      %  
     (in thousands, except percentages)  

Operating expenses:

               

Research and development

   $ 55,155         28.5   $ 98,587         27.3   $ 43,432         78.7

Sales and marketing

     28,603         14.8        55,115         15.2        26,512         92.7   

General and administrative

     8,501         4.4        18,688         5.2        10,187         119.8   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

Total operating expenses

   $ 92,259         47.7   $ 172,390         47.7   $ 80,131         86.9
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

Research and development. Research and development expenses increased $43.4 million, or 78.7%, for the year ended December 31, 2013 compared to 2012. The increase was primarily due to an increase in personnel costs of $21.8 million, which was a result of an increase of 153 employees (a 50.0% increase) in research and development headcount. The increase was also due to a $10.1 million increase in prototype expenses as a result of new product introductions and an increase in facilities expenses of $4.5 million.

Sales and marketing. Sales and marketing expenses increased $26.5 million, or 92.7%, for the year ended December 31, 2013 compared to 2012. The increase was primarily due to an increase in personnel costs of $19.8 million, which was a result of an increase of 57 employees (a 41.3% increase) in sales and marketing headcount. The increase was also due to an increase of $3.0 million in marketing, consulting and promotional expense related to trade shows, product demonstrations and other marketing activities and an increase in sales and marketing-related IT and system engineering expenses of $2.6 million.

 

-69-


Table of Contents

General and administrative. General and administrative expenses increased $10.2 million, or 119.8%, for the year ended December 31, 2013 compared to 2012. The increase was primarily due to a $5.5 million increase in professional service fees related to outside legal, accounting, consulting and IT services to support increased business activity and preparations for becoming a public company. The increase was also due to a $3.4 million increase in personnel costs, which was a result of an increase of 23 employees (a 67.6% increase) in general and administrative headcount.

Other Income (Expense), Net

 

     Year Ended December 31,     Change in  
         2012             2013         $     %  
     (in thousands, except percentages)  

Other income (expense), net:

        

Interest expense

   $ (7,057   $ (7,119   $ (62     0.9

Other income (expense), net

     135        (754     (889     NM   
  

 

 

   

 

 

   

 

 

   

Total other income (expense), net

   $ (6,922   $ (7,873   $ (951     13.7
  

 

 

   

 

 

   

 

 

   

Interest expense. Interest expense was consistent for the year ended December 31, 2013 compared to 2012.

Other income (expense), net. Other income (expense), net decreased $1.0 million for the year ended December 31, 2013 compared to 2012.

Provision for Income Taxes

 

     Year Ended December 31,     Change in  
         2012             2013         $      %  
     (in thousands, except percentages)  

Provision for income taxes

   $ 11,626      $ 15,815      $ 4,189         36.0

Effective tax rate

     35.3     27.1     

Provision for income taxes. Provision for income taxes increased $4.2 million, or 36.0%, for the year ended December 31, 2013 compared to 2012. Our effective tax rate decreased 8.2 percentage points from 35.3% for the year ended December 31, 2012 to 27.1% for 2013. The decrease in the effective tax rate was primarily due to the beneficial impact of the passage of the American Tax Relief Act of 2012 signed into law on January 2, 2013, which reinstated the federal research and development credit. The prior year impact of the 2012 federal research and development tax credit benefit was recorded in the three months ended March 31, 2013.

Year Ended December 31, 2012 Compared to the Year Ended December 31, 2011

Revenue, Cost of Revenue and Gross Profit

 

     Year Ended December 31,        
     2011     2012     Change in  
     $     % of
revenue
    $     % of
revenue
    $      %  
     (in thousands, except percentages)  

Revenue

   $ 139,848        100.0   $ 193,408        100.0   $ 53,560         38.3

Cost of revenue

     43,366        31.0        61,252        31.7        17,886         41.2   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

Gross profit

   $ 96,482        69.0   $ 132,156        68.3   $ 35,674         37.0
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

Gross margin

     69.0       68.3       

 

-70-


Table of Contents

Revenue. Revenue increased $53.6 million, or 38.3%, in 2012 compared to 2011. The increase in revenue predominantly included an increase in sales of switch products and related accessories of $47.2 million, or 35.6%, primarily to existing customers, as these customers purchased our newer products to further evolve their data centers. Our revenue also increased to a lesser extent due to sales to new customers. The increase in product revenue was largely driven by the number of switch ports shipped, which increased by 77.5% during 2012 compared to the prior year. This increase was partially offset by a reduction of 22.0% in the average selling price per port shipped. The decrease in the average selling price per port was primarily attributable to lower pricing terms for sales to our large customers. Our cumulative number of customers grew approximately 51.4% from December 31, 2011 to December 31, 2012 as we continued to broaden our market penetration.

Cost of revenue. Cost of revenue increased $17.9 million, or 41.2%, in 2012 compared to 2011. The increase in cost of revenue was primarily due to the corresponding increase in revenue as our shipment volume significantly increased during 2012 resulting in an increase in product costs of $9.5 million in 2012 compared to 2011. The increase was also due to increased warranty expenses of $1.6 million and an increase in write-downs of excess and obsolete inventory of $1.6 million from the introduction of new products and product enhancements. We also experienced an increase in manufacturing overhead costs of $1.1 million to support the growth in production during 2012.

Gross margin. Gross margin decreased one percentage point from 69.0% in 2011 to 68.3% in 2012. This decrease in gross margin was primarily due to an increase in our warranty-related expenses of $1.6 million, an increase in write-downs of excess and obsolete inventory of $1.6 million, and an increase in manufacturing overhead costs of $1.1 million. This decrease was also due, to a lesser extent, to an increase in the size of contracts with large end customers with lower margins, which was partially offset by cost reductions primarily due to more favorable component pricing from our contract manufacturers as we increased volume.

Operating Expenses

 

     Year Ended December 31,        
     2011     2012     Change in  
     $      % of
revenue
    $      % of
revenue
    $      %  
     (in thousands, except percentages)  

Operating expenses:

               

Research and development

   $ 26,408         18.9   $ 55,155         28.5   $ 28,747         108.9

Sales and marketing

     19,450         13.9        28,603         14.8        9,153         47.1   

General and administrative

     6,224         4.5        8,501         4.4        2,277         36.6   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

Total operating expenses

   $ 52,082         37.3   $ 92,259         47.7   $ 40,177         77.1
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

Research and development. Research and development expenses increased $28.7 million, or 108.9%, in 2012 compared to 2011. The increase in research and development expenses was primarily due to a $20.6 million increase in personnel costs, which was a result of an increase of 148 employees (a 93.7% increase) in research and development headcount. The increase was also due to a $4.5 million increase in prototype expenses as a result of new product introductions, a $1.5 million increase in third-party engineering and contractor support costs and a $1.7 million increase in research and development-related facilities and IT infrastructure expenses.

Sales and marketing. Sales and marketing expenses increased $9.2 million, or 47.1%, in 2012 compared to 2011. The increase in sales and marketing expenses was primarily due to a $9.3 million increase in personnel costs, which was a result of an increase of 57 employees (a 70.4% increase) in sales and marketing headcount. This increase was partially offset by a decrease in consulting expenses of $0.9 million.

General and administrative. General and administrative expenses increased $2.3 million, or 36.6%, in 2012 compared to 2011. The increase in general and administrative expenses was primarily due to a $1.5 million increase in professional service fees related to outside legal, accounting and consulting services to support

 

-71-


Table of Contents

increased business activity. The increase was also due to a $0.8 million increase in personnel costs, which was a result of an increase of 17 employees (a 100.0% increase), and a $0.6 million increase in facilities expenses. These increases were partially offset by a $1.1 million decrease in our provision for doubtful accounts.

Other Income (Expense), Net

 

     Year Ended December 31,     Change in  
         2011             2012         $     %  
     (in thousands, except percentages)  

Other income (expense), net:

        

Interest expense

   $ (6,417   $ (7,057   $ (640     10.0

Other income (expense), net

     (357     135        492        NM   
  

 

 

   

 

 

   

 

 

   

Total other income (expense), net

   $ (6,774   $ (6,922   $ (148     2.2
  

 

 

   

 

 

   

 

 

   

Interest expense. Interest expense increased $0.6 million, or 10.0%, in 2012 compared to 2011. The increase in interest expense was due to the sale of $100.0 million in convertible promissory notes during 2011, partially offset by the repayment of the outstanding principal on our related party convertible promissory notes of $55.6 million in 2011.

Other income (expense), net. Other income (expense), net increased $0.5 million in 2012 compared to 2011.

Provision for Income Taxes

 

     Year Ended December 31,     Change in  
         2011             2012         $      %  
     (in thousands, except percentages)  

Provision for income taxes

   $ 3,591      $ 11,626      $ 8,035         223.8

Effective tax rate

     9.5     35.3     

Provision for income taxes. Provision for income taxes increased $8.0 million, or 223.8%, in 2012 compared to 2011. Our effective tax rate increased 25.8 percentage points from 9.5% in 2011 to 35.3% in 2012. The increase in our provision for income taxes as well as our effective tax rate was due to the release of our valuation allowance on our federal deferred tax assets during 2011 coupled with the lapse of the federal research and development credit during 2012.

 

-72-


Table of Contents

Quarterly Results of Operations

The following tables set forth selected unaudited quarterly statements of operations data for each of the five quarters in the period ended March 31, 2014, as well as the percentage of revenue that each line item represents for each such quarter. The information for each of these quarters has been prepared on the same basis as the annual audited financial statements included elsewhere in this prospectus and, in the opinion of management, includes all adjustments, which includes only normal recurring adjustments, necessary for the fair presentation of the results of operations for these periods in accordance with generally accepted accounting principles in the United States. This data should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this prospectus. These quarterly operating results are not necessarily indicative of our operating results for a full year or any future period.

 

     Three Months Ended  
     Mar. 31,
2013
    Jun. 30,
2013
    Sep. 30,
2013
    Dec. 31,
2013
    Mar. 31,
2014
 
     (in thousands)  

Consolidated Statements of Operations Data:

          

Revenue

   $ 61,348      $ 83,485      $ 101,625      $ 114,766      $ 117,207   

Cost of revenue

     19,220        29,584        36,589        37,293        35,893   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     42,128        53,901        65,036        77,473        81,314   

Operating expenses:

          

Research and development

     19,514        21,086        26,635        31,352        33,446   

Sales and marketing

     10,135        13,045        14,523        17,412        18,655   

General and administrative

     3,736        3,506        5,242        6,204        7,231   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     33,385        37,637        46,400        54,968        59,332   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     8,743        16,264        18,636        22,505        21,982   

Other income (expense), net:

          

Interest expense

     (1,751     (1,772     (1,797     (1,799     (1,771

Other income (expense), net

     (99     (1     (23     (631     (764
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other income (expense), net

     (1,850     (1,773     (1,820     (2,430     (2,535
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before provision for income taxes

     6,893        14,491        16,816        20,075        19,447   

Provision for income taxes

     282        4,240        4,960        6,333        7,118   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 6,611      $ 10,251      $ 11,856      $ 13,742      $ 12,329   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

-73-


Table of Contents
     Three Months Ended  
     Mar. 31,
2013
    Jun. 30,
2013
    Sep. 30,
2013
    Dec. 31,
2013
    Mar. 31,
2014
 
     (As a percentage of revenue)  

Consolidated Statements of Operations Data:

          

Revenue

     100     100     100     100     100

Cost of revenue

     31.3        35.4        36.0        32.5        30.6   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross margin

     68.7        64.6        64.0        67.5        69.4   

Operating expenses:

          

Research and development

     31.8        25.3        26.2        27.3        28.5   

Sales and marketing

     16.5        15.6        14.3        15.2        15.9   

General and administrative

     6.1        4.2        5.2        5.4        6.2   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     54.4        45.1        45.7        47.9        50.6   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     14.3        19.5        18.3        19.6        18.8   

Other income (expense), net:

          

Interest expense

     (2.9 )      (2.1 )      (1.8 )      (1.6     (1.5

Other income (expense), net

     (0.2 )                    (0.5     (0.7
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other income (expense), net

     (3.1     (2.1     (1.8     (2.1     (2.2

Income before provision for income taxes

     11.2        17.4        16.5        17.5        16.6   

Provision for income taxes

     0.4        5.1        4.8        5.5        6.1   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     10.8 %      12.3 %      11.7 %      12.0     10.5
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Quarterly Revenue Trends

Our revenue increased in each quarter throughout 2013 and during the three months ended March 31, 2014. The increase in revenue was due to an increase in sales of our switch products and related accessories to existing and new customers. We increased our market penetration during the year by increasing sales and growing our cumulative customer base by approximately 43.2% from December 31, 2012 to December 31, 2013. During the quarter ended June 30, 2013, revenue increased by 36.1% from the prior quarter, which was primarily driven by increased sales to our largest customer, coupled with the introduction of new products and an increase in sales of existing products. The number of switch ports shipped and the average selling price per port increased by 32.5% and 8.7%, respectively, during the quarter ended June 30, 2013, as compared to the quarter ended March 31, 2013. Sales continued to increase for the remainder of 2013 and during the first quarter of 2014 as our new and existing products continued to gain market acceptance. We believe that our rapid growth has reduced the impact of seasonal or cyclical trends that might have influenced our business to date and believe that seasonal variations in our business may become more pronounced over time. Historical patterns in our business may not be a reliable indicator of our future sales activity or performance.

Quarterly Gross Margin Trends

Gross profit increased sequentially quarter over quarter, while our total quarterly gross margins ranged from 64.0% to 69.4% during the periods presented. Our cost of revenue increased during the periods presented primarily due to corresponding increases in revenue as shipment volumes increased. During the quarters ended June 30 and September 30, 2013, the decline in gross margins was primarily due to an increase in write-downs of excess and obsolete inventory driven by the introduction of new products and increased manufacturing overhead costs to support the growth in production. The gross margins during the June and September quarters were also impacted by sales to high-volume customers which tend to receive volume-related discounts.

Quarterly Expense Trends

Total operating expenses increased sequentially during the year primarily due to the addition of personnel in connection with the expansion of our business. Research and development expense increased sequentially over

 

-74-


Table of Contents

the year as we increased headcount and prototype expenses to support investment in new products. Sales and marketing expenses increased sequentially over the year primarily due to an increase in personnel costs related to expansion of the sales and marketing teams worldwide and increased marketing activities. General and administrative expenses rose in the second half of the year primarily due to an increase in professional service fees related to outside legal, accounting, consulting and IT services, as well as an increase in personnel costs, to support business activity and in preparation for becoming a public company. Our effective tax rate declined significantly during the quarter ended March 31, 2013 primarily due to research and development tax credits from fiscal 2012 that were reinstated at the beginning of 2013. Our effective tax rate remained relatively consistent over the remaining quarters of 2013 and the three months ended March 31, 2014.

Liquidity and Capital Resources

As of March 31, 2014, cash and cash equivalents were $129.5 million, including $38.5 million held outside the United States in our foreign subsidiaries. If we were to repatriate cash held outside of the United States, it could be subject to U.S. income taxes less any previously paid foreign income taxes.

Since inception, we have primarily financed our operations and capital expenditures through debt, cash flows from our operations and private sales of preferred stock. As of December 31, 2013 and March 31, 2014, we had outstanding $75.0 million aggregate principal amount of convertible promissory notes and $25.0 million aggregate principal amount of related party convertible promissory notes.

We plan to continue to invest for long-term growth. One of the principal purposes of this offering is to obtain additional capital to fund the growth of our business. We believe that our existing cash and cash equivalents balance together with cash proceeds from operations will be sufficient to meet our working capital requirements and our growth strategies for at least the next 12 months. Our future capital requirements will depend on many factors, including our growth rate, the timing and extent of our spending to support research and development activities, the timing and cost of establishing additional sales and marketing capabilities, the introduction of new and enhanced products and services offerings, our costs of outsourcing, our manufacturing and possible acquisitions or investments. We expect to incur a total of $17.3 million in capital expenditures in 2014 due to investment in our research and development and manufacturing processes. If we are unable to raise additional capital when we need it, our business, results of operations and financial condition would be adversely affected. The sale of additional equity could result in additional dilution to our stockholders. If we raise additional funds by borrowing from third parties, the terms of those financing arrangements may include negative covenants or other restrictions on our business that could impair our operating flexibility and would require us to incur interest expense. We can provide no assurance that additional financing will be available at all or, if available, that we would be able to obtain financing on terms favorable to us.

We consider the undistributed earnings of our foreign subsidiaries as of December 31, 2013 and March 31, 2014 to be indefinitely reinvested, and, accordingly, no U.S. income taxes have been provided thereon. As of December 31, 2013 and March 31, 2014, the amount of cash associated with indefinitely reinvested foreign earnings was approximately $33.4 million and $38.5 million, respectively. If these funds are needed for our operations in the United States, we would be required to accrue and pay U.S. income taxes to repatriate these funds. However, we have not repatriated nor do we anticipate the need to repatriate funds to the United States to satisfy domestic liquidity needs arising in the ordinary course of business, including liquidity needs associated with our domestic debt service requirements.