10-Q 1 a630201610q.htm 10-Q Document

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_______________________
FORM 10-Q
_______________________
(Mark one)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2016
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to .

Commission file number 001-33870
_______________________
NetSuite Inc.
(Exact name of registrant as specified in its charter)
_______________________
Delaware
94-3310471
(State or other jurisdiction of
(I.R.S. Employer Identification No.)
incorporation or organization)
 
2955 Campus Drive, Suite 100
 
San Mateo, California
94403-2511
(Address of principal executive offices)
(Zip Code)
(650) 627-1000
(Registrant's telephone number, including area code)
_______________________

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No ¨

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer", "accelerated filer" and "smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
x
 
Accelerated filer
¨
 
 
 
 
 
Non-accelerated filer
¨
(do not check if a smaller reporting company)
Smaller reporting company
¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x

On July 29, 2016, 80,928,937 shares of the registrant’s Common Stock, $0.01 par value, were issued and outstanding.
 



NetSuite Inc.

Index




PART I – Financial Information

ITEM 1. Financial Statements

NetSuite Inc.
Condensed Consolidated Balance Sheets
(dollars in thousands)
(unaudited)
 
June 30,
2016
 
December 31,
2015
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
317,510

 
$
289,966

Short-term marketable securities
90,185

 
74,748

Accounts receivable, net of allowances of $3,216 and $1,988 as of June 30, 2016 and December 31, 2015, respectively
177,088

 
176,720

Deferred commissions
68,974

 
69,579

Other current assets
47,325

 
44,087

Total current assets
701,082

 
655,100

Marketable securities, non-current
2,972

 
13,875

Property and equipment, net
95,563

 
89,643

Deferred commissions, non-current
17,553

 
15,287

Goodwill
305,705

 
291,956

Other intangible assets, net
55,158

 
60,980

Other assets
11,010

 
10,756

Total assets
$
1,189,043

 
$
1,137,597

Liabilities and total equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
9,976

 
$
3,545

Deferred revenue
436,677

 
404,986

Accrued compensation
54,868

 
55,586

Accrued expenses
34,106

 
37,901

Other current liabilities (including note payable to related party of $2,967 and $2,901 as of June 30, 2016 and December 31, 2015, respectively)
16,295

 
17,032

Total current liabilities
551,922

 
519,050

Long-term liabilities:
 
 
 
Convertible 0.25% senior notes, net
281,540

 
274,576

Deferred revenue, non-current
26,813

 
22,743

Other long-term liabilities (including note payable to related party of $1,527 and $3,027 as of June 30, 2016 and December 31, 2015, respectively)
14,783

 
15,027

Total long-term liabilities
323,136

 
312,346

Total liabilities
875,058

 
831,396

Commitments and contingencies (Note 4)

 

Total equity:
 
 
 
Common stock, par value $0.01, 500,000,000 shares authorized; 80,921,604 and 79,802,618 shares issued and outstanding at June 30, 2016 and December 31, 2015, respectively
809

 
798

Additional paid-in capital
1,068,920

 
992,362

Accumulated other comprehensive loss
(14,306
)
 
(13,009
)
Accumulated deficit
(741,438
)
 
(673,950
)
Total equity
313,985

 
306,201

Total liabilities and total equity
$
1,189,043

 
$
1,137,597

See accompanying Notes to Condensed Consolidated Financial Statements.

1


NetSuite Inc.
Condensed Consolidated Statements of Operations and Comprehensive Loss
(dollars and shares in thousands, except per share data)
(unaudited)
 
Six Months Ended June 30,
 
Three Months Ended June 30,
 
2016
 
2015
 
2016
 
2015
Revenue:
 
 
 
 
 
 
 
 
 
 
 
Subscription and support
 
$
353,528

 
 
$
273,896

 
 
$
180,194

 
 
$
140,922

Professional services and other
 
93,821

 
 
68,201

 
 
50,577

 
 
36,358

Total revenue
 
447,349

 
 
342,097

 
 
230,771

 
 
177,280

Cost of revenue:
 
 
 
 
 
 
 
 
 
 
 
Subscription and support
 
61,809

 
 
43,444

 
 
32,018

 
 
22,454

Professional services and other
 
94,148

 
 
68,058

 
 
52,087

 
 
36,687

Total cost of revenue
 
155,957

 
 
111,502

 
 
84,105

 
 
59,141

Gross profit
 
291,392

 
 
230,595

 
 
146,666

 
 
118,139

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
Product development
 
77,449

 
 
62,256

 
 
39,597

 
 
32,537

Sales and marketing
 
227,005

 
 
179,057

 
 
117,314

 
 
95,803

General and administrative
 
45,513

 
 
44,075

 
 
23,219

 
 
25,642

Total operating expenses
 
349,967

 
 
285,388

 
 
180,130

 
 
153,982

Operating loss
 
(58,575
)
 
 
(54,793
)
 
 
(33,464
)
 
 
(35,843
)
Other income / (expense), net:
 
 
 
 
 
 
 
 
 
 
 
Interest income
 
354

 
 
216

 
 
203

 
 
113

Interest expense
 
(7,547
)
 
 
(7,153
)
 
 
(3,797
)
 
 
(3,520
)
Other income, net
 
465

 
 
(264
)
 
 
307

 
 
(266
)
Total other income / (expense), net
 
(6,728
)
 
 
(7,201
)
 
 
(3,287
)
 
 
(3,673
)
Loss before income taxes
 
(65,303
)
 
 
(61,994
)
 
 
(36,751
)
 
 
(39,516
)
Provision for income taxes
 
2,185

 
 
(6,994
)
 
 
992

 
 
(7,229
)
Net loss
 
$
(67,488
)
 
 
$
(55,000
)
 
 
$
(37,743
)
 
 
$
(32,287
)
Net loss per common share, basic and diluted
$
(0.84
)
 
 
$
(0.71
)
 
 
$
(0.47
)
 
 
$
(0.41
)


Weighted average number of shares used in computing net loss per share
80,364

 
 
77,627

 
 
80,641

 
 
77,975

 
 
 
 
 
 
 
 
 
 
 
 
 
Comprehensive loss:
 
 
 
 
 
 
 
 
 
 
 
Foreign currency translation gain / (loss), net of taxes
 
(1,569
)
 
 
(1,411
)
 
 
(2,535
)
 
 
2,587

Unrealized gain on marketable securities
 
134

 
 
16

 
 
44

 
 

Accumulated pension liability
 
138

 
 
98

 
 
69

 
 
49

Comprehensive loss
 
$
(68,785
)
 
 
$
(56,297
)
 
 
$
(40,165
)
 
 
$
(29,651
)

See accompanying Notes to Condensed Consolidated Financial Statements.


2

NetSuite Inc.
Condensed Consolidated Statements of Cash Flows
(dollars in thousands)
(unaudited)


 
Six Months Ended June 30,
 
2016
 
2015
Cash flows from operating activities:
 
 
 
Net loss
$
(67,488
)
 
$
(55,000
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization
19,224

 
13,420

Amortization of other intangible assets
9,658

 
6,817

Amortization of debt discount and transaction costs
6,964

 
6,641

Provision for accounts receivable allowances
1,347

 
496

Stock-based compensation
64,066

 
53,288

Amortization of deferred commissions
58,635

 
46,164

Excess tax benefit on stock-based compensation
(79
)
 
(223
)
Changes in operating assets and liabilities, net of acquired assets and assumed liabilities:
 
 
 
Accounts receivable
(1,332
)
 
4,557

Deferred commissions
(60,314
)
 
(48,072
)
Other current assets
(2,310
)
 
1,488

Other assets
(87
)
 
(8,216
)
Accounts payable
5,489

 
318

Accrued compensation
(908
)
 
(3,682
)
Deferred revenue
35,165

 
29,435

Other current liabilities
(1,384
)
 
4,251

Other long-term liabilities
1,321

 
192

Net cash provided by operating activities
67,967

 
51,874

Cash flows from investing activities:
 
 
 
Purchases of property and equipment
(24,137
)
 
(23,239
)
Capitalized internal use software
(1,834
)
 
(1,633
)
Cash paid in business combination, net of amounts received
(18,247
)
 
(95,565
)
Purchases of marketable securities
(79,527
)
 
(65,674
)
Maturities of marketable securities
62,235

 
70,263

Sales of marketable securities
12,693

 
104

Net cash used in investing activities
(48,817
)
 
(115,744
)
Cash flows from financing activities:
 
 
 
Payments under capital leases
(28
)
 
(112
)
Payments under capital leases and long-term debt - related party
(1,434
)
 
(1,371
)
Payments related to business combinations
(44
)
 
(1,335
)
RSUs acquired to settle employee withholding liability
(105
)
 
(6,926
)
Excess tax benefit on stock-based compensation
79

 
223

Proceeds from issuance of common stock
11,931

 
4,512

Net cash provided by / (used in) financing activities
10,399

 
(5,009
)
Effect of exchange rate changes on cash and cash equivalents
(2,005
)
 
(273
)
Net change in cash and cash equivalents
27,544

 
(69,152
)
Cash and cash equivalents at beginning of period
289,966

 
367,769

Cash and cash equivalents at end of period
$
317,510

 
$
298,617

Supplemental cash flow disclosure:
 
 
 
Cash paid for interest to related parties
$
125

 
$
188

Cash paid for interest to other parties
$
463

 
$
464

Cash paid for income taxes, net of tax refunds
$
1,305

 
$
1,099

Noncash financing and investing activities:
 
 
 
Common stock issued in connection with business combination
$

 
$
85,881


See accompanying Notes to Condensed Consolidated Financial Statements.

3


NetSuite Inc.
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 1. Organization

NetSuite Inc. (the “Company”) provides cloud-based financials/Enterprise Resource Planning (“ERP”) and omnichannel commerce software suites. In addition, the Company offers a broad suite of applications, including financial management, Customer Relationship Management (“CRM”), ecommerce and retail management, commerce marketing automation, Professional Services Automation (“PSA”) and Human Capital Management ("HCM") that enable companies to manage most of their core business operations in its single integrated suite. The Company’s "real-time dashboard" technology provides an easy-to-use view into up-to-date, role-specific business information. The Company also offers customer support and professional services related to implementing and supporting its suite of applications. The Company delivers its suite over the Internet as a subscription service using the software-as-a-service ("SaaS") model. The Company’s headquarters are located in San Mateo, California. The Company conducts its business worldwide with international locations in Canada, Europe, Asia, Australia and Uruguay.

Note 2. Basis of Presentation

The Condensed Consolidated Financial Statements as of and for the six months ended June 30, 2016 included in this Quarterly Report on Form 10-Q have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). The condensed consolidated balance sheet data as of December 31, 2015 was derived from the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015 filed on February 24, 2016. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures contained in this Quarterly Report comply with the requirements of Section 13(a) of the Securities Exchange Act of 1934, as amended, for a Quarterly Report on Form 10-Q and are adequate to make the information presented not misleading. These Condensed Consolidated Financial Statements are meant to be, and should be, read in conjunction with the Consolidated Financial Statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015 filed on February 24, 2016.
 
The unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q reflect all adjustments (which include only normal, recurring adjustments and those items discussed in these Notes) that are, in the opinion of management, necessary to state fairly the financial position and results for the dates and periods presented. The results for such periods are not necessarily indicative of the results to be expected for the full fiscal year.

Recent Accounting Pronouncements

In March 2016, the Financial Accounting Standards Board ("FASB") issued new accounting guidance: Compensation-Stock Compensation: Improvements to Employee Share-Based Payment. The guidance simplifies the accounting for share-based transactions, including the income tax consequences, classification of awards as either equity or liabilities on the balance sheet, and classification of employee taxes paid on statement of cash flows when an employer withholds shares for tax-withholding purposes. The new standard is effective for interim and annual periods beginning after December 15, 2016 and early adoption is permitted. The Company has elected not to early adopt. The Company is evaluating the impact of adopting this new accounting standard on its financial statements.

In February 2016, the FASB issued new accounting guidance: Leases. The guidance requires lessees to put most leases on their balance sheets but recognize the expenses on their income statements in a manner similar to current practice. The guidance states that a lessee would recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use the underlying asset for the lease term. The new standard is effective for interim and annual periods beginning after December 15, 2018 and early adoption is permitted. The Company has elected not to early adopt and is evaluating the potential impact on the Company's condensed consolidated financial statements.

In May 2014, the FASB issued new accounting guidance related to revenue recognition, Revenue from Contracts with Customers. This new standard will replace most existing U.S. GAAP guidance on this topic. The new revenue recognition standard provides a unified model to determine when and how revenue is recognized. The core principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the

4


consideration for which the entity expects to be entitled in exchange for those goods or services. In July 2015, the FASB approved a one-year deferral of the effective date for the new revenue reporting standard for entities reporting under U.S. GAAP. In accordance with the deferral, this guidance will be effective for the Company beginning January 1, 2018 and can be applied either retrospectively to each period presented or as a cumulative-effect adjustment as of the date of adoption. Early adoption is permitted beginning January 1, 2017. The Company is evaluating the impact of adopting this new accounting standard on its financial statements and has not selected a transition method.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany balances and transactions have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Revenue Recognition

The Company generates revenue from two sources: (1) subscription and support; and (2) professional services and other. Subscription and support revenue includes subscription fees from customers accessing its on-demand application suite and support fees from customers purchasing support. Arrangements with customers do not provide the customer with the right to take possession of the software supporting the on-demand application service at any time. Professional services and other revenue includes fees generated from training and consulting services such as business process mapping, configuration, data migration and integration. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. For the most part, subscription and support agreements are entered into for 12 to 36 months. In aggregate, 85% of the professional services component of the arrangements with customers is performed within 300 days of entering into a contract with the customer.
 
The subscription agreements generally provide service level commitments of 99.5% uptime per period, excluding scheduled maintenance. The failure to meet this level of service availability may require the Company to credit qualifying customers up to the value of an entire month of their subscription and support fees. In light of the Company’s historical experience with meeting its service level commitments, the Company's accrued liability related to such obligations in the accompanying consolidated financial statements is negligible.

The Company commences revenue recognition when all of the following conditions are met:
There is persuasive evidence of an arrangement;
The service is being provided to the customer;
The collection of the fees is reasonably assured; and
The amount of fees to be paid by the customer is fixed or determinable.
 
In most instances, revenue from new customer acquisition is generated under sales agreements with multiple elements, comprised of subscription and support fees from customers accessing the Company's on-demand application suite and professional services associated with consultation services. The Company evaluates each element in a multiple-element arrangement to determine whether it represents a separate unit of accounting. An element constitutes a separate unit of accounting when the delivered item has standalone value and delivery of the undelivered element is probable and within the Company’s control. Subscription and support have standalone value because they are routinely sold separately by the Company. Professional services have standalone value because the Company has sold professional services separately and there are several third-party vendors that routinely provide similar professional services to its customers on a standalone basis.

The Company allocates revenue to each element in an arrangement based on a selling price hierarchy. The selling price for a deliverable is based on its vendor-specific objective evidence (“VSOE”), if available, third-party evidence (“TPE”), if VSOE is not available, or estimated selling price (“ESP”), if neither VSOE nor TPE is available. As the Company has been unable to establish VSOE or TPE for the elements of its arrangements, the Company establishes the ESP for each element primarily by considering the weighted average of actual sales prices of professional services sold on a standalone basis and subscription and support including various add-on modules when sold together without professional services, and other factors such as gross margin objectives, pricing practices and growth strategy. The consideration allocated to subscription and support

5


is recognized as revenue over the contract period commencing when the subscription service is made available to the customer. The consideration allocated to professional services is recognized as revenue using the proportional performance method.

The total arrangement fee for a multiple element arrangement is allocated based on the relative ESP of each element. However, since the professional services are generally completed prior to completion of delivery of subscription and support services, the revenue recognized for professional services in a given reporting period does not include fees subject to delivery of subscription and support services. This results in the recognition of revenue for professional services that is generally no greater than the contractual fees for those professional services.

For single element sales agreements, subscription and support revenue is recognized ratably over the contract term beginning on the provisioning date of the contract. The Company recognizes professional services revenue using the proportional performance method for single element arrangements.

Sales and other taxes collected from customers to be remitted to government authorities are excluded from revenues.

Concentration of Credit Risk and Significant Customers
 
Financial instruments potentially exposing the Company to concentration of credit risk consist primarily of cash and cash equivalents, marketable securities, restricted cash and trade accounts receivable. The Company maintains an allowance for doubtful accounts receivable balances. The allowance is based upon historical loss patterns and an evaluation of the potential risk of loss associated with problem accounts. The Company generally charges off the receivable balances of uncollectible accounts when accounts are 120 days past-due based on the account’s contractual terms. Credit risk arising from accounts receivable is mitigated due to the large number of customers comprising the Company’s customer base and their dispersion across various industries. As of June 30, 2016 and December 31, 2015, there were no customers that represented more than 10% of the net accounts receivable balance. There were no customers that individually exceeded 10% of the Company’s revenue in any of the periods presented. As of June 30, 2016 and December 31, 2015, long-lived assets located outside the United States totaled $27.7 million and $21.4 million, respectively.

Revenue by geographic region, based on the billing address of the customer, was as follows for the periods presented:
 
Six Months Ended June 30,
 
Three Months Ended June 30,
 
2016
 
2015
 
2016
 
2015
 
(dollars in thousands)
United States
$
334,638

 
$
254,639

 
$
172,158

 
$
133,269

International
112,711

 
87,458

 
58,613

 
44,011

Total revenue
$
447,349

 
$
342,097

 
$
230,771

 
$
177,280

 
 
 
 
 
 
 
 
Percentage of revenue generated outside of the United States
25
%
 
26
%
 
25
%
 
25
%

No single country outside the United States represented more than 10% of revenue during the six months ended June 30, 2016 or 2015.

The Company maintains cash balances at several banks. Accounts located in the United States are insured by the Federal Deposit Insurance Corporation (“FDIC”), up to $250,000. Certain operating cash accounts may exceed the FDIC limits.

Intellectual Property Rights Indemnification

The Company’s arrangements include provisions indemnifying customers against liabilities if the Company's products infringe a third-party’s intellectual property rights. The Company has not incurred any costs as a result of such indemnifications and has not accrued any liabilities related to such obligations in the accompanying condensed consolidated financial statements.







6


Business Combinations

During six months ended June 30, 2016, the Company purchased all the outstanding equity of a professional services firm ("PFS") and acquired certain assets and assumed certain obligations from an on-demand manufacturing software company ("MSC"), a private company that provides its customers with resource planning, production scheduling and quality management services. In connection with these acquisitions, the Company incurred transaction costs totaling $1.8 million, and are reflected as general and administrative expense in the Company's statement of operations.

The following table summarizes the preliminary allocation of the consideration to the fair value of assets acquired and liabilities assumed as of the acquisition dates:

 
2016 Acquisitions
 
PFS
 
MSC
 
April 1, 2016
 
February 26, 2016
 
(dollars in thousands)
Developed technology
$

 
$
1,500

Customer relationships
1,840

 
250

Goodwill
7,034

 
7,774

Other assets / (liabilities), net
1,033

 
(212
)
Fair value of assets acquired and liabilities assumed
$
9,907

 
$
9,312



Under the acquisition method of accounting, the Company allocated the purchase price to the identifiable assets and liabilities based on their estimated fair value at the date of acquisition. To determine the value of the intangible assets, the Company made various estimates and assumptions. For PFS, the methodologies used in valuing the intangible assets include, but are not limited to, multiple period excess earnings method for customer relationships. For MSC, the methodologies used in valuing the intangible assets include, but are not limited to, the multiple period excess earnings approach for developed technology and the with-and-without approach for customer relationships. In both acquisitions, the excess of the purchase price over the total net identifiable assets has been recorded as goodwill which includes synergies expected from the expanded service capabilities and the value of the assembled workforce in accordance with generally accepted accounting principles. $7.0 million of the acquired PFS goodwill is expected to be deductible for tax purposes, and $7.8 million of the acquired MSC goodwill is expected to be deductible for tax purposes. The Company did not record any in-process research and development intangible assets in connection with the acquisitions.

The Company will amortize certain intangible assets on a straight-line basis over the following periods:

 
 
PFS
 
MSC
 
 
Fair Value
 
Useful Life
 
Fair Value
 
Useful Life
 
 
(dollars in thousands)
 
(in years)
 
(dollars in thousands)
 
(in years)
Developed technology
 
$

 
 
$
1,500

 
5
Customer relationships
 
1,840

 
3
 
250

 
4

PFS

On April 1, 2016, the Company acquired PFS to increase its professional services resources. Beginning in the second quarter of 2016, PFS assets, liabilities and operating results are reflected in the Company’s condensed consolidated financial statements from the date of acquisition. On the closing date, the Company paid approximately $9.7 million in cash and will pay an additional $202,000 in the third quarter of 2016. Of the consideration paid, $1.4 million is being held in escrow for up to 24 months following the close of the transaction in the event of certain breaches of representations and warranties. Acquisition related transaction costs amounted to $1.0 million in the three months period ended June 30, 2016, and are reflected as general and administrative expense in the Company's statement of operations.
 
The initial accounting for PFS accounts receivable, intangible assets, other employee related liabilities, and vendor obligations is incomplete because the Company is in the process of determining the fair value of these assets and liabilities. The

7


Company is also undertaking an analysis of certain tax matters associated with the PFS acquisition which could result in an adjustment to the acquisition price allocation.

MSC

On February 26, 2016, the Company acquired certain assets and assumed certain obligations from an on-demand manufacturing software company ("MSC"), a private company that provides its customers with resource planning, production scheduling and quality management services. MSC functionality will be added to the Company's existing solution. Beginning in the first quarter of 2016, MSC assets, liabilities and operating results are reflected in the Company’s condensed consolidated financial statements from the date of acquisition. The Company paid approximately $9.3 million in cash. Of the consideration paid, $1.1 million is being held in escrow for up to 24 months following the close of the transaction in the event of certain breaches of representations, and warranties. Additionally, $400,000 of the total consideration is being held in escrow for potential tax obligations covered in the purchase agreement. Acquisition related transaction costs amounted to $725,000 in the six months ended June 30, 2016, and are reflected as general and administrative expense in the statement of operations.

The initial accounting for MSC accounts receivable, intangible assets, other customer related liabilities, and vendor obligations is incomplete because the Company is in the process of determining the fair value of these assets and liabilities. The Company is also undertaking an analysis of certain tax matters associated with the MSC acquisition which could result in an adjustment to the acquisition price allocation.

Comparative pro forma financial information for the acquisitions above have not been presented because the historical financial results of both PFS and MSC are not material to the Company's condensed consolidated results of operations individually or in aggregate.

Goodwill

The following table details the Company's goodwill activity during the six months ended June 30, 2016:

 
 
 (dollars in thousands)
Balance as of January 1, 2016
 
$
291,956

Acquisition of MSC
 
7,774

Acquisition of PFS
 
7,034

Other adjustments to goodwill
 
(1,872
)
Foreign exchange adjustment
 
813

 Balance as of June 30, 2016
 
$
305,705


On June 8, 2015, the Company completed the purchase of all the outstanding equity of Bronto Software, Inc. (“Bronto"), a private company that provides a cloud-based marketing platform for its customers to drive revenue through their email, mobile and social campaigns. Bronto functionality enhances the Company’s existing email marketing solution and its existing omnichannel commerce platform. The Company paid approximately $98.2 million in cash and issued 1,030,508 unregistered shares of the Company's common stock with a fair value of $85.9 million, inclusive of a discount from the quoted market price due to certain trading restrictions associated with the shares. During the second quarter of 2016, the Company decreased Bronto goodwill by $1.1 million due to working capital and tax adjustments.

On August 5, 2015, the Company completed the purchase of all the outstanding equity of Monexa Services Inc. ("Monexa"), a private company that provides cloud-based invoicing and payment services for its customers. Monexa functionality enhances the Company’s existing invoicing and payment solution. On the closing date, the Company paid approximately $33.1 million in cash as consideration. During the first quarter of 2016, the Company increased the fair value of the customer relationships and developed technology by a total of $900,000 resulting in a reduction of goodwill.

The initial accounting for Monexa intangible assets is incomplete because the Company is in the process of determining the fair value of these assets. The Company is also undertaking an analysis of certain tax matters associated with the Monexa acquisition which could result in an adjustment to the acquisition price allocation.
 
Accumulated Other Comprehensive Loss


8


Accumulated other comprehensive loss is comprised of foreign currency translation gains and losses, net of tax, marketable securities unrealized gains and losses and an accumulated pension liability for employees located in the Philippines. There were no significant reclassification adjustments out of accumulated other comprehensive loss to the condensed consolidated statement of operations and comprehensive loss.

Note 3. Financial Instruments

The Company invests primarily in money market funds, commercial paper, highly liquid debt instruments of the U.S. government and its agencies, U.S. municipal obligations, and U.S. and foreign corporate debt securities. All highly liquid investments with maturities of 90 days or less from date of purchase are classified as cash equivalents and all highly liquid investments with maturities of greater than 90 days but less than a year from date of purchase are classified as short-term marketable securities. Highly liquid investments with maturities of greater than a year from the balance sheet date are classified as marketable securities, non-current. Short-term marketable securities and marketable securities, non-current are also classified as available-for-sale. The Company intends to hold marketable securities, non-current, until maturity; however, it may sell these securities at any time for use in current operations or for other purposes, such as consideration for acquisition. Consequently, the Company may or may not hold securities with stated maturities greater than twelve months until maturity.

The Company carries its fixed income investments at fair value and unrealized gains and losses on these investments, net of taxes, are included in accumulated other comprehensive loss, a component of total equity. Realized gains or losses are included in other income / (expense), net section of the condensed consolidated statement of operations and comprehensive loss. When a determination has been made that an other-than-temporary decline in fair value has occurred, the amount of the decline that is related to a credit loss is realized and is included in the other income / (expense), net section of the consolidated statement of operations and comprehensive loss.

Cash equivalents and Marketable securities consist of the following investments:
 
June 30, 2016
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Cash equivalents:
(in thousands)
Money market funds
$
21,316

 
$

 
$

 
$
21,316

Commercial paper
1,700

 

 

 
1,700

Marketable securities:
 
 
 
 
 
 
 
Commercial paper
51,100

 
24

 

 
51,124

Corporate notes and obligations
12,776

 
12

 

 
12,788

U.S. agency bonds
5,406

 

 
(1
)
 
5,405

U.S. treasury securities
23,827

 
13

 

 
23,840

     Total
$
116,125

 
$
49

 
$
(1
)
 
$
116,173


 
December 31, 2015
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Cash equivalents:
(in thousands)
Money market funds
$
16,092

 
$

 
$

 
$
16,092

Commercial paper
10,998

 

 

 
10,998

Marketable securities:
 
 
 
 
 
 
 
Commercial paper
33,170

 

 

 
33,170

Corporate notes and obligations
12,402

 

 
(13
)
 
12,389

U.S. agency bonds
11,410

 

 
(25
)
 
11,385

U.S. treasury securities
31,727

 

 
(48
)
 
31,679

     Total
$
115,799

 
$

 
$
(86
)
 
$
115,713



9


The Company does not believe any of the unrealized losses represent an other-than-temporary impairment based on its evaluation of available evidence as of June 30, 2016. The Company expects to receive the full principal and interest on the following cash equivalents and marketable securities as of June 30, 2016:
 
 
 
 
 
Fair Value
 
(in thousands)
Due within one year
 
$
113,201

Due within two years
 
2,972

     Total
 
$
116,173


Fair Value Measurements

The Company measures certain financial assets at fair value on a recurring basis based on a fair value hierarchy that requires the Company to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The three levels of inputs that may be used to measure fair value are:

Level 1 - Quoted prices in active markets for identical assets or liabilities.
Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3 - Unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities.

Level 1 Measurements

The Company's cash equivalents held in money market funds and available-for-sale United States Treasury securities are measured at fair value using level 1 inputs.

Level 2 Measurements

The Company's available-for-sale corporate debt securities, commercial paper and United States government agency securities are measured at fair value using level 2 inputs. The Company obtains the fair values of its level 2 available-for-sale securities from a professional pricing service.

The Company’s foreign currency forward contracts are measured at fair value using foreign currency rates quoted by banks or foreign currency dealers and other public data sources. Such instruments are classified as Level 2 and are included in other current assets and liabilities.



10


The fair value of these financial assets and liabilities was determined using the following inputs as of June 30, 2016 and December 31, 2015:

 
June 30, 2016
 
December 31, 2015
 
Fair value measurements at reporting date using
 
Fair value measurements at reporting date using
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(in thousands)
 
(in thousands)
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash
$
294,494

 
$

 
$

 
$
294,494

 
$
262,876

 
$

 
$

 
$
262,876

Money market funds
21,316

 

 

 
21,316

 
16,092

 

 

 
16,092

Commercial paper

 
1,700

 

 
1,700

 

 
10,998

 

 
10,998

Marketable securities
 
 
 
 
 
 


 
 
 
 
 
 
 


Commercial paper

 
51,124

 

 
51,124

 

 
33,170

 

 
33,170

Corporate notes and obligations

 
12,788

 

 
12,788

 

 
12,389

 

 
12,389

U.S. agency bonds

 
5,405

 

 
5,405

 

 
11,385

 

 
11,385

U.S. treasury securities
23,840

 

 

 
23,840

 
31,679

 

 

 
31,679

Foreign exchange contracts

 
879

 

 
879

 

 
384

 

 
384

     Total
$
339,650

 
$
71,896

 
$

 
$
411,546

 
$
310,647

 
$
68,326

 
$

 
$
378,973

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
$

 
$
322

 
$

 
$
322

 
$

 
$

 
$

 
$

Total
$

 
$
322

 
$

 
$
322

 
$

 
$

 
$

 
$


Balance Sheet Hedging - Hedging of Foreign Currency Assets and Liabilities

During the six months ended June 30, 2016, the Company hedged certain of its nonfunctional currency denominated assets and liabilities to reduce the risk that earnings would be adversely affected by changes in exchange rates. Gains and losses from these forward contracts are recorded each period as a component of other income / (expense) in the condensed consolidated statements of operations. The notional amount of derivative instruments acquired during the period was $234.4 million. The Company accounts for derivative instruments as other current assets and liabilities on the balance sheet and measures them at fair value with changes in the fair value recorded as other income / (expense). These derivative instruments do not subject the Company to material balance sheet risk due to exchange rate movements because gains and losses on these derivatives are intended to offset gains and losses on the assets and liabilities being economically hedged.


11


As of June 30, 2016 and December 31, 2015, the Company had the following outstanding foreign exchange forward contracts:
 
June 30, 2016
 
December 31, 2015
 
Notional Value Sold
 
Notional Value Purchased
 
Notional Value Sold
 
Notional Value Purchased
 
(US dollars in thousands)
 
(US dollars in thousands)
British pound
$
18,612

 
$
11,443

 
$
16,959

 
$
9,183

Euro
16,882

 
3,040

 
13,364

 
2,245

Australian dollar
15,895

 
7,716

 
17,148

 
6,953

Philippines peso
9,990

 
9,990

 
9,560

 
9,560

Czech crown
8,150

 
8,370

 
6,621

 
6,320

Japan yen
4,835

 

 
4,435

 

Canadian dollar
4,054

 
3,047

 
5,488

 
4,034

New Zealand dollar
556

 
263

 
505

 

Mexican peso
135

 

 
387

 
252

Total
$
79,109

 
$
43,869

 
$
74,467

 
$
38,547


The fair value of the derivative instruments reported on the Company’s Condensed Consolidated Balance Sheet were as follows:
 
Asset Derivatives
 
Liability Derivatives
 
Balance Sheet Location
 
June 30, 2016
 
December 31, 2015
 
Balance Sheet Location
 
June 30, 2016
 
December 31, 2015
Derivatives and forward contracts
 
Fair Value
 
Fair Value
 
 
Fair Value
 
Fair Value
 
(in thousands)
 
(in thousands)
Foreign exchange contracts
Other current assets
 
$
879

 
$
384

 
Other current liabilities
$
322

 
$

Total
 
 
$
879

 
$
384

 
 
 
$
322

 
$


The effect of derivative instruments on the Company's Condensed Consolidated Statement of Operations and Comprehensive Loss was as follows for the periods presented:
 
 
Location of net gain (loss) recognized in income on derivatives
 
Amount of net gain (loss) recognized in income on derivatives during the
 
 
 
Six Months Ended June 30,
 
Three Months Ended June 30,
Derivatives and forward contracts
 
 
2016
 
2015
 
2016
 
2015
 
 
 
 
(in thousands)
Foreign exchange contracts
 
Other income/ (expense), net
 
$
269

 
$
717

 
$
1,432

 
$
(509
)
Total
 
 
 
$
269

 
$
717

 
$
1,432

 
$
(509
)

The Company has entered into its foreign exchange contracts with multiple counterparties. During the periods such contracts are open, the Company is subject to a potential maximum amount of loss due to credit risk equal to the gross fair value of the derivative instrument, if the counterparties to the instruments failed completely to perform according to the terms of the contracts. The agreements with the counterparties do not require either party to provide collateral to mitigate the credit risk of the agreements.

Note 4. Commitments and Contingencies

The Company is involved in various legal proceedings and receives claims from time to time, arising from the normal course of business activities. The Company has accrued for estimated losses in the accompanying condensed consolidated financial statements for matters with respect to which it believes the likelihood of an adverse outcome is probable and the

12


amount of the loss is reasonably estimable. Accrued estimated losses included in the financial statements as of June 30, 2016 are negligible.

During the three months ended June 30, 2016, the Company entered into various office space leases to expand its operations primarily in the United States and the Philippines. The corresponding lease terms for these agreements expire at various dates through 2027. The Company will pay a total of $8.3 million, net of any lessor lease incentives, over the corresponding lease terms for additional office space.

During the three months ended March 31, 2016, the Company entered into various office space leases to expand its operations primarily in the United Kingdom and Australia. The corresponding lease terms for these agreements expire at various dates through 2024. The Company will pay a total of $10.2 million, net of any lessor lease incentives, over the corresponding lease terms for additional office space.

Future minimum lease payments under non-cancelable operating leases (with initial or remaining lease terms in excess of one year) as of June 30, 2016 are as follows:
 
Operating leases
 
 (dollars in thousands)
Years ending:
 
 
Remainder of 2016
 
$
8,259

2017
 
25,063

2018
 
24,965

2019
 
23,200

2020
 
18,908

Thereafter
 
37,191

Future minimum lease payments
 
$
137,586


Note 5. Stock-based Compensation

In April 2016, the Company's board of directors granted selected executives and other key employees 236,586 performance share units ("PSUs") whose vesting is contingent upon the Company's performance in comparison to certain indexed companies' performance over a three year period. In May 2019, the Company will determine the number of shares the participants will receive which can range from zero to 200% based on the Company's performance. The fair value and the related stock-based compensation expense of performance based PSUs are determined based on the value of the underlying shares on the date of grant and will be recognized over the performance term. The fair value of the market-based PSUs on the date of grant (measurement date) is $73.13 for the 231,443 shares granted on April 1, 2016 and $99.91 for the 5,143 shares granted on April 28, 2016. The fair value was calculated using a Monte Carlo simulation model that estimates the distribution of the potential outcomes of the PSU grants based on simulated future stock prices of the indexed companies.

    Under the Company's employee stock purchase plan ("ESPP"), employees may purchase the Company’s common stock through accumulated payroll deductions. Stock purchase rights are granted to eligible employees during a six month offering period with purchase dates at the end of each offering period. The offering periods generally commence each May 1 and November 1. Shares are purchased through employees’ payroll deductions, up to a maximum of 15% of employees’ compensation, at purchase prices equal to 85% of the lesser of the fair market value of the Company’s common stock at either the date of the employee’s entrance to the offering period or the purchase date. During the second quarter of 2016, employees purchased 98,099 shares for $64.52 per share under the ESPP. ESPP share-based compensation expense was $2.0 million and $1.1 million for the six and three months ended June 30, 2016, respectively.

During the first quarter of 2016, the Company's board of directors set the performance goals for 41,635 performance shares (“PS”), with a fair value of $53.66 per share, that were included in the 2015 PS grant to selected executives and other key employees. The PS vesting is contingent upon the Company meeting certain company-wide revenue performance goals (performance-based) in 2016. These shares are subject to term vesting conditions. The PS fair value and the related stock-based compensation expense were determined based on the value of the underlying shares on February 9, 2016 when the performance goals were established and will be recognized over the vesting term. During the interim financial periods, management estimates the probable number of PS that will be granted until the achievement of the performance goals are known at December 31, 2016.


13


Note 6. Debt

0.25% Convertible Senior Notes

In June 2013, the Company issued at par value $310.0 million of 0.25% convertible senior notes due June 1, 2018 (the “Notes”). Interest is payable semi-annually in arrears on December 1 and June 1 of each year, commencing December 1, 2013.

The Notes are governed by an indenture dated as of June 4, 2013, between the Company, as issuer, and Wells Fargo Bank, National Association, as trustee. The Notes do not contain any financial covenants or any restrictions on the payment of dividends, the incurrence of senior debt or other indebtedness, or the issuance or repurchase of securities by the Company. The Notes are unsecured and rank senior in right of payment to the Company's future indebtedness that is expressly subordinated in right of payment to the Notes, rank equal in right of payment to the Company's existing and future unsecured indebtedness that is not so subordinated. The Notes are effectively subordinated in right of payment to any of the Company's secured indebtedness to the extent of the value of the assets securing such indebtedness and are structurally subordinated to all existing and future indebtedness, liabilities incurred by our subsidiaries including trade payables, and preferred stock of the Company.

Upon conversion, the Company may choose to pay or deliver, as the case may be, either cash, shares of the Company's common stock or a combination of cash and shares of the Company's common stock. If converted, holders will receive, at the Company's election, cash and/or shares of the Company's common stock for the principal amount of the Notes and any amounts in excess of the principal amounts. The Company intends to settle the principal amount of the Notes with cash if converted.

The initial conversion rate is 8.6133 shares of the Company's common stock per $1,000 principal amount of Notes, subject to anti-dilution adjustments. The initial conversion price is approximately $116.10 per share of the Company's common stock and represents a conversion premium of approximately 35% based on the last reported sale price of the Company's common stock of $86.00 on May 29, 2013, the date the Notes offering was priced. The conversion rate is subject to adjustment from time to time upon the occurrence of certain events, including, but not limited to, the issuance of stock dividends and payment of cash dividends. Holders of the Notes will not receive any cash payment representing accrued and unpaid interest upon conversion of a Note unless the conversion date occurs after a regular record date related to the Notes and prior to the related interest payment date. At any time prior to the close of business on the business day immediately preceding March 1, 2018, holders may convert their Notes at their option only under the following circumstances:
 
 ●
 
 
during any calendar quarter commencing after the calendar quarter ended on September 30, 2013 (and only during such calendar quarter), if the last reported sale price of the common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;
 
 ●
 
 
during the five business day period after any five consecutive trading day period (the “measurement period”) in which the trading price per $1,000 principal amount of Notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of the Company's common stock and the conversion rate on each such trading day; or
 
 ●
 
 
upon the occurrence of certain corporate transactions described in the indenture governing the Notes.
 
On and after March 1, 2018 until the close of business on the business day immediately preceding the maturity date, holders may convert their Notes at any time, regardless of the foregoing circumstances. If a make-whole fundamental change (as defined in the Indenture governing the Notes) occurs when the Company's stock price is between $86.00 and $275.00 per share and a holder elects to convert its Notes in connection with such make-whole fundamental change, such holder may be entitled to an increase in the conversion rate as provided for in the Indenture governing the Notes.

As of June 30, 2016, circumstances that would give rise to a conversion option for the holders of Notes do not exist.

Holders of the Notes have the right to require the Company to purchase with cash all or a portion of the Notes upon the occurrence of any event that constitutes a fundamental change (as defined in the Indenture governing the Notes) at a purchase price equal to 100% of the principal amount of the Notes plus accrued and unpaid interest.

In accounting for the issuance of the Notes, the Company separated the Notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component representing the conversion option was

14


determined by deducting the fair value of the liability component from the par value of the Notes as a whole. The excess of the principal amount of the liability component over its carrying amount (“debt discount”) is amortized to interest expense using the effective interest method over the term of the Note. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.

In accounting for the $8.4 million in transaction costs related to the Note issuance, the Company allocated the total amount incurred to the liability and equity components based on their relative values. The $6.7 million in transaction costs attributable to the liability component which offset the convertible notes are being amortized to interest expense over the term of the Notes, and the $1.7 million in transaction costs attributable to the equity component were netted with the equity component in additional paid-in capital. The Notes consisted of the following as of June 30, 2016:
 
 
June 30,
2016
 
December 31,
2015
 
 
(in thousands)
Equity component (1)
 
$
60,931

 
$
60,931

Liability component:
 
 
 
 
Principal
 
$
310,000

 
$
310,000

Less: debt discount, net
 
(25,750
)
 
(32,045
)
Less: unamortized transaction costs
 
(2,710
)
 
(3,379
)
Net carrying amount
 
$
281,540

 
$
274,576

 
 
 
 
 
Fair value - level 2
 
$
305,133

 
$
307,024


(1) Included in the consolidated balance sheets within additional paid-in capital, net of the $1.7 million in equity issuance costs.

To comply with the recent FASB accounting guidance, effective in the first quarter of 2016, the Company changed the presentation of unamortized transaction costs on the balance sheets from being presented in other long term assets to a direct deduction from the convertible debt liability. The Company also retrospectively changed its December 31, 2015 balance sheet for this presentation. The Notes are carried at face value less any unamortized debt discount and transaction costs, and also require disclosure of an estimate of fair value. The Company considers the fair value of the Notes at each balance sheet date to be a level 2 measurement because it is determined based on a recent quoted market price or dealer quote for the Notes. The Notes quoted market price or dealer quote is based on the trading price of the Company's common stock and market activity that is less than an active exchange.

As of June 30, 2016, the remaining life of the Notes is approximately 1.9 years. The following table sets forth total interest expense recognized related to the Notes:
 
 
Six Months Ended June 30,
 
Three Months Ended June 30,
 
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Contractual interest expense
 
$
388

 
$
388

 
$
194

 
$
194

Amortization of debt issuance costs
 
669

 
640

 
336

 
322

Amortization of debt discount
 
6,295

 
6,001

 
3,173

 
3,025

Total
 
$
7,352

 
$
7,029

 
$
3,703

 
$
3,541

 
 
 
 
 
 
 
 
 
Effective interest rate
5.4%


15


Note 7. Income Taxes

The Company has incurred annual operating losses since inception. As a result of those continuing losses, management has determined insufficient evidence exists to support that it is more likely than not that the Company will realize the benefits of its U.S. net deferred tax assets and therefore has recorded a valuation allowance to reduce the net carrying value of these deferred tax assets to zero. Accordingly, the Company has not recorded a provision for income taxes for any of the periods presented other than provisions for state and foreign income taxes.

As of June 30, 2016, the Company had net deferred tax asset in foreign jurisdictions of approximately $700,000. Based on available evidence, both positive and negative, the Company believes that it is more likely than not that the benefits of the foreign deferred tax assets will be realized in full with the exception of the Japanese deferred tax assets.

The Company does not anticipate a material change in the total amount or composition of its unrecognized tax benefits within 12 months of the reporting date.

As of June 30, 2016, the Company has not provided for residual U.S. taxes on any of its income from foreign jurisdictions since it intends to indefinitely reinvest the net undistributed earnings of its foreign subsidiaries offshore.

The Company files federal, state and foreign income tax returns in jurisdictions with varying statutes of limitations. Due to the carry forward of net operating losses, the Company's income tax returns generally remain subject to examination by federal and most state tax authorities. In most of the Company's significant foreign jurisdictions, 2009 through the current taxable year remain subject to examination by their respective tax authorities.

Note 8. Net Loss Per Share of Common Stock

Basic net loss per common share is computed by dividing net loss by the weighted-average number of shares of common stock outstanding during the period. Diluted net loss per share of common stock is computed by giving effect to all potential dilutive shares of common stock, including options, restricted stock units ("RSUs"), performance share units ("PSUs"), performance shares ("PS"), employee stock purchase plan shares and convertible debt shares. Basic and diluted net loss per share of common stock were the same for all periods presented as the impact of all potentially dilutive securities outstanding was anti-dilutive.

The following table presents the calculation of the numerator and denominator used in the basic and diluted net loss per share of common stock:
 
Six Months Ended June 30,
 
Three Months Ended June 30,
 
2016
 
2015
 
2016
 
2015
 
(dollars and shares in thousands, except per share amounts)
Numerator:
 
 
 
 
 
 
 
Net loss
$
(67,488
)
 
$
(55,000
)
 
$
(37,743
)
 
$
(32,287
)
Denominator:
 
 
 
 
 
 
 
Weighted-average number of shares of common stock outstanding used in computing basic and diluted net loss per share of common stock
80,364

 
77,627

 
80,641

 
77,975

Net loss per share of common stock, basic and diluted
$
(0.84
)
 
$
(0.71
)
 
$
(0.47
)
 
$
(0.41
)
 
The Company’s unvested RSUs, PSUs and PS do not contain non-forfeitable rights to dividends and dividend equivalents. As such, unvested RSUs, PSUs and PS are not participating securities and the Company is not required to use the two-class method to calculate diluted earnings per share in periods when the Company has net income.








16


The following table presents the weighted average potential shares that are excluded from the computation of diluted net loss per common share for the periods presented because including them would have had an anti‑dilutive effect:
 
Six Months Ended June 30,
 
Three Months Ended June 30,
 
2016
 
2015
 
2016
 
2015
 
(Shares in thousands)
Options to purchase shares of common stock
1,861

 
2,237

 
1,932

 
2,306

Unvested RSUs, PSUs, PS and ESPP awards
3,908

 
3,033

 
4,691

 
3,151

Total
5,769

 
5,270

 
6,623

 
5,457


The effect of the convertible Notes is reflected in diluted earnings per share by application of the treasury stock method as the Company intends to settle the principal amount of the Note in cash upon conversion. During the six and three months ended June 30, 2016, the Company's weighted average common stock price was below the Notes conversion price for the periods during which the Notes were outstanding.

Note 9. Related Party Transactions

The Company has entered into various software license agreements with Oracle USA, Inc., an affiliate of Oracle Corporation. Lawrence J. Ellison, who beneficially owns a significant portion of the Company’s common stock, is the Chief Technology Officer, a director and a principal stockholder of Oracle Corporation.

On February 28, 2013, the Company entered into the third amendment to the perpetual software license agreement with Oracle USA ("Amendment"). The Amendment provides for a 48 month extension to the May 2010 second amendment to the Oracle unlimited license agreement. The Amendment provides that the Company will pay a one-time fee of $13.1 million to extend the term for unlimited licenses from May 31, 2014 to May 31, 2018. The Amendment also provides for technical support services. During the first quarters of 2015 and 2016, the Company renewed the support service agreement for $4.3 million per annum and may renew support services for the 2017 annual period at the same rate. The support services to be provided to the Company by Oracle automatically renew unless the Company provides written notice of cancellation at least 60 days prior to the support renewal date. The Company financed the license fees due under the Amendment pursuant to a note issued to Oracle Credit Corporation. The note bears interest at a rate of 2.00% per annum with payments scheduled over the term of the amendment. The Company discounted the note at a rate of 4.5% because it approximates the interest rate the Company would obtain on the open market. The $12.4 million discounted note value was recorded as an asset addition to property and equipment that will be depreciated over seven years.
 
Future debt payments under notes payable as of June 30, 2016 are as follows:
 
 
 (dollars in thousands)
Years ending:
 
 
Remainder of 2016
 
$
1,560

2017
 
3,119

Future debt payments
 
4,679

Amount representing interest
 
185

Present value of future debt payments
 
$
4,494


The following table details payments to Oracle USA and Oracle Credit Corporation for support services and license fees related to the following periods:
 
Six Months Ended June 30,
 
Three Months Ended June 30,
 
2016
 
2015
 
2016
 
2015
 
(dollars in thousands)
License fee
$
1,434

 
$
1,371

 
$
721

 
$
690

Support
2,150

 
2,150

 
1,075

 
1,075

Interest
125

 
188

 
58

 
90

Total paid
$
3,709

 
$
3,709

 
$
1,854

 
$
1,855



17


The Company has also entered into various other software license agreements with Oracle Corporation. During the three months ended June 30, 2016, the Company entered into an agreement with Oracle Corporation to purchase additional software licenses and support for $450,000. The licenses were recorded as an asset addition to property and equipment that will be depreciated over seven years. During the six months ended June 30, 2016, the Company received negligible payments from Oracle Corporation and received payments totaling $150,000 during the same period in 2015 for services it performed.

In addition to the companies affiliated with Lawrence J. Ellison, the Company enters into sales and purchases agreements with various companies that have a relationship with the Company's executive officers or members of the Company's board of directors. The relationships are typically an equity investment by the executive officer or board member in the customer / vendor company or the Company's executive officer or board member is a member of the customer / vendor company's board of directors. The Company has renewed the license agreements and sold additional services to these customers or purchased services from these vendors at various points in time. As of June 30, 2016, the Company's accounts receivable related to these customers totaled $0.7 million. Below is a summary of transactions between the Company and related parties other than Mr. Ellison:

 
Six Months Ended June 30,
 
Three Months Ended June 30,
 
2016
 
2015
 
2016
 
2015
 
(dollars in thousands)
Revenue earned from related party
$
1,664

 
$
1,455

 
$
923

 
$
671

Fees NetSuite paid for services
$
614

 
$
122

 
$
408

 
$
91


A member of the Company's board of directors, Edward Zander, is a member of the EVault, Inc. board of directors. During the second quarter of 2016, the Company entered into a $153,000 agreement for the Company to provide services to EVault, Inc.

A member of the Company's board of directors, Kevin Thompson, is the President and Chief Executive Officer of SolarWinds. During the second quarter of 2016, the Company entered into a $208,000 agreement for the Company to provide services to SolarWinds.

The Company's President and Chief Operating Officer, Jim McGeever, is a member of the Twilio Inc. board of directors. During the second quarter of 2016, the Company entered into a $326,000 agreement for the Company to provide services to Twilio Inc.

The Company's President, Worldwide Sales and Distribution, Marc Huffman, is a member of the ChannelAdvisor board of directors. During the first quarter of 2016, the Company entered into a $219,000 agreement for the Company to provide services to ChannelAdvisor. Additionally, during the second quarter of 2016, the Company entered into a $112,000 agreement for the Company to provide services to ChannelAdvisor.

A member of the Company's board of directors, William Beane III, is the General Manager of the Oakland Athletics. During the first quarter of 2016, the Company entered into a $510,000 amendment to the agreement with the Oakland Athletics to purchase in-stadium sponsorship.

Note 10. Subsequent Event

On July 28, 2016, the Company entered into a definitive agreement to be acquired by Oracle Corporation ("Oracle"). The transaction is valued at $109.00 per share in cash, or approximately $9.3 billion. The Board of Directors has unanimously approved the transaction. The consummation of the transaction is conditioned on there having been validly tendered and not withdrawn: (1) a number of shares of Common Stock that, together with any shares of Common Stock owned by Oracle and certain of its affiliates, represents a majority of the shares of Common Stock (calculated on a fully diluted basis in accordance with the definitive agreement); and (2) a number of shares Common Stock (excluding, in such number, shares of Common Stock beneficially owned by: (i) NetSuite Restricted Holdings LLC, Lawrence J. Ellison, David Ellison and Margaret Ellison (and their respective affiliates who beneficially own shares of Common Stock) (collectively, the “LJE Parties”); (ii) Oracle and certain of its affiliates; and (iii) any executive officers or directors of the Company and their affiliates (the persons and entities referred to in clauses (i), (ii) and (iii), the “Specified Persons”)) that represents a majority of the shares of Common Stock issued and outstanding immediately prior to the acceptance time (excluding, from such issued and outstanding shares, shares of Common Stock beneficially owned by the Specified Persons). The consummation of the transaction is also conditioned on (1) receipt of certain regulatory approvals, including expiration of the waiting period under the Hart-Scott-Rodino Antitrust

18


Improvements Act of 1976 and certain foreign antitrust laws; (2) the accuracy of the representations and warranties and compliance with the covenants contained in the definitive agreement, subject to qualifications; and (3) other customary conditions. The transaction is expected to close in 2016.


19


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

The following discussion and analysis is intended to provide greater details of our results of operations and financial condition and should be read in conjunction with our condensed consolidated financial statements and the notes thereto included elsewhere in this document and the discussion contained in our Annual Report on Form 10-K for the year ended December 31, 2015 as filed with the SEC on February 24, 2016. Certain statements in this Quarterly Report constitute forward-looking statements and as such, involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Such forward-looking statements include any expectation of earnings, revenues or other financial items; any statements of the plans, strategies and objectives of management for future operations; factors that may affect our operating results; statements concerning new products or services; statements related to adding employees; statements related to future capital expenditures; statements related to future economic conditions or performance; statements related to the integration of acquired companies; statements as to industry trends and other matters that do not relate strictly to historical facts or statements of assumptions underlying any of the foregoing. These statements are often identified by the use of words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” or “will,” and similar expressions or variations. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to those discussed in the section titled “Risk Factors” included in Item 1A of Part II of this Quarterly Report on Form 10-Q, and the risks discussed in our other SEC filings.

We urge you to consider these factors carefully in evaluating the forward-looking statements contained in this Quarterly Report on Form 10-Q. These statements are based on the beliefs and assumptions of our management based on information currently available to management. The forward-looking statements included in this Quarterly Report are made only as of the date of this Quarterly Report. All subsequent written or oral forward-looking statements attributable to our company or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. We do not undertake, and specifically disclaim, any obligation to update any forward-looking statements to reflect the occurrence of events or circumstances after the date of such statements except as required by law.

Overview

NetSuite Inc. ("NetSuite" or the "Company") is the industry's leading provider of cloud-based financials / Enterprise Resource Planning (“ERP”) and omnichannel commerce software suites.  In addition, we offer a broad suite of applications, including financial management, Customer Relationship Management (“CRM”), ecommerce and retail management, commerce marketing automation, Professional Services Automation (“PSA”) and Human Capital Management ("HCM") that enables companies to manage most of their core business operations in our single integrated suite.  Our "real-time dashboard" technology provides an easy-to-use view into up-to-date, role-specific business information.  We also offer customer support and professional services related to the support and implementation of our suite of applications.  We deliver our suite over the Internet as a subscription service using the software-as-a-service ("SaaS") model.

Our headquarters are located in San Mateo, California. We were incorporated in California in September 1998 and reincorporated in Delaware in November 2007. We conduct business worldwide, with international locations in Canada, Europe, Asia, Australia and Uruguay.

Key Components of Our Results of Operations

Revenue

We generate sales directly through our sales team and, to a lesser extent, indirectly through channel partners. We sell our service to customers across a broad spectrum of industries, and we have tailored our service for wholesalers/distributors, manufacturers, retailers, services companies, software companies and other businesses, including advertising/media, publishing and non-profits. The primary target customers for our service are medium-sized businesses, divisions of large companies and enterprises. An increasing percentage of our customers and our revenue have been derived from larger businesses within this market. For the three months ended June 30, 2016, we did not have any single customer that accounted for more than 3% of our revenue.

We are pursuing a number of strategies that we believe will enable us to continue to grow. The goals of those strategic objectives are to continue to move up market; to increase use of NetSuite as a platform; and to extend the verticalization of our

20


product line. Although we have made progress towards our goals in recent periods, there are still many areas where we believe that we can continue to grow. To achieve these goals, we are focused on the following initiatives:

Growth of sales of OneWorld, our platform for ERP, CRM and Ecommerce capabilities in multi-currency environments across multiple subsidiaries and legal entities, which supports the needs of large, standalone companies, and divisions of very large enterprises;

Continue to expand our SuiteCommerce platform to enable commerce on every device, anytime, anywhere;

Strengthening our offerings for targeted industries such as wholesale/distribution, manufacturing, retail, high technology and professional services by adding deeper verticalized functionality; and

Developing our SuiteCloud ecosystem to enable third parties to extend our offerings with their vertical expertise or horizontal solution.

We experience competitive pricing pressure when our products are compared with solutions that address a narrower range of customer needs or are not fully integrated (for example, when compared with Ecommerce or CRM stand-alone solutions). In addition, since we sell primarily to medium-sized businesses, we also face pricing pressure in terms of the more limited financial resources or budgetary constraints of many of our target customers. We do not currently experience significant pricing pressure from competitors that offer a similar on-demand, integrated business management suite.

We sell our application suite pursuant to subscription agreements. For the most part, the duration of subscription and support agreements is 12 to 36 months. We rely in part on a large percentage of our customers to renew their agreements to drive our revenue growth. Our customers have no obligation to renew their subscriptions after the expiration of their subscription period.

We generally invoice our customers in advance in monthly, annual or quarterly installments, and typical payment terms provide that our clients pay us within 30 to 60 days of invoice. Amounts that have been invoiced where the customer has a legal obligation to pay are recorded in accounts receivable and deferred revenue. As of June 30, 2016, we had deferred revenue of $463.5 million.

Our subscription agreements generally provide service level commitments of 99.5% uptime per period, excluding scheduled maintenance. The failure to meet this level of service availability may require us to credit qualifying customers up to the value of an entire month of their subscription and support fees. In light of the Company’s historical experience with meeting its service level commitments, the Company's accrued liability related to such obligations in the accompanying consolidated financial statements is negligible.

As part of our overall growth, we expect the percentage of our revenue generated outside of the United States to increase as we invest in and enter new markets. Revenue by geographic region, based on the billing address of the customer, was as follows for the periods presented:
 
Six Months Ended June 30,
 
Three Months Ended June 30,
 
2016
 
2015
 
2016
 
2015
 
(dollars in thousands)
United States
$
334,638

 
$
254,639

 
$
172,158

 
$
133,269

International
112,711

 
87,458

 
58,613

 
44,011

Total revenue
$
447,349

 
$
342,097

 
$
230,771

 
$
177,280

 
 
 
 
 
 
 
 
Percentage of revenue generated outside of the United States
25
%
 
26
%
 
25
%
 
25
%

Employees

The number of full-time employees as of June 30, 2016 was 4,979 as compared to 4,603 at December 31, 2015 and 4,101 at June 30, 2015. As of June 30, 2016, our headcount included 1,430 employees in sales and marketing; 1,991 employees in operations, professional services, training and customer support; 1,069 employees in product development; and 489 employees in a general and administrative capacity.


21


Cost of Revenue

Subscription and support cost of revenue primarily consists of costs related to hosting our application suite, providing customer support, data communications expenses, personnel and related costs of operations, stock-based compensation, software license fees, outsourced subscription services, costs associated with website development activities, allocated overhead, amortization expense associated with capitalized internal use software and acquired developed technology, and related plant and equipment depreciation and amortization expenses.

Professional services and other cost of revenue primarily consists of personnel and related costs for our professional services employees and executives, external consultants, stock-based compensation and allocated overhead.

We allocate overhead such as rent, information technology costs and employee benefit costs to all departments based on headcount. Recruiting costs are systematically allocated to the respective departments that utilize recruiting services during the period. As such, general overhead expenses are reflected in cost of revenue and each operating expense category.

We expect cost of revenue to increase in absolute dollars over the near term; however, it could fluctuate period to period depending on the growth of our professional services business.

Operating Expenses - Product Development

Product development expenses primarily consist of personnel and related costs for our product development employees and executives, including salaries, stock-based compensation, employee benefits and allocated overhead. Our product development efforts have been devoted primarily to increasing the functionality and enhancing the ease of use of our on-demand application suite, as well as localizing our product for international use. A key component of our strategy is to expand our business internationally. This will require us to conform our application suite to comply with local regulations and languages, causing us to incur additional expenses related to translation and localization of our application for use in other countries.

We expect product development expenses to increase in absolute dollars as we continue to extend our service offerings internationally and as we expand and enhance our application suite technologies. Such expenses may vary due to the timing of these offerings and technologies.

Operating Expenses - Sales and Marketing

Sales and marketing expenses primarily consist of personnel and related costs for our sales and marketing employees and executives, including wages, benefits, bonuses, commissions and training, stock-based compensation, commissions paid to our channel partners, the cost of marketing programs such as on-line lead generation, promotional events, webinars and other meeting costs, amortization of intangible assets related to trade name and customer relationships and allocated overhead. We market and sell our application suite worldwide through our direct sales organization and indirect distribution channels such as strategic resellers. We capitalize and amortize our direct and channel sales commissions over the period the related revenue is recognized.

We expect to continue to invest in sales and marketing to pursue new customers and expand relationships with existing customers. As such, we expect our sales and marketing expenses to increase in terms of absolute dollars over the near term.

Operating Expenses - General and Administrative

General and administrative expenses primarily consist of personnel and related costs for executive, finance, human resources and administrative personnel, stock-based compensation, legal and other professional fees, other corporate expenses and IT, facility and recruiting costs allocated to other departments.

We expect our general and administrative expenses to increase in terms of absolute dollars over the near term.

Income Taxes

Since inception, we have incurred annual operating losses and, accordingly, have not recorded a provision for income taxes for any of the periods presented other than provisions for state and foreign income taxes.



22



Critical Accounting Policies and Judgments

Our condensed consolidated financial statements are prepared in accordance with GAAP. The preparation of these condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period-to-period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected.

In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application, while in other cases, significant judgment is required in selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. We consider these policies requiring significant management judgment to be critical accounting policies. These critical accounting policies are:

Revenue recognition;
Deferred commissions;
Accounting for stock-based compensation; and
Other intangible assets.

There have been no significant changes in our critical accounting policies and estimates during the six months ended June 30, 2016 as compared to the critical accounting policies and estimates disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Judgments” included in our Annual Report on Form 10-K for the year ended December 31, 2015 filed on February 24, 2016. In addition, please see Note 2 of Notes to the Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q and Note 2 of the Notes to Consolidated Financial Statements included in our 2015 Annual Report on Form 10-K filed on February 24, 2016 for a description of our accounting policies.

Results of Operations

Revenue, Cost of Revenue, Gross Profit and Gross Margin

Information about revenue, cost of revenue, gross profit and gross margin was as follows for the periods presented:
 
Six Months Ended June 30,
 
Three Months Ended June 30,
 
2016
 
2015
 
2016
 
2015
 
(dollars in thousands)
Revenue:
 
 
 
 
 
 
 
Subscription and support
$
353,528

 
$
273,896

 
$
180,194

 
$
140,922

Professional services and other
93,821

 
68,201

 
50,577

 
36,358

Total revenue
447,349

 
342,097

 
230,771

 
177,280

Cost of revenue (1):
 
 
 
 
 
 
 
Subscription and support
61,809

 
43,444

 
32,018

 
22,454

Professional services and other
94,148

 
68,058

 
52,087

 
36,687

Total cost of revenue
155,957

 
111,502

 
84,105

 
59,141

Gross profit
$
291,392

 
$
230,595

 
$
146,666

 
$
118,139

Gross margin
65
%
 
67
%
 
64
%
 
67
%
 
 
 
 
 
 
 
 
(1) Includes stock-based compensation expense, amortization of intangible assets and transaction costs associated with business combinations of:
Cost of revenue:
 
 
 
 
 
 
 
Subscription and support
$
7,745

 
$
5,159

 
$
3,973

 
$
2,646

Professional services and other
7,449

 
5,622

 
4,802

 
2,826

 
$
15,194

 
$
10,781

 
$
8,775

 
$
5,472


23



Six Months Ended June 30, 2016 as Compared to the Six Months Ended June 30, 2015

Revenue for the six months ended June 30, 2016 increased $105.3 million, or 31%, compared to the same period in 2015.

Subscription and support revenue: Subscription and support revenue for the six months ended June 30, 2016 increased $79.6 million, or 29%, compared to the same period in 2015. The increase was primarily the result of a $66.5 million increase in revenue resulting from the acquisition of new customers and a $13.1 million increase in revenue from existing customers. Subscription and support revenue increased during the period due to an increase in number of customers and continued adoption of OneWorld. Additionally, subscription and support revenue for the six months ended June 30, 2016 also includes $22.7 million in revenue related to Bronto, which was acquired in June 2015.

Professional services and other revenue: Professional services and other revenue for the six months ended June 30, 2016 increased $25.6 million, or 38%, compared to the same period in 2015. The increase was primarily the result of a $50.1 million increase in revenue resulting from the acquisition of new customers. The increase in professional services and other revenue was partially offset by a $24.5 million decrease in revenue from existing customers related to services purchased in connection with the initial implementation of our product in 2015 that did not recur for those customers in 2016. Overall, our billable professional services hours increased during the six months ended June 30, 2016 as a result of an increase in customer demand and headcount, while our average consulting rates for professional services decreased slightly. Additionally, professional services and other revenue for the six months ended June 30, 2016 also includes $2.6 million in revenue related to Bronto, which was acquired in June 2015.

Revenue generated outside of the United States was $112.7 million, or 25%, of our total revenue for the six months ended June 30, 2016, as compared to $87.5 million, or 26%, for the same period in 2015. Revenue generated outside the United States increased primarily as a result of our increased presence in Europe. The revenue generated outside the United States as a percentage of total revenue decreased because our United States market presence expanded at a higher rate than outside the United States during the six months ended June 30, 2016.

Cost of revenue for the six months ended June 30, 2016 increased $44.5 million, or 40%, compared to the same period in 2015.

Subscription and support cost of revenue: Subscription and support cost of revenue for the six months ended June 30, 2016 increased $18.4 million, or 42%, compared to the same period in 2015. The increase was primarily the result of a $10.5 million increase in data center production costs, a $7.0 million increase in personnel costs, and a $0.9 million increase in IT, facility and other operating expenses. Data center and other production costs increased due to an increase in depreciation of new equipment as a result of our data center expansion, an increase in amortization of intangibles related to our business acquisitions and an increase in support costs, maintenance costs and other operational costs associated with an increase in our data center capacity and activity. Personnel costs increased due to an overall increase in headcount and an increase in incentive bonuses. IT, facility and other operating expenses related to our data center increased due to an increase in costs associated with our global expansion.

Professional services and other cost of revenue: Professional services and other cost of revenue for the six months ended June 30, 2016 increased $26.1 million, or 38%, compared to the same period in 2015. The increase was primarily the result of a $21.8 million increase in personnel costs and a $4.3 million increase in IT, facility and other operating expenses. Personnel costs increased due to an overall increase in headcount, annual merit increases and incentive bonuses. Headcount increased as a result of an increase in the demand for our professional services. IT, facility and other operating expenses related to our professional services increased due to an increase in costs associated with our global expansion.

Our gross margin decreased to 65% during the six months ended June 30, 2016 from 67% during the same period in 2015. Our gross margin decreased due to an increase in the mix of professional service business which delivers a lower gross margin than subscription revenue. Additionally, our gross margin decreased from the same period in 2015 due to an increase in data center production costs associated with an expansion of our production environment to increase capacity, and an increase in amortization of intangible assets resulting from business combinations.






24




Three Months Ended June 30, 2016 as Compared to the Three Months Ended June 30, 2015

Revenue for the Three Months Ended June 30, 2016 increased $53.5 million, or 30%, compared to the same period in 2015.

Subscription and support revenue: Subscription and support revenue for the three months ended June 30, 2016 increased $39.3 million, or 28%, compared to the same period in 2015. The increase was primarily the result of a $32.8 million increase in revenue resulting from the acquisition of new customers and a $6.5 million increase in revenue from existing customers. Subscription and support revenue increased during the period due to an increase in number of customers and continued adoption of OneWorld. Additionally, subscription and support revenue for the second quarter of 2016 also includes $11.5 million in revenue related to Bronto which was acquired in June 2015.

Professional services and other revenue: Professional services and other revenue for the three months ended June 30, 2016 increased $14.2 million, or 39%, compared to the same period in 2015. The increase was primarily the result of a $26.2 million increase in revenue resulting from the acquisition of new customers. The increase in professional services and other revenue was partially offset by a $12.0 million decrease in revenue from existing customers related to services purchased in connection with the initial implementation of our product in 2015 that did not recur for those customers in 2016. Overall, our billable professional services hours increased during the three months ended June 30, 2016 as a result of an increase in customer demand and headcount, while our average consulting rates for professional services decreased slightly. Additionally, professional services and other revenue for the second quarter of 2016 also includes $1.3 million in revenue related to Bronto which was acquired in June 2015.

Revenue generated outside of the United States was $58.6 million, or 25%, of our total revenue for the three months ended June 30, 2016, as compared to $44.0 million, or 25%, for the same period in 2015. Revenue generated outside the United States as a percentage of total revenue remained constant because of proportional revenue growth domestically and internationally.

Cost of revenue for the three months ended June 30, 2016 increased $25.0 million, or 42%, compared to the same period in 2015.

Subscription and support cost of revenue: Subscription and support cost of revenue for the three months ended June 30, 2016 increased $9.6 million, or 43%, compared to the same period in 2015. The increase was primarily the result of a $5.4 million increase in data center production costs, a $3.8 million increase in personnel costs and a $0.4 million increase in IT, facility and other operating expenses. Data center and other production costs increased due to an increase in depreciation of new equipment as a result of our data center expansion, an increase in amortization of intangibles related to our business acquisitions and an increase in support costs, maintenance costs and other operational costs associated with an increase in our data center capacity and activity. Personnel costs increased due to an overall increase in headcount and an increase in incentive bonuses. IT, facility and other operating expenses related to our data center increased due to an increase in costs associated with our global expansion.

Professional services and other cost of revenue: Professional services and other cost of revenue for the three months ended June 30, 2016 increased $15.4 million, or 42%, compared to the same period in 2015. The increase was primarily the result of an $12.9 million increase in personnel costs and a $2.5 million increase in IT, facility and other operating expenses. Personnel costs increased due to an overall increase in headcount, annual merit increases and incentive bonuses. Headcount increased as a result of an increase in the demand for our professional services. IT, facility and other operating expenses related to our professional services increased due to an increase in costs associated with our global expansion.

Our gross margin decreased to 64% during the three months ended June 30, 2016 from 67% during the same period in 2015. Our gross margin decreased due to an increase in the mix of professional service business which delivers a lower gross margin than subscription revenue. Additionally, our gross margin decreased from the same period in 2015 due to an increase in data center production costs associated with an expansion of our production environment to increase capacity, and an increase in amortization of intangible assets resulting from business combinations.


25


Operating Expenses

Operating expenses were as follows for the periods presented:

 
Six Months Ended June 30,
 
2016
 
2015
 
Amount
 
% of revenue
 
Amount
 
% of revenue
 
(dollars in thousands)
Operating expenses (1):
 
 
 
 
 
 
 
Product development
$
77,449

 
17%
 
$
62,256

 
18%
Sales and marketing
227,005

 
51%
 
179,057

 
52%
General and administrative
45,513

 
10%
 
44,075

 
13%
Total operating expenses
$
349,967

 
78%
 
$
285,388

 
83%

 
Three Months Ended June 30,
 
2016
 
2015
 
Amount
 
% of revenue
 
Amount
 
% of revenue
 
(dollars in thousands)
Operating expenses (1):
 
 
 
 
 
 
 
Product development
$
39,597

 
17%
 
$
32,537

 
18%
Sales and marketing
117,314

 
51%
 
95,803

 
54%
General and administrative
23,219

 
10%
 
25,642

 
14%
Total operating expenses
$
180,130

 
78%
 
$
153,982

 
87%

(1) Includes stock-based compensation expense, amortization of acquisition-related intangible assets and transaction costs associated with business combinations as follows:
 
Six Months Ended June 30,
 
Three Months Ended June 30,
 
2016
 
2015
 
2016
 
2015
 
(dollars in thousands)
Product development
$
19,337

 
$
16,205

 
$
9,852

 
$
8,421

Sales and marketing
25,249

 
20,467

 
13,754

 
11,196

General and administrative
16,385

 
19,598

 
8,500

 
13,524

Total
$
60,971

 
$
56,270

 
$
32,106

 
$
33,141


Six Months Ended June 30, 2016 as Compared to the Six Months Ended June 30, 2015

Product development expenses for the six months ended June 30, 2016 increased $15.2 million, or 24%, as compared to the same period in 2015. The increase was primarily the result of a $11.5 million increase in personnel costs resulting from an overall increase in headcount, annual salary increases, payroll tax increases and an increase in stock-based compensation. The increase in personnel costs includes a $3.2 million increase in stock-based compensation resulting primarily from the issuance of annual equity awards to a larger employee base. Additionally, IT, facility and other operating expenses increased by $3.7 million due to an increase in product development operational costs and an increase in facility costs associated with our global expansion.

Sales and marketing expenses for the six months ended June 30, 2016 increased $47.9 million, or 27%, as compared to the same period in 2015. The increase was primarily the result of a $36.4 million increase in personnel costs, a $7.1 million increase in marketing, sales and other operating expenses and a $4.4 million increase in IT, facility and recruiting costs. The increase in personnel costs related primarily to increases in commission and payroll expenses resulting from higher sales and an increase in headcount. Additionally, the increase in personnel costs includes a $3.4 million increase in stock-based compensation resulting primarily from the issuance of annual equity awards and grants to new employees. Marketing and other

26


operating expenses increased because of an increase in costs associated with our annual product marketing and user conference, SuiteWorld. We also attended more trades shows, and increased our media campaigns and product branding. Sales related costs increased due to an increase in amortization expenses resulting from customer relationship and trade name intangible assets acquired through our business acquisitions. IT, facility and recruiting costs increased due to an increase in costs associated with our global expansion.

General and administrative expenses for the six months ended June 30, 2016 increased $1.4 million, or 3%, as compared to the same period in 2015. The increase was primarily the result of a $3.4 million increase in personnel costs offset by a $1.9 million decrease in other operating expenses. The increase in personnel costs resulted from an increase in headcount, incentive pay and other personnel costs. Additionally, personnel costs includes a $1.4 million increase in stock-based compensation costs resulting primarily from the issuance of annual equity awards and equity awards to new employees. Other operating expenses decreased due to $4.1 million net acquisition related costs, primarily related to Bronto, incurred in the second quarter of 2015 but not in 2016. This decrease was partially offset by an increase in finance administration costs and other operating expenses.

Three Months Ended June 30, 2016 as Compared to the Three Months Ended June 30, 2015

Product development expenses for the three months ended June 30, 2016 increased $7.1 million, or 22%, as compared to the same period in 2015. The increase was primarily the result of a $5.7 million increase in personnel costs resulting from an overall increase in headcount, annual salary increases, payroll tax increases and an increase in stock-based compensation. The increase in personnel costs includes a $1.4 million increase in stock-based compensation resulting primarily from the issuance of annual equity awards to a larger employee base. Additionally, IT, facility and other operating expenses increased by $1.4 million due to an increase in product development operational costs and an increase in facility costs associated with our global expansion.

Sales and marketing expenses for the three months ended June 30, 2016 increased $21.5 million, or 22%, as compared to the same period in 2015. The increase was primarily the result of a $16.8 million increase in personnel costs, a $2.9 million increase in marketing, sales and other operating expenses, and a $1.8 million increase in IT, facility and recruiting costs. The increase in personnel costs related primarily to increases in commission and payroll expenses resulting from higher sales and an increase in headcount. Additionally, the increase in personnel costs includes a $2.2 million increase in stock-based compensation resulting primarily from the issuance of annual equity awards and grants to new employees. Marketing and other operating expenses increased because of an increase in costs related to our annual product marketing and user conference, SuiteWorld. We also attended more trades shows, and increased our media campaigns and product branding. Sales related costs include an increase in amortization expenses resulting from customer relationship and trade name intangible assets acquired through our business acquisitions. IT, facility and recruiting costs increased due to an increase in costs associated with our global expansion.

General and administrative expenses for the three months ended June 30, 2016 decreased $2.4 million, or 9%, as compared to the same period in 2015. The decrease was primarily the result of a $3.2 million decrease in other operating expenses, offset by a $754,000 increase in personnel costs. Other operating expenses decreased due to $5.0 million in net acquisition related costs, primarily related to Bronto, incurred in the second quarter of 2015 but not in 2016. This decrease was offset by an increase in finance administration costs and other operating expenses. The increase in personnel costs resulted from an increase in headcount, incentive pay and other personnel costs.

Non-operating Items

Non-operating items, including interest income and expense, other income, net and income taxes were as follows for the periods presented:
 
Six Months Ended June 30,
 
2016
 
2015
 
Amount
 
% of revenue
 
Amount
 
% of revenue
 
(dollars in thousands)
Interest income
$
354

 
—%
 
$
216

 
—%
Interest expense
(7,547
)
 
(2)%
 
(7,153
)
 
(2)%
Other income, net
465

 
—%
 
(264
)
 
—%
Provision/(Benefit) for income taxes
2,185

 
—%
 
(6,994
)
 
(2)%

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Three Months Ended June 30,
 
2016
 
2015
 
Amount
 
% of revenue
 
Amount
 
% of revenue
 
(dollars in thousands)
Interest income
$
203

 
—%
 
$
113

 
—%
Interest expense
(3,797
)
 
(2)%
 
(3,520
)
 
(2)%
Other income, net
307

 
—%
 
(266
)
 
—%
Provision/(Benefit) for income taxes
992

 
—%
 
(7,229
)
 
(4)%

During the six and three months ended June 30, 2016, our income tax provision increased from the same periods in the prior year. During the quarter ended June 30, 2015, the Company recorded approximately $8.3 million of additional net deferred tax liabilities related to the Bronto acquisition.  These additional deferred tax liabilities create a new source of taxable income, thereby requiring us to release a portion of our deferred tax asset valuation allowance with a related reduction in income tax expense of approximately $8.3 million for 2015.

Liquidity and Capital Resources

As of June 30, 2016, our primary sources of liquidity were our cash and cash equivalents totaling $317.5 million, marketable securities totaling $93.2 million and $177.1 million in accounts receivable, net of allowance.

In the six months ended June 30, 2016, cash flows from operations were $68.0 million.

A summary of our cash flow activities was as follows for the periods presented:
 
Six Months Ended June 30,
 
2016
 
2015
 
(dollars in thousands)
Net cash provided by operating activities
$
67,967

 
$
51,874

Net cash used in investing activities
(48,817
)
 
(115,744
)
Net cash provided by / (used in) financing activities
10,399

 
(5,009
)
Effect of exchange rate changes on cash and cash equivalents
(2,005
)
 
(273
)
Net change in cash and cash equivalents
$
27,544

 
$
(69,152
)

Cash provided by operating activities was driven by sales of our application suite offset by costs incurred to deliver that service. The timing of our billings and collections relating to our sales and the timing of the payment of our liabilities have a significant impact on our cash flows. Cash flows from operations increased during the six months ended June 30, 2016 as compared to the same period in 2015, primarily as a result of an increase in collections from customers and the timing of payments to vendors, partially offset by an increase in commissions paid.

Cash used in investing activities during the six months ended June 30, 2016 decreased from the same period in 2015 primarily due to a decrease in acquisition related payments. We made net cash payments of $95.5 million in June 2015 in connection with our acquisition of Bronto compared to net cash payments of $18.2 million during the six months ended June 30, 2016 in connection with our acquisition of a manufacturing software company ("MSC") and a professional services firm ("PFS"). Additionally, cash receipts from marketable security activity decreased $9.3 million during the six months ended June 30, 2016 compared to the same period in the 2015 due to the timing of investment purchases, sales and maturities. Also in 2016, capital expenditures for property and equipment increased by $1.1 million.

Cash provided by / (used in) financing activities for the six months ended June 30, 2016 increased from the same period in 2015 primarily due to an increase of $7.4 million in proceeds received from employee stock plans, a $6.8 million decrease in RSUs acquired to settle employee withholding liabilities, and a decrease of $1.3 million in acquisition related payments.


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We intend to use our cash for general corporate purposes, including potential future acquisitions or other transactions. Further, we expect to incur additional expenses in connection with our international expansion. We believe that our cash and cash equivalents are adequate to fund those potential or anticipated activities.

While we believe that our uncommitted current working capital and anticipated cash flows from operations will be adequate to meet our cash needs for daily operations and capital expenditures for at least the next 12 months, we may elect to raise additional capital through the sale of additional equity or debt securities, obtain a credit facility or sell certain assets. If additional funds are raised through the issuance of additional debt securities, these securities could have rights, preferences and privileges senior to holders of common stock or holders of the convertible notes, and terms of any debt could impose restrictions on our operations. The sale of additional equity or convertible debt securities could result in additional dilution to our stockholders and additional financing may not be available in amounts or on terms acceptable to us. If additional financing becomes necessary and we are unable to obtain the additional funds, we may be required to reduce the scope of our planned product development and marketing efforts, potentially harming our business, financial condition and operating results.

Off Balance Sheet Arrangements and Contractual Obligations

During the six months ended June 30, 2016 and 2015, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off‑balance sheet arrangements or other contractually narrow or limited purposes.

During the three months ended June 30, 2016, we entered into various office space leases to expand our operations primarily in the United States and the Philippines. The corresponding lease terms for these agreements expire at various dates through 2027. We will pay a total of $8.3 million, net of any lessor lease incentives, over the corresponding lease terms for additional office space.

During the three months ended March 31, 2016, we entered into various office space leases to expand our operations primarily in the United Kingdom and Australia. The corresponding lease terms for these agreements expire at various dates through 2024. We will pay a total of $10.2 million, net of any lessor lease incentives, over the corresponding lease terms for additional office space.



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ITEM 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Sensitivity

We had cash and cash equivalents of $317.5 million and marketable securities of $93.2 million as of June 30, 2016. These amounts were held primarily in money market funds, commercial paper and US government securities.

Cash and cash equivalents are held for working capital purposes, marketable securities are held as short-term investments and restricted cash amounts are held as security against various lease obligations. Due to the short‑term nature of these investments, we believe that we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates.

Market Risk

In June 2013, we issued at par value $310.0 million of 0.25% convertible senior notes due June 1, 2018. The Notes have a fixed annual interest rate of 0.25% and we, therefore, do not have economic interest rate exposure on the Notes. However, the value of the Notes is exposed to interest rate risk. Generally, the fair value of the Notes will increase as interest rates fall and decrease as interest rates rise. These Notes are also affected by volatility in our common stock price. As of June 30, 2016, the fair value of the Notes was $305.1 million.

Foreign Currency Risk

Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the British Pound Sterling, Canadian Dollar, Japanese Yen, Australian Dollar, Philippine Peso, Uruguayan Peso, Thai Baht and the Czech Crown. Our revenue is generally denominated in the local currency of the contracting party. The majority of our invoicing relates to sales occurring in the United States and therefore is denominated in U.S. dollars. A certain percentage of sales are denominated in foreign currencies including, but not limited to, the local currencies of Australia, the United Kingdom and Canada. Our expenses are incurred primarily in the United States, Canada, the Philippines, Australia and the United Kingdom, with a small portion of expenses incurred in other countries where our international sales, development and operations offices are located. Our results of operations and cash flows are, therefore, subject to fluctuations due to changes in foreign currency exchange rates. During the six and three months ended June 30, 2016, the U.S. dollar strengthened by 4.7% and 4.0%, respectively, against the foreign currencies in which our operational expenses are denominated when compared to the same period in the prior year. For the six and three months ended June 30, 2016, the fluctuation in foreign currency rates reduced our net losses by approximately $2.3 million and $637,000, respectively.

During the six and three months ended June 30, 2016, we continued a hedging program to limit the exposure of foreign currency risk resulting from the revaluation of foreign denominated assets and liabilities through the use of forward exchange contracts. See “Balance Sheet Hedging - Hedging of Foreign Currency Assets and Liabilities” in Note 3 (Financial Instruments) under the heading “Notes to Condensed Consolidated Financial Statements” of Part 1, Item 1, “Financial Statements” herein for further disclosures.

Fair Value of Financial Instruments

We do not have material exposure to market risk with respect to investments, as our investments consist primarily of highly liquid investments with various maturity dates over the next 12 months. We do not use derivative financial instruments for speculative or trading purposes. However, this does not preclude our adoption of specific hedging strategies in the future.

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ITEM 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

An evaluation was performed by management, with the participation of our Chief Executive Officer ("CEO") and our Chief Financial Officer (“CFO”), with respect to the effectiveness of our disclosure controls and procedures as of June 30, 2016 (as defined in Rules 13a-15(e) and 15d - 15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Based on that evaluation, our CEO and CFO have concluded that as of June 30, 2016, our disclosure controls and procedures are effective, provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms, and that such information is accumulated and communicated to management including the CEO and CFO, as appropriate, to allow timely decisions regarding required disclosures.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations of Internal Controls

Our management, including our CEO and CFO, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.


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PART II – OTHER INFORMATION

ITEM 1. Legal Proceedings

We are involved in various legal proceedings and receive claims from time to time, arising from the normal course of business activities. We have accrued for estimated losses in the accompanying condensed consolidated financial statements for matters with respect to which we believe the likelihood of an adverse outcome is probable and the amount of the loss is reasonably estimable.

ITEM 1A. Risk Factors

A description of the risks and uncertainties associated with our business is set forth below. This description includes any material changes to and supersedes the description of the risks and uncertainties associated with our business previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2015 filed on February 24, 2016. You should carefully consider such risks and uncertainties, together with the other information contained in this report, our Annual Report on Form 10-K for the fiscal year ended December 31, 2015 and in our other public filings. If any of such risks and uncertainties actually occurs, our business, financial condition or operating results could differ materially from the plans, projections and other forward-looking statements included in the section titled "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this report and in our other public filings. In addition, if any of the following risks and uncertainties, or if any other risks and uncertainties, actually occurs, our business, financial condition or operating results could be harmed substantially, which could cause the market price of our stock to decline, perhaps significantly.

Risks Related to Our Business

The announcement and pendency of our agreement to be acquired by entities affiliated with Oracle Corporation could adversely affect our business.

On July 28, 2016, we announced that we had entered into a definitive agreement for entities affiliated with Oracle Corporation (“Oracle”) to acquire us. Uncertainty about the effect of the proposed transaction on our customers, employees, partners and other parties may adversely affect our business. Our employees may experience uncertainty about their roles or seniority following the transaction. There can be no assurance that our employees, including key personnel, can be retained to the same extent that we have previously been able to attract and retain employees. Any loss or distraction of such employees could adversely affect our business and operations. In addition, we have diverted, and will continue to divert, significant management resources toward the completion of the transaction, which could adversely affect our business and operations. Parties with which we do business may experience uncertainty associated with the transaction and related transactions, including with respect to current or future business relationships with us. Uncertainty may cause clients to refrain from doing business with us, which could adversely affect our business, results of operations and financial condition.

The failure to complete the sale to entities affiliated with Oracle could adversely affect our business.

Completion of the sale to entities affiliated with Oracle is subject to several conditions beyond our control that may prevent, delay, or otherwise adversely affect its completion, The consummation of the transaction is conditioned on there having been validly tendered and not withdrawn: (1) a number of shares of common stock that, together with any shares of common stock owned by Oracle and certain of its affiliates, represents a majority of the shares of common stock (calculated on a fully diluted basis in accordance with the definitive agreement); and (2) a number of shares common stock (excluding, in such number, shares of Common Stock beneficially owned by: (i) NetSuite Restricted Holdings LLC, Lawrence J. Ellison, David Ellison and Margaret Ellison (and their respective affiliates who beneficially own shares of Common Stock) (collectively, the “LJE Parties”); (ii) Oracle and certain of its affiliates; and (iii) any executive officers or directors of the Company and their affiliates (the persons and entities referred to in clauses (i), (ii) and (iii), the “Specified Persons”)) that represents a majority of the shares of common stock issued and outstanding immediately prior to the acceptance time (excluding, from such issued and outstanding shares, shares of common stock beneficially owned by the Specified Persons). The consummation of the transaction is also conditioned on (1) receipt of certain regulatory approvals, including expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 and certain foreign antitrust laws; (2) the accuracy of the representations and warranties and compliance with the covenants contained in the definitive agreement, subject to qualifications; and (3) other customary conditions. Many of the conditions to consummation of the transaction are not within our control or the control of Oracle and none of us can predict when or if these conditions will be satisfied. If any of these conditions are not satisfied or waived, it is possible that the transaction will not be consummated in the expected time frame or that the definitive agreement may be terminated. If the proposed sale or a similar transaction is not completed, the share price

32


of our common stock will drop to the extent that the current market price of our common stock reflects an assumption that a transaction will be completed. In addition, under circumstances defined in the definitive agreement, we may be required to pay a termination fee of $300 million to Oracle. Further, a failed transaction may result in negative publicity and a negative impression of us in the investment community. Finally, any disruption to our business resulting from the announcement and pendency of the transaction and from intensifying competition from our competitors, including any adverse changes in our relationships with our clients, employees, partners and other parties, could continue or accelerate in the event of a failed transaction. There can be no assurance that our business, these relationships or our financial condition will not be adversely affected, as compared to the condition prior to the announcement of the transaction, if the transaction is not consummated.

While the acquisition by Oracle is pending, we are subject to business uncertainties