10-K 1 form10k.htm PROCERA NETWORKS, INC 10-K 12-31-2013

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-K
 
(Mark One)
þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2013

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

For the transition period from         to.
 
Commission file number 001-33691
 

PROCERA NETWORKS, INC.
(Exact name of registrant as specified in its charter)
 

 
Delaware
 
33-0974674
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
47448 Fremont Boulevard
 
94538
Fremont, California
 
(Zip Code)
(Address of principal executive offices)
 
 
 
Registrant’s telephone number, including area code: (510) 230-2777
 
Securities registered pursuant to Section 12(b) of the Act
 
Title of Each Class
 
Name of Each Exchange on Which Registered
Common Stock par value $0.001 per share
 
The NASDAQ Global Select Market
 
Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes   o No   þ
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes   o No   þ
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes   þ No   o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   þ No   o
 


Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§232.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o
 
Accelerated filer þ
Non-accelerated filer o
(Do not check if a smaller reporting company)
 
Smaller reporting o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).      Yes   o No   þ
 
The aggregate market value of the voting stock held by non-affiliates of the registrant on June 28, 2013, based upon the closing price of common stock on such date as reported on the NASDAQ Global Market, was approximately $228,745,795. Shares of voting stock held by directors, officers and stockholders or stockholder groups whose beneficial ownership exceeds 5% of the registrant’s common stock outstanding have been excluded in that such persons may be deemed to be affiliates. The number of shares owned by stockholders whose beneficial ownership exceeds 5% was determined based upon information supplied by such persons and upon Schedules 13D and 13G, if any, filed with the Securities and Exchange Commission. This assumption regarding affiliate status is not necessarily a conclusive determination for other purposes.

The number of shares of common stock outstanding as of March 7, 2014 was 20,653,949.

DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Registrant’s Definitive Proxy Statement for its 2014 Annual Stockholders’ Meeting are incorporated by reference into Part III of this Annual Report on Form 10-K, to be filed within 120 days of the Registrant’s fiscal year ended December 31, 2013.
3

PROCERA NETWORKS, INC.
 
FISCAL YEAR 2013
Form 10-K
 
ANNUAL REPORT
 
TABLE OF CONTENTS
 
PART I
5
 
Item 1.
5
 
Item 1A.
16
 
Item 1B.
30
 
Item 2.
30
 
Item 3.
31
 
Item 4.
31
PART II
32
 
Item 5.
32
 
Item 6.
34
 
Item 7.
35
 
Item 7A.
45
 
Item 8.
46
 
Item 9.
74
 
Item 9A.
74
 
Item 9B.
77
PART III
77
 
Item 10.
77
 
Item 11.
77
 
Item 12.
77
 
Item 13.
77
 
Item 14.
77
PART IV
78
 
Item 15.
78
 
80
 
82
 
Exhibit 23.1
 
 
Exhibit 23.2
 
 
Exhibit 31.1
 
 
Exhibit 31.2
 
 
Exhibit 32.1
 
 
In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements regarding our strategy, financial performance and revenue sources that involve a number of risks and uncertainties, including those discussed under the title “RISK FACTORS” in Item 1A.  Forward-looking statements in this report include, but are not limited to, those relating to our potential for future revenues, revenue growth and profitability; markets for our products; our ability to continue to innovate and obtain intellectual property protection; operating expense targets; liquidity; new product development; the possibility of acquiring (and our ability to consummate any acquisition of) complementary businesses, products, services and technologies; the geographical dispersion of our sales; expected tax rates; our international expansion plans; and our development of relationships with providers of leading Internet technologies.  In some cases, you can identify forward-looking statements by terms such as “believe”, “expects”, “anticipates”, “intends”, “estimates”, “projects”, “target”, “goal”, “plans”, “objective”, “should”, or similar expressions or variations on such expressions.
 
While these forward-looking statements represent our current judgment on the future direction of our business, such statements are subject to many risks and uncertainties which could cause actual results to differ materially from any future performance suggested in this Annual Report on Form 10-K due to a number of factors, including, without limitation, our ability to produce and commercialize new product introductions, particularly our acceleration-related technologies; our ability to successfully compete in an increasingly competitive market; the perceived need for our products; our ability to convince potential customers of the value of our products; the costs of competitive solutions; our reliance on third party suppliers; continued capital spending by prospective customers and macro-economic conditions.  Readers are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K.  We undertake no obligation to publicly release any revisions or updates to forward-looking statements to reflect events, information or circumstances arising after the date of this document, except as required by federal securities laws.  Therefore, you should not assume that our silence over time means that actual events are bearing out as expressed or implied in these forward-looking statements.  See “RISK FACTORS” appearing in Item 1A.

Throughout this Annual Report on Form 10-K, we refer to Procera Networks, Inc., a Delaware corporation, as “Procera” or the “Company” and, together with its consolidated subsidiaries, as “we,” “our” and “us,” unless otherwise indicated.  Any reference to “Netintact” refers collectively to our wholly owned subsidiaries, Procera Networks AB (formerly Netintact AB), a Swedish corporation, and Netintact, PTY, an Australian corporation.

PART I

Item 1. Business
 
We are a leading provider of Internet Intelligence solutions designed for network operators worldwide.  Procera’s PacketLogic solutions provide actionable intelligence and policy enforcement to ensure a high quality experience for Internet connected devices.  Network operators deploy our technology to enable real-time visibility, superior performance and scalability, and deliver personalized services for millions of enterprises and consumers.  Enterprises utilize our embedded Network Application Visibility Library, or NAVL, solutions to ensure that they can deliver “bring your own device” and cloud services to their employees.  We believe that the intelligence our products provide about users and their usage enables our network operator customers to make informed business decisions.  Our network operator customers include service provider customers and enterprises.  Our service provider customers include mobile service providers and broadband service providers, which include cable multiple system operators, or MSOs, telecommunications companies and Internet Service Providers, or ISPs.  Our enterprise customers include educational institutions, commercial enterprises, government and municipal agencies.  We sell our products directly to network operators; through partners, value added resellers and system integrators; and to other network solution suppliers for incorporation into their network solutions.
 
Our Intelligent Policy Enforcement, or IPE, products are part of the high-growth market for mobile packet and broadband core products.  The market for IPE products was $596.0 million in 2012 and is expected to grow to $1.9 billion in 2017, a 2012–2017 compounded annual growth rate of 26%.  Our bundled products containing hardware and software elements deliver a solution that is a key element of the mobile packet and broadband core ecosystems.  Our solutions are often integrated with additional elements in the mobile packet and broadband core, including Policy Management and Charging functions, and are compliant with the widely adopted 3rd Generation Partnership Program, or 3GPP, standard.  In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, service providers are seeking higher degrees of intelligence, optimization, network management, service creation and delivery in order to differentiate their offerings and deliver a high quality of experience to their subscribers.  We believe the need to create more intelligent and innovative mobile and broadband networks will continue to drive demand for our products.

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

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

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

We were incorporated in the State of Nevada in 2002 and, in June 2013, we reincorporated from the State of Nevada to the State of Delaware.  Our Company is headquartered in Fremont, California and we have key operating entities in Kelowna, Canada and Varberg, Sweden, as well as a geographically dispersed sales force.  We sell our products through our direct sales force, resellers, distributors, system integrators and other equipment manufacturers in the Americas, Asia Pacific and Europe.  Our corporate website address is www.proceranetworks.com.  Investors may access our filings with the Securities and Exchange Commission, including our annual reports on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and amendments to such reports on our website, free of charge, at www.proceranetworks.com, but the information on our website does not constitute part of this Annual Report on Form 10-K and is not incorporated by reference.

Industry Background
 
Network traffic has risen sharply in recent years as a result of the advent of ubiquitous broadband Internet Protocol, or IP, and mobile networks covering an increasing portion of the world’s population, the proliferation of sophisticated edge devices, including smartphones, tablets and laptops and the rise in connections, communications, social networking and data-intensive applications.  We refer to this new era of hyper-connectivity as the New Digital Lifestyle.  According to the Cisco Visual Networking Index, globally, mobile data traffic may reach 11,155,531 Terabytes (11.16 Exabytes) per month in 2017, the equivalent of 2,789 million DVDs each month or 30,742 million text messages each second.

Mobile data networks are an essential tool in the New Digital Lifestyle for streaming video, social networking and collaboration.  Consumers are accessing content from multiple mobile broadband connections and have high expectations on this information being available in real-time.  Social networking, applications and entertainment content resides in the cloud in real-time and without quality access to the Internet, the New Digital Lifestyle can be disrupted.  As networks advance in capabilities in both speed and capacity, new advanced devices and applications will spur more competition for scarce bandwidth.  This results in greater network congestion, causing network operators to balance subscriber demand for network bandwidth with the cost of building additional capacity.  In addition, network providers must be able to adapt to evolving user behavior by rapidly introducing new services and business models to keep pace with demand, which we call service personalization.  IPE enables mobile and broadband network operators to provide unprecedented levels of personalization, service optimization, network assurance and rapid service creation to monetize network investments.  Personalization is tailoring service plans to the needs of the consumer. For example, social networking users may judge Quality of Experience, or QoE, through their Facebook experience and Video Streamers may judge QoE by the speed and quality of Netflix or YouTube video downloads. A critical element for network operators to keep pace with demand and cope with evolving user behavior is to gain as much insight as possible into network activity at levels of detail that are not possible with existing routers, switches and broadband termination devices.

3GPP Policy Ecosystem

Within 3GPP, a framework has been defined for Policy Management and Policy Enforcement:
 

 
With the policy framework established by 3GPP, a management layer and an enforcement layer were created to control user behavior and network provisioning.  The Policy and Charging Rules Function, or PCRF, was established as the policy decision point that establishes the policies that are applied to subscribers and mobile data traffic on the network.  The management layer on the network has specifically defined protocols for interacting with the network layer to translate the policy decisions into policy enforcement.

The policy enforcement layer on the network is designed to enforce policies as instructed by the policy management layer.  However, different devices on the network have different levels of visibility and intelligence, translating to different capabilities for enforcing policies.  More intelligent network elements can implement more sophisticated policies.  Sophisticated policies go far beyond simple byte counters or session timers and can include subscriber, location, device and application awareness.  Awareness gives a powerful advantage in the policy enforcement and billing ecosystem in that policy enforcement “instructions” for highly aware network elements can be much simpler than for “unaware” enforcement points.  A contrasting example of this scenario would be if a PCRF is informed of congestion on a specific location, an intelligent policy enforcement point could be passed an instruction to “prioritize real-time applications at Site A”, where an unaware enforcement point would need to pass a number of new rules that might match specific devices and flows using access control lists, or a much less sophisticated congestion management policy that might make all users equally unsatisfied.  The signaling load on the network normally will be considerably lower on an intelligent network than on an unaware network, as intelligent systems have a greater awareness of location, devices and applications for each active subscriber on the network.

IPE enables mobile and broadband network operators to provide exceptional levels of personalization, service optimization, network assurance and rapid creation of business models to monetize network investments.  IPE uses DPI technology as the core technology to gain awareness of subscribers, location, devices and applications.  This awareness can then be used with the 3GPP policy ecosystem to deliver superior collection of services and applications to mobile and broadband networks.  Features of IPE include:

Business Intelligence  Monitors application and usage trends in order to offer more compelling service packages to subscribers in a timely fashion.  The ability to innovate applications and service bundles includes creating new services targeted to specific consumer groups, age groups or application users with fast time to market with minimal cost.

Service Personalization  Enables policy-based services designed to provide each individual subscriber with a service that meets their pricing, service and quality needs.  Services include delivering prioritization during congestion, minimum bandwidth, usage limits, differentiated pricing, zero-rated content and time-based or value-added services such as Parental Control.

Network Optimization Ensures that network resources are used most effectively throughout the network, including high touch services for high usage subscribers and formatted for specific device types.  Included in network optimization is the ability to manage network congestion by understanding the root cause for the congestion and effectively resolving it to deliver higher QoE to subscribers without excessive capital expenditures.

Network Protection Reacts quickly to network threats and attacks to minimize subscriber impact and QoE, as well as protects network integrity.  This can be accomplished directly by the IPE solution or through integration with other security systems that leverage the visibility of the IPE system.
 
Bill Shock Prevention Prevents user churn due to excessive roaming charges, data usage or distributed denial of service attacks that can inflate a subscriber’s bill.  These notifications need to be proactive and function in real-time to notify subscribers as they approach service limits or pre-defined limits.

Industry Growth Catalysts

According to Infonetics Research, the market for IPE products was $596.0 million in 2012 and is expected to grow to $1.9 billion in 2017, a 2012–2017 compounded annual growth rate of 26%.  The increasing necessity for Policy Management and IPE will be spurred by growing subscriber demand for mobile content and applications, coupled with the network operators’ need to control usage, cost and create new personalized services.  Growth will be aided in part by:

Increase in global broadband users Broadband connectivity has become globally ubiquitous, particularly as underdeveloped and developing markets continue to gain increased broadband access.  Ericsson, in the third quarter of 2013 noted total mobile subscriptions were approximately 6.6 billion.  By the end of 2019, they are expected to reach around 9.3 billion.  Global mobile broadband subscriptions passed 2 billion in 2013, and are predicted to grow 4 times by 2019, reaching 8 billion. We believe that the mobile phone will continue to be the dominant mobile broadband access device.  This increase in the number of broadband users is placing significant stress on bandwidth capacity.  Network operators need to implement new tiered service plans and business models that utilize Policy Management and IPE solutions in order to effectively manage their user growth and sustain a high level of Quality of Service, or QoS.

Device penetration Mobile network operators have made significant investments in new technology to increase network performance and alleviate bandwidth congestion.  At the same time, new mobile devices, including smartphones and tablets, are being introduced to take advantage of higher capacity 3G and LTE networks.  Gartner forecasted that mobile phones are expected to dominate overall device shipments, with 1.9 billion mobile phones shipped in 2014, a five percent increase from 2013.  It also forecasted the worldwide tablet market is forecast to grow 47 percent with lower average selling prices attracting new users.  Unlike legacy devices, new smartphones and tablets are designed to take advantage of data-intensive services, like video and gaming, which will deplete available capacity.  Mobile network operators will need to continue to adopt Policy Management and IPE solutions that provide more sophisticated network control and include subscriber, location, device, and application awareness.

Competitive pressure across network operators  The competition among network operators continues to increase as they battle for the latest generation of broadband users and seek to capture new revenue opportunities.  It is incumbent upon network operators to upgrade their networks while they simultaneously improve user QoS and QoE to grow their subscriber bases.  Network operators who adapt best to the evolving requirements of their users with more flexible business models and service plans should be well positioned to attract and retain subscribers.  In order to do so, we believe that operators will need to integrate Policy Management and IPE solutions into their existing network infrastructure.

Industry Challenges

The industry also faces a number of challenges as an increasing amount of bandwidth is necessary to run increasingly sophisticated and data-intense applications.  These network operator challenges include:

De-coupling of usage and revenue In recent years, network capacity and service speeds have increased along with progressively sophisticated edge devices connected to the network such as smartphones, tablets and laptops, resulting in a tremendous surge of network traffic.  A large catalyst of this surge is the ease of capture, ingestion and delivery of video, coupled with emerging business models for video publishing.  In addition, new business models and the increasing popularity of applications have turned mobile handsets into mobile entertainment devices.  However, this surge in traffic has not been accompanied by a similar rise in revenue in large part due to unlimited usage subscriptions and application models that have circumvented the service provider billing systems, excluding the service providers’ revenue participation.

Multiple devices per user  As the New Digital Lifestyle becomes more pervasive, users in developed markets are increasingly adopting sophisticated devices.  In addition to smartphones, a typical user can have multiple devices connected to the network, including tablets, e-readers, netbooks, laptops, televisions, gaming devices, digital music players, cameras and more.  This incremental device population is increasing traffic on the network, often without associated revenue.

New data-intensive applications  The advent of smartphones and tablets has enabled an ecosystem of applications that are increasing in popularity among users.  Many of these applications are free to download and use, but are very data-intensive.  Social networking applications in particular have led to constant subscriber connectivity and frequent information synchronization, which translates to higher session counts per user. Apple’s Siri and iCloud applications have dramatically increased background mobile data traffic for Apple devices and the increasing use of cloud-based services will only continue to drive bandwidth usage up on a per user basis.

Limited service differentiationMobile and broadband network operators have been limited in their ability to view and identify network traffic, which has therefore limited their ability to appropriately charge and differentiate themselves by offering advanced services.

Our Technology

The foundational element of our IPE solutions is our Datastream Recognition Definition Language, or DRDL, DPI technology.  DRDL facilitates a broad range of criteria to properly identify the application of each individual datastream.  The identification relies on bidirectional information, including header information, protocol, actual payload and other distinguishing characteristics of an application.  This allows DRDL to properly identify even encrypted applications.

The standard-syntax language of DRDL enables rapid development of new signatures.  The DRDL database currently consists of over 2,000 signatures.  DRDL interconnects control and data sessions of protocols like File Transfer Protocol, or FTP.  During the identification process, DRDL aggregates detailed traffic properties like Multipurpose Internet Mail Extensions, or MIME, type, filename, chat channel and Session Initiation Protocol, or SIP, caller ID.  A unique and integral feature of DRDL is the classification function.  Connection flags classify the traffic based on its behavior.  Typical classifications are “interactive”, “streaming”, “random-looking” and “bulky”.  This classification system enables network operators to set preferences on unidentifiable traffic or when they need to be application agnostic.

We believe that our technology has several advantages that we extend to our mobile and broadband network operator customers, including:

Radical Simplicity - We believe our solutions are more powerful for service creation and service delivery than competitive solutions without sacrificing ease-of-use.  Our report studio products allow our customers the flexibility and ease of creating virtual charging solutions while delivering a faster rollout of services.

Service Flexibility Our DRDL technology allows for a high degree of service flexibility.  Our subscriber model is highly configurable to meet the varying needs of our customer base.  We also enable our customers to provide mass personalization for their subscriber base, creating and delivering services based on individual customer needs and behaviors.  Lastly, we allow our customers to provide tiered service levels based on usage or by application.

Granular Accuracy We also provide deep visibility into our customers’ networks, enabling visibility to a subscriber level to determine location and device usage to enable a high degree of personalization and customer service.  It also allows our customers to enforce policies on their network.

Performance & Scalability We believe that our DRDL technology is robust and has industry-leading performance that supports millions of subscribers and tens of thousands of transactions per second.
 
Real-Time Analytics  All of our analytics are delivered in real-time, providing up-to-the-second visibility to our customers of subscriber location, behavior and activity.  This allows our customers to deliver a high degree of QoS to their subscribers and manage network capacity.  Our report studio technology delivers detailed business intelligence and reports, and has deep application visibility.

Our Products & Solutions

We deliver IPE solutions for network operators, leveraging our industry-leading DRDL DPI technology.  We believe our family of PacketLogic solutions is one of the engines that can drive the New Digital Lifestyle.  Our solutions empower network operators with the ability to support more subscribers and services on their network with high performing and highly-scalable IPE systems.  Our IPE solutions support deep levels of awareness and a broad universe of applications, enabling richer services to be offered to consumers.  Our analytics provide highly relevant business intelligence reports that enable service providers to better understand consumer trends and rapidly respond to the dynamic application landscape.

Product Lines

Our IPE solutions are powered by our four main product lines:

PacketLogic Subscriber Manager (PSM) – The PacketLogic Subscriber Manager, or PSM, integrates PacketLogic with network management and operation systems, including AAA, OSS, BSS, provisioning and policy managers.  This integration enables policy enforcement and per-user tracking, also known as user awareness, as well as knowledge of where in the network the user connects (location awareness).  User awareness can be leveraged to create personalized offerings that attract new customers, minimize churn and increase average revenue per user, or ARPU, through value-add services. Location awareness makes it possible to resolve, or even avoid, congestion, enhancing the user-experience. It can also control roaming costs through automatic policy enforcement.

PacketLogic Intelligence Center (PIC) The PacketLogic Intelligence Center, or PIC, with PacketLogic Report Studio provides the visualization of the application and subscriber intelligence gathered by deployed PacketLogic systems. Leveraging the subscriber and location awareness provided by the PSM and the application intelligence provided by the PacketLogic Real-Time Enforcement platforms, or PRE (as discussed below), the PIC is able to present a wealth of information to the network operator based on the behavior of their network.  The intelligence can be presented in a multi-dimensional format, with per user, application, location and device views available for business intelligence and planning.  The PIC gives network managers access to relevant network traffic intelligence that enables network optimization, creation of appealing services and protection against malicious behavior.

PacketLogic Real-Time Enforcement Platform (PRE) – The PRE utilizes multiple platforms, both hardware and virtual, that run the same operating software offering very high performance and capacity.  Our solutions range from 100Mbps in our PL7000 series, up to 70Gbps in our PL8000 series, and up to 320Gbps in the PL20000 series.  Each of the platforms offers consistent, rich features enabled through the different PacketLogic software modules: LiveView, Filtering, Traffic Shaping and Statistics. The PacketLogic hardware platforms offer a range of configurations beginning with the entry-level PL7810, a 1RU unit with up to 5Gbps throughput.  The mid-range PL8720 is a 2RU unit with up to 10Gbps throughput. At the top of the line is the PL8960 with 70 Gbps throughput, an appliance in a compact 2RU form factor and the PL20000, the industry’s first 100GE capable IPE platform, with support for up 320 Gbps of throughput and 10 million subscribers in a single system and multi-system performance scaling up to 5 Tbps.

Network Application Visibility Library (NAVL) – NAVL is a next-generation DPI software engine that provides real-time, Layer-7 classification of network traffic. Running on all popular processors and operating systems, NAVL allows integrators to remain focused on core competencies while implementing industry-leading DPI functionality from Procera in their products.  The resultant savings in time-to-market and variable labor costs can be significant. NAVL provides high-performance in application identification and metadata extraction enabling throughput levels of up to 4-8Gbps per core or processor, depending on configuration. Using a wide variety of inspection techniques including: surgical pattern matching, conversation semantics, protocol dissection, behavioral and statistical analysis, as well as future flow awareness and association, NAVL is an advanced technology for core DPI applications.

Product Features

Our IPE and DPI solutions provide a deep visualization of network traffic and subscriber behavior that enables our customers to provide high QoS to their subscribers, both by maintaining network integrity and performance, as well as deploying new services demanded by their subscribers and creating additional revenue opportunities.  Our product features include the following:

Awareness – Enabling the New Digital Lifestyle requires superior awareness of subscribers’ characteristics and behaviors to ensure that a high level of QoE is delivered.  These characteristics and behaviors include subscriber location, device and application usage.  Our solutions provide a high level of visibility through our DRDL traffic classification engine and the interaction with our PSM, which delivers comprehensive subscriber, location and device awareness.

Analysis – Mobile and broadband network operators require detailed reporting of subscriber behavior and evolving consumer trends.  Our PIC is designed to ensure that mobile and broadband network operators understand what applications are most prevalent among their user base, where those applications are utilized most frequently and how changes in service plans affect network congestion.  PIC delivers succinct, digestible and customizable reports through our report studio that drive profitable services and efficient network management.

Control – Through our IPE solution, we provide alternative service creation and congestion management for mobile and broadband network operators.  Our solutions are designed for maximum implementation flexibility, and can be customized for each deployment to fit the business, financial and regulatory needs of each network operator.

Product Benefits

Our solutions provide many benefits to our customers, including the following:

Superior Accuracy – Our proprietary DRDL and NAVL software solution allows us to provide our customers with a high degree of application identification accuracy and the flexibility to regularly update our software to keep up with the rapid introduction of new applications.

Higher Scalability – Our family of products is scalable from a few hundred megabits to 320 gigabits of traffic per second, up to 10 million subscribers and up to 120 million simultaneous data flows, which is critical to service providers as they upgrade to LTE (enabling higher bandwidth mobile phone networks), FTTX (high bandwidth fiber to the home or neighborhood used by telecom broadband network providers) and DOCSIS 3.0 (a high bandwidth broadband cable standard) technologies in the access network.  NAVL, our embedded DPI engine, scales linearly with the number of processors and cores through a zero-copy, no-lock approach to data acquisition and inspection.

Platform Flexibility – Our PacketLogic products are deployable in many locations in the network and leverage off-the-shelf hardware. Our products can rapidly leverage advances in computing technology which we believe to be a better solution than those that are dependent upon specific network silicon processors or hardware platforms. NAVL, our embedded DPI engine, is deployed on industry standard platforms and operating systems.

Drop-in Simplicity – Our NAVL products provide embedded DPI solutions that can be implemented simply on a broad array of processors and operating systems with minimal or no customization. The easy-to-use API enables integration to be completed quickly, in a matter of days, compared to competitive offerings that can require weeks of integration planning and project management.
 
Global Services

Our products and solutions are supported by our Global Services team that provides a suite of services that include both pre- and post-sales technical support to our direct field sales organization, channel partners and customers; professional services for planning, implementation and deployment; customer services for support post-deployment; training for our customers to maximize use of our IPE products and solutions; and consulting services to assist in all service phases from initial planning and evaluation to onsite testing and operation.  Customers also have access to the technical support team via a web-based partner portal, email and interactive chat forum. Issues are logged and tracked using a computerized tracking system that provides automatic levels of escalation and quick visibility into problems by our Research and Development organization.  This tracking system also provides input to our development team for new feature requests from our worldwide customer base.

Limitations of Alternative Solutions

We believe that first-generation IPE products have significant deficiencies, perhaps the greatest of which is their limited ability to accurately identify traffic types and applications.  Because the first-generation IPE products provide limited visibility into traffic flows, they provide a limited ability to manage network traffic.  First-generation IPE products were a good start at introducing network operators to the value of network visibility, and introduced the opportunity to provide some level of differentiated services.  As applications have become more complex and increasingly web-based, differentiating between applications has become more challenging to products that have limited application signatures used to identify network traffic and less sophisticated application identification mechanisms.

Growth Strategy
 
Our goal is to become the leading provider of IPE solutions to mobile and broadband network operators on a global scale.  We believe our PacketLogic and NAVL solutions position us to  effectively compete for a larger share of the growing IPE market.  Additionally, our embedded NAVL products provide an additional approach to the market for DPI technology through OEM sales to integration partners and customers.  We plan to achieve our strategic growth objectives through the following efforts:
Expand our technology advantage Our technology was designed with the ability to rapidly identify new application signatures, and thereby adapt to a dynamic IP network environment across multiple hardware platforms.  We are further developing our products and solutions based on feedback from our customers and industry experts as well as our ongoing research and development of technology, products and solutions that we believe will add value to our customers.  We currently intend to build upon our innovations, continue to release leading-edge products with state-of-the-art capabilities and regularly release new solution features and performance upgrades.

Expand our customer footprint with leading mobile and broadband network operatorsOur PacketLogic and NAVL product line provides us with a solution that can address the network needs of leading mobile and broadband network operators.  We built a team with deep network operator experience, both from a technology perspective and from selling to network operators.  We have experienced significant traction in the network operator space, and these achievements have provided us with improved access to potential customers and valuable references, which we believe will continue to enhance our sales growth effort.  In addition, we intend to increase our indirect distribution channel.  We currently intend to utilize existing value added reseller partners and to add new partners to increase our ability to address geographic regions and a greater quantity of customers.  Our NAVL product has been implemented in a number of OEM products that serve the mobile and broadband market, thereby enabling further adoption of our technologies.

Pursue new partnerships  We currently intend to establish partnerships with complementary mobile packet core ecosystem vendors to increase the value we can provide and gain additional access to leading mobile and broadband network operators.  Where feasible from a business as well as technical perspective, we intend to provide broader solutions by bundling our products with complementary products and technologies from other solution providers.  We believe that the flexibility of our software platform gives us the potential to efficiently integrate with complementary solutions and thereby deliver greater benefits to our customers and enhance our ability to compete against competitors whose solutions are more hardware constrained.

Maximize opportunities with existing customers by increasing our share within their network footprint We will continue to seek to increase our market share within our existing customers’ networks by expanding our product footprint within these networks.  Typically, our first order from a new network operator represents a small portion of their total network as measured by either a single product function or by geography.  We believe we can successfully sell additional solutions to our existing customers following their initial purchase as they realize the benefits of our products and seek to extend their IPE capabilities throughout their networks.  In addition, many service providers operate dual networks (i.e., mobile and broadband) and in these instances, we believe there are opportunities for us to offer our solutions for each network.  We have many captive mobile and broadband network operators that are well positioned to increase service creation and network performance.  We believe we are well positioned to experience tremendous growth with these customers as they build out their capabilities and infrastructure.
 
Customers

We sell our products and solutions both directly and indirectly to our end-customers.  As of December 31, 2013, we had approximately 650 customers throughout North America, Europe and Asia.  Our customers are mobile and broadband network operators, which include cable MSOs, telecommunications companies, and ISPs.  Our enterprise customers include educational institutions, commercial enterprises, and government and municipal agencies.  Our service provider customers serve subscriber customers and enterprise customers operate private networks to optimize their internal networks.

Our current customers and anticipated future customers include the following:

Mobile Network Operators  Mobile network operators are constrained by the bandwidth of their wireless signals and infrastructure.  Additional upgrades in bandwidth and network infrastructure are immediately consumed by new applications and devices that place greater stress on the network.  Managing network traffic and broadband usage more intelligently can greatly improve QoS and QoE for subscribers and save significant resources for network operators.

MSOsMSOs are constrained by the bandwidth of their network and the varying number of users connecting to any given loop in the network.  Controlling network traffic by application type can greatly improve the quality of the experience of the average subscriber.

Fixed-Line Telecommunications Network OperatorsFixed-line telecommunications network operators use fiber infrastructure or digital subscriber lines, or DSL, to offer broadband services to end customers.  Many fixed-line telecommunications network operators also operate mobile networks and provide either bundled service to end customers or mobile and broadband service on a stand-alone basis.  These service bundles are increasingly including video services as networks increase in capacity and capabilities.  Adding intelligence to their networks can help them offer differentiated services.

ISPsISPs generally lease, rather than own, access infrastructure.  They compete by attempting to offer the best of breed Internet service.  ISPs’ greatest competitive advantages are brand and customer relationships.  IPE solutions can improve the performance of ISPs by making the use of their bandwidth more efficient and by allowing them to offer best of breed quality.

Education, Business and Government EntitiesEducation institutions generally provide Internet access to students, faculty and employees.  Education institutions are particularly vulnerable to low QoS for legitimate educational purposes because students frequently have made extensive use of high-bandwidth applications such as peer-to-peer services.  Businesses and government entities rely on large and complex networks for communication infrastructure.  They typically rely on service providers for Internet access and interconnectivity, and can use IPE to optimize the use of their expensive network resources, prioritize business critical applications and limit leisure or unauthorized use of expensive network resources.

Telecommunications and Enterprise Network Equipment ManufacturersNetwork equipment and software manufacturers serving the enterprise and service provider markets can embed and implement NAVL for application identification and metadata extraction. By deploying NAVL, these companies typically cut their development cycle and time to market while maintaining focus and resources on their core network value proposition. Companies with broadband network solutions of many types have licensed and embedded. We have licensed NAVL for numerous broadband network products and solutions, including routers, switches, firewalls, IDS/IPSs, SIM, SIEMs, gateways, and UTMs.
 
Our revenue has historically been dependent on a small number of large customers. For the year ended December 31, 2013, revenue from three customers, Shaw Communications, Inc., British Telecommunications plc and Itochu Techno-Solutions Corp. represented 13%, 12% and 10% of net revenues, respectively, with no other single customer accounting for more than 10% of net revenues.  For the year ended December 31, 2012, revenue from one customer, Shaw Communications, Inc., represented 16% of net revenues, with no other single customer accounting for more than 10% of net revenues.  For the year ended December 31, 2011, revenues from two customers, Shaw Communications, Inc. and Jet Infosystems, represented 27% and 12% of net revenues, respectively, with no other single customer accounting for more than 10% of net revenues.

Foreign Operations

Sales made to customers located outside the United States as a percentage of total net revenues were 77%, 67% and 76% for the years ended December 31, 2013, 2012 and 2011, respectively.  Revenues derived from foreign sales generally are subject to additional risks such as fluctuations in exchange rates, tariffs, the imposition of other trade barriers and potential currency restrictions.  To date, however, we have experienced no notable negative impact from such risks. Further information regarding our foreign operations, as required by Item 101(d) of Regulation S-K, can be found in the Consolidated Financial Statements and related notes herein.

Partners

We have established critical technology, distribution and business partnerships to further promote our brand and suite of solutions for network operators.  We believe these partnerships provide an immediate opportunity to extend our capabilities into adjacent, complementary points within the mobile packet core and broadband core.  For example, we recently announced a joint solution with one of our key technology partners that provides integrated policy management and PCRF functionality on top of our IPE platform.

Competition

The market for our products and services is highly competitive as mobile and broadband network operators seek to manage the rapid growth of data on both broadband and mobile networks.  Our primary competitors include:

· Allot Communications Ltd.;
· Blue Coat Systems;
· Brocade Communications Systems;
· Cisco Systems, Inc.;
· Citrix Systems (acquired Bytemobile);
· Ericsson;
· F5 Networks;
· Huawei Technologies Company;
· Qosmos;
· SAIC (acquired Cloudshield Technologies);
· Sandvine Corporation; and
· Tektronicx, Inc. (acquired Arbor Networks).
 
We also face competition from vendors supplying platform products with some limited IPE functionality, such as switches and routers, session border controllers and VoIP switches.  In addition, we face competition from large integrators that package third-party IPE solutions into their products, including Alcatel-Lucent and Nokia Siemens.  It is possible that these companies will develop their own IPE solutions or strategically acquire existing competitor IPE vendors in the future.

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

Our primary method of differentiation from our competition is our IPE DRDL technology, which we believe to be a superior solution that enables service providers advanced identification of network traffic.  However, we also believe we effectively compete with respect to price and service.  Our products now address service provider requirements ranging from 100 megabit (edge applications) to the 320 gigabit per second market (core applications).

Backlog

Our sales are made primarily pursuant to standard purchase orders for the delivery of products. Quantities of our products to be delivered and delivery schedules may vary based on changes in customers’ needs or circumstances. Customer orders generally can be cancelled, modified or rescheduled on short notice without significant penalty to the customer. In addition, most of our revenue in any quarter depends on customer orders for our products that we receive and fill in the same quarter. For these reasons, our backlog as of any particular date is not representative of actual sales for any succeeding period, and therefore we believe that backlog is not necessarily a reliable indicator of our future revenue trends.

Sales and Marketing

We use a combination of direct sales and channel partnerships to sell our products and services.  As of December 31, 2013, we had 61 employees in sales and many independent channel partners worldwide.  We also engage a worldwide network of value added resellers to reach particular geographic regions and markets.

Our marketing organization is focused on building our brand awareness, managing channel marketing efforts and supporting our sales force in additional capacities.  As of December 31, 2013, we had 11 marketing professionals globally.

Research and Development

We have built a team of skilled software programmers who continue to develop enhancements to our PacketLogic modules and proprietary DRDL and NAVL processing software engines.  We have enhanced our products with features and functionality to address the needs of mobile and broadband network operators, as well as to provide new functionality for network protection and subscriber management.  As of December 31, 2013, we had 78 employees in research and development.  Historically, substantially all of our research and development has been performed by our employees in Sweden.  On January 9, 2013, we acquired Vineyard in Canada, and are in the process of expanding and integrating the research and development personnel attained in the acquisition.  We believe this integration has helped expand our research and development efforts and has provided enhanced stability and disaster recovery capabilities.  Our research and development costs were $17.5 million, $7.5 million and $4.6 million for the years ended December 31, 2013, 2012 and 2011, respectively.

Intellectual Property

Our intellectual property is central to our competitive position and our future success will depend on our continued ability to protect our core technologies.  We believe that our DRDL signature compiler, and the inherent complexity of our software-based PacketLogic and NAVL solutions, makes it difficult to copy or replicate our features.  We rely primarily on patent law, trademark law, copyright law, trade secret law and contractual rights to protect our intellectual property rights in our proprietary software.  To help ensure this protection, we include proprietary information and confidentiality provisions in our agreements with customers, third parties and employees.

Manufacturing

We purchase our hardware from a select group of supplier partners.  We have negotiated minimum production quantities and lead times in our contracts to prevent supply shortages.  Our supplier partners will then load our proprietary software for specific orders, final testing and fulfillment.  We believe that our process allows us to focus on development of our PacketLogic and NAVL software solutions, reduce manufacturing costs and more quickly adjust to changes in demand.  We have not historically experienced any production capacity shortages and do not foresee a need to alter our process in the future.

We source completed hardware boards and chassis included in our products from leading industry suppliers, including Advantech Technologies Inc., Lanner Electronics, Inc., and RadiSys Corporation.  The hardware used in our products is comprised of standard components which are less susceptible to supply shortages and significant lead times.  We believe our reliance on standard hardware components facilitates quicker time to market, rapid design cycles and the ability to take advantage of the latest semiconductor industry advances.
Employees

As of December 31, 2013, we had a total of 205 employees and 21 full-time independent contractors.  As of December 31, 2013, we had 33 operations and technical support employees, 78 research and development employees, 72 sales and marketing employees and 22 general and administrative employees.  As of December 31, 2013, our headcount was 58 employees in the United States, 81 employees in Sweden, 36 employees in Canada, eight employees in the United Kingdom, and a total of 22 employees in Malaysia, Hong Kong, Japan, Singapore, Austria, Australia, France, Germany, Korea, Argentina, Brazil, Russia, Spain, Taiwan, Thailand, South Africa and the United Arab Emirates.

Executive Officers of the Company

Set forth below are the name, age, position(s) and a description of the business experience of each of our executive officers as of December 31, 2013:

Name
 
Age
 
Position(s)
 
Employee
Since
 
James F. Brear
  48  
President, Chief Executive Officer and Director (Principal Executive Officer)
  2008  
Charles Constanti
  50  
Vice President, Chief Financial Officer and Secretary (Principal Financial & Accounting Officer)
  2009  

James F. Brear joined us as our President, Chief Executive Officer and a member of our Board of Directors in February 2008.   Mr. Brear is a Silicon Valley industry veteran with more than 20 years of experience in the networking industry, most recently as Vice President of Worldwide Sales and Support for Bivio Networks, a maker of deep packet inspection platform technology, from July 2006 to January 2008.  From September 2004 to July 2006, Mr. Brear was Vice President of Worldwide Sales for Tasman Networks (acquired by Nortel), a maker of converged WAN solutions for enterprise branch offices and service providers for managed WAN services. From April 2004 to July 2004, Mr. Brear served as Vice President of Sales at Foundry Networks, a provider of switching, routing, security and application traffic management solutions.  Earlier in his career, Mr. Brear was the Vice President of Worldwide Sales for Force10 Networks (acquired by Dell) from March 2002 to April 2004, during which time the company grew from a pre-revenue start-up to the industry leader in switch routers for high performance Gigabit and 10 Gigabit Ethernet. In addition, he spent five years with Cisco Systems from July 1997 to March 2002 where he held senior management positions in Europe and North America with responsibility for delivering more than $750 million in annual revenues selling into the world’s largest service providers.  Previously, Mr. Brear held a variety of sales management positions at both IBM and Sprint Communications.  He is a member of the Young Presidents Organization (YPO) and holds a Bachelor of Arts degree from the University of California at Berkeley.

Charles Constanti joined us as our Chief Financial Officer in May 2009 and has over 25 years of public company financial experience.  Most recently, Mr. Constanti was the vice president and CFO of Netopia, Inc., a NASDAQ-listed telecommunications equipment and software company, from April 2005 until its acquisition in February 2007 by Motorola, Inc., where he subsequently held a senior finance position until May 2009.  From May 2001 to April 2005, Mr. Constanti was the vice president and corporate controller of Quantum Corporation, for which he earlier served in different accounting and finance positions since January 1997.  Previously, Mr. Constanti held various finance positions at BankAmerica Corporation and was an auditor for PricewaterhouseCoopers.  Mr. Constanti is an inactive certified public accountant.  He earned a B.S., magna cum laude, in Accounting from Binghamton University.

Significant Employees of the Company

Set forth below are the name, age, position and a description of the business experience of each of our significant employees as of December 31, 2013:

Name
 
Age
 
Position
 
Employee
Since
 
Alexander Haväng
  35  
Chief Technical Officer
  2006  
Jon Lindén
  39  
Chief Strategy Officer
  2006  

Alexander Haväng has been our Chief Technology Officer since August 2006 when we acquired Netintact AB. Mr. Haväng was a founder of Netintact AB, which was formed in August 2000. Mr. Haväng is responsible for our strategic technology direction.  Mr. Haväng is widely known and a respected authority in the open source community, and is the lead architect for PacketLogic.  Earlier in his career, Mr. Haväng was one of the chief architects for the open source streaming server software Icecast, along with the secure file transfer protocol GSTP.  Mr. Haväng studied computer science at the Linköping University in Sweden.

Jon Lindén has been our Chief Strategy Officer since September 2011 and was our Vice President of Marketing from January 2008 to September 2011.  Mr. Lindén joined us in August 2006 as part of the acquisition of Netintact AB, a company he joined in 2001.  Mr. Lindén has a background in sales and business development with experience in managing networking products throughout their lifecycle.  Prior to joining Netintact, Mr. Lindén was the Chief Executive Officer of the venture-funded company TheSchoolbook.com from 1999 to 2001, and managed sales and marketing at a content management software company from 1998 to 1999.  He was project manager at the Swedish Trade Council in Chicago from 1997 to 1998.
 
Available information
 
Our annual reports on Form 10-K, our quarterly reports on Form 10-Q and our current reports on Form 8-K, and all amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are available free of charge on our website at www.proceranetworks.com as soon as reasonably practicable after we electronically file such reports with the Securities and Exchange Commission, or the SEC. Information contained in, or accessible through, our website is not incorporated by reference into and does not form a part of this report.
 
The SEC also maintains a website containing reports, proxy and information statements, annual filings and other relevant information available free of charge to the public at www.sec.gov.

Item 1A.
Risk Factors

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

Risks Related to Our Business

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

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

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

successfully introducing new products and entering new markets;
successfully servicing and upgrading new products once introduced;
increasing brand recognition;
developing strategic relationships and alliances;
managing expanding operations and sales channels;
successfully responding to competition; and
attracting, retaining and motivating qualified personnel.

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

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

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

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

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

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

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

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

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

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

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

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

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

If we fail to effectively manage our inventory, we could have excess inventory or experience inventory shortages, which could result in decreased revenue and gross margins and harm our business.

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

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

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

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

For the year ended December 31, 2013, revenue from three customers, Shaw Communications, Inc., British Telecommunications plc and Itochu Techno-Solutions Corp. represented 13%, 12% and 10% of net revenues, respectively, with no other single customer accounting for more than 10% of net revenues.  For the year ended December 31, 2012, revenues from one customer, Shaw Communications, Inc., represented 16% of net revenues, with no other single customer accounting for more than 10% of net revenues.  For the year ended December 31, 2011, revenues from two customers, Shaw Communications, Inc. and Jet Infosystems, represented 27% and 12% of net revenues, respectively, with no other single customer accounting for more than 10% of net revenues.  The proportion of our revenues derived from a limited number of customers may be even higher in any future year or quarter.  If we cannot maintain or replace the customers that purchase large amounts of our products, or if they do not purchase products at the levels or at the times that we anticipate, our ability to maintain or grow our revenues will be adversely affected.

Changes in customer or product mix, downward pressure on sales prices, changes in volume of orders and other factors could cause our gross margin percentage to fluctuate or decline in the future.
 
Our gross profit margins have fluctuated from period to period, and these fluctuations are expected to continue in the future. Within the last two years, our gross profit margin has fluctuated from 55% for the year ended December 31, 2013 to 67% for the year ended December 31, 2012. Factors that may cause our gross margins to fluctuate include customer and product mix, market acceptance of our new products, competitive pricing dynamics, geographic and/or market segment pricing strategies, decreases in average selling prices of our products, our ability to successfully develop new products, and our ability to manage manufacturing, labor and materials costs. A higher proportion of hardware sales versus software and service revenue in any period generally results in a lower gross profit margin for that period. In addition, our industry has been characterized by declining product prices over time, and we are under continuous pressure to reduce our prices to increase or even maintain our market share. Forecasting our gross margins is difficult due to our lengthy sales cycle, particularly with respect to larger customers, and our revenue recognition practices. Because our gross profit margins may fluctuate materially from period to period, or decline over time, the price of our common stock may decline.

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

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

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

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

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

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

integrating the operations and technologies of the two companies;
retaining and assimilating the key personnel of each company;
retaining existing customers of both companies and attracting additional customers;
leveraging our existing sales channels to sell new products into new markets;
developing an appropriate sales and marketing organization and sales channels to sell new products into new markets;
retaining strategic partners of each company and attracting new strategic partners; and
implementing and maintaining uniform standards, internal controls, processes, procedures, policies and information systems.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

We had an accumulated deficit of $69.2 million as of December 31, 2013. We may incur losses from operations in future periods.  The profitability we achieved in the years ended December 31, 2012 and 2011 were the first in our history and may not be indicative of profitability in future periods.  Any losses incurred in the future may result from increased costs related to continued investments in sales and marketing, product development and administrative expenses, and/or less than anticipated revenues.  Furthermore, if our revenue growth does not continue or is slower than anticipated, or our operating expenses exceed expectations, our results of operations and financial condition may be adversely affected.

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

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

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

lower than anticipated revenues;
higher than expected cost of goods sold or operating expenses;
our inability to liquidate short-term investments; or
the inability of our customers to pay for the goods and services ordered.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

As part of our cost management efforts, we endeavor to lower per unit product costs from our suppliers by means of volume efficiencies that utilize manufacturing sites in lower-cost geographies. However, we cannot be certain when or if such cost reductions will occur.  The failure to obtain such cost reductions would adversely affect our gross margins and operating results.
 
If our suppliers fail to adequately supply us with certain original equipment manufacturer, or OEM, sourced components, our product sales may suffer.

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

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

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

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

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

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

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

· trade and foreign exchange restrictions;
· foreign currency exchange fluctuations;
· economic or political instability in foreign markets;
· greater difficulty in enforcing contracts, accounts receivable collection and longer collection periods;
· changes in regulatory requirements;
· difficulties and costs of staffing and managing foreign operations;
· the uncertainty and limitation of protection for intellectual property rights in some countries;
· costs of compliance with foreign laws and regulations and the risks and costs of non-compliance with such laws and regulations;
· costs of complying with U.S. laws and regulations for foreign operations, including import and export control laws, tariffs, trade barriers, economic sanctions and other regulatory or contractual limitations on our ability to sell our products in certain foreign markets, and the risks and costs of non-compliance;
· heightened risks of unfair or corrupt business practices in certain geographies and of improper or fraudulent sales arrangements;
· the potential for political unrest, acts of terrorism, hostilities or war;
· longer accounts receivable payment cycles and difficulties in collecting accounts receivable;
· management communication and integration problems resulting from cultural differences and geographic dispersion; and
· multiple and possibly overlapping tax structures.

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

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

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

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

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

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

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

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

amortization of intangible assets, including acquired product rights;
impairment of goodwill and intangible assets;
stock-based compensation expense; and
impairment of long-lived assets.

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

changes in the relative proportions of revenues and income before taxes in the various jurisdictions in which we operate that have differing statutory tax rates;
changing tax laws, regulations and interpretations in multiple jurisdictions in which we operate, as well as the requirements of certain tax rulings;
changes in accounting and tax treatment of stock-based compensation;
the tax effects of purchase accounting for acquisitions and restructuring charges that may cause fluctuations between reporting periods; and
tax assessments, or any related tax interest or penalties, which could significantly affect our income tax expense for the period in which the settlements take place.

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

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

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

pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. GAAP, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

For the years ended December 31, 2013, 2012 and 2011, we did not identify any material weaknesses in our internal controls.

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

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

faulty human judgment and simple errors, omissions or mistakes;
collusion of two or more people;
inappropriate management override of procedures; and
the risk that enhanced controls and procedures may still not be adequate to assure timely and reliable financial information.

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

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

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

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

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

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

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

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

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

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

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

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

Risks Related to Our Industry

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

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

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

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

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

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

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

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

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

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

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

On January 14, 2014, the D.C. Circuit Court of Appeals, in Verizon v. FCC, struck down major portions of the “net neutrality” rules adopted by the FCC in December 2010 governing the operating practices of broadband service providers. The FCC originally designed the rules to ensure an “open Internet” and included three key requirements for broadband service providers: (1) a prohibition on preventing end-user customers from accessing lawful content or running applications of their choice over the Internet and from connecting and using devices that do not harm the network; (2) a requirement to treat lawful content, applications and services in a nondiscriminatory manner; and (3) a transparency requirement compelling the disclosure of network management policies. The court struck down the anti-blocking and nondiscrimination provisions of the rules but upheld the transparency requirement. The court also found that the FCC has the statutory authority to impose such rules so long as they do not contravene other express statutory mandates. It is unclear whether and to what degree the FCC will appeal the court’s decision or pursue new net neutrality regulations or other regulation of broadband Internet access services. In addition, in light of the court’s decision, Congress could seek to adopt legislation banning the blocking of Internet traffic and/or imposing nondiscrimination requirements on broadband service providers. As a result, broadband service providers may lessen their capital investments in their networks and we may have fewer opportunities to sell our products to both current and prospective customers, and our opportunity for continued revenue growth could be adversely impacted.  If our revenue growth slows or our revenues decrease, our results of operations and our financial condition also may be adversely impacted.

Risks Related to Ownership of Our Common Stock
 
Our common stock price is likely to continue to be highly volatile.

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

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

actual or anticipated fluctuations in our quarterly operating results;
announcements of technology innovations by our competitors;
changes in financial estimates by securities analysts;
conditions or trends in the network control and management industry;
the acceptance by institutional investors of our stock;
rumors, announcements or press articles regarding our operations, management, organization, financial condition or financial statements;
the gain or loss of a significant customer; or
the stock market in general, and the market prices of stocks of technology companies, in particular, have experienced extreme price volatility that has adversely affected, and may continue to adversely affect, the market price of our common stock for reasons unrelated to our business or operating results.

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

We are authorized to issue up to 32.5 million shares of common stock and 15.0 million shares of preferred stock. Our Board of Directors has the authority, without seeking stockholder approval, to issue additional shares of common stock and/or preferred stock in the future for such consideration as our Board of Directors may consider sufficient.  In addition, in connection with our acquisition of Vineyard, we issued an aggregate of 825,060 shares of our common stock to the former shareholders of Vineyard. If we were to issue equity securities as all or part of the purchase price for any future acquisitions, the issuance of such equity securities would have a dilutive effect on our existing stockholders.  Additionally, if we finance acquisitions by issuing equity securities, our existing stockholders may be diluted.  At December 31, 2013, there were 20,652,126 shares of our common stock outstanding, outstanding stock options to purchase 1.8 million shares of our common stock, of which options to purchase 412,000 shares of our common stock were granted to new employees in connection with our acquisition of Vineyard in January 2013 and outstanding restricted stock units with respect to 114,167 shares of our common stock.  At December 31, 2013, we had an authorized reserve of 549,698 shares of common stock, which we may grant as stock options, restricted stock, restricted stock units or other equity awards pursuant to our existing equity incentive plan.
 
The issuance of additional common stock and/or preferred stock in the future would reduce the proportionate ownership and voting power of our common stock held by existing stockholders and also could cause the trading price of our common stock to decline.

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

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

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

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

authorizing the issuance of “blank check” preferred stock with rights senior to those of our common stock, without any need for action by stockholders;
eliminating the ability of stockholders to call special meetings of stockholders;
restricting the ability of stockholders to take action by written consent, which requires stockholder action to be taken at an annual or special meeting of stockholders;
establishing advance notice requirements for nominations for election to the Board of Directors or for proposing matters that can be acted on by stockholders at stockholder meetings; and
prohibiting cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates.

In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the General Corporation Law of the State of Delaware which, subject to certain exceptions, prohibits stockholders owning in excess of 15% of our outstanding voting stock from merging or combining with us. These anti-takeover provisions and other provisions under Delaware law could discourage, delay or prevent a transaction involving a change in control of our company, even if doing so would benefit our stockholders.

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

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

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

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

Our corporate headquarters are located in Fremont, California.  During the year ended December 31, 2013, we entered into a new lease agreement with our current landlord for a larger total space, which consists of approximately 18,000 square feet of space housing administrative, sales and marketing, logistics and support functions.  The current lease term runs through November 30, 2018.

Our European headquarters are located in Sweden, where we lease office space in Varberg and Malmo consisting of approximately 19,000 square feet.  These facilities are used primarily for research and development, sales and marketing and support.

We have offices in Kelowna, British Columbia, Canada which were originally attained through our acquisition of Vineyard in January 2013.  We currently lease office space totaling approximately 8,000 square feet in Canada.  These facilities are primarily used for research and development, sales and marketing and support.

Our offices in Japan are located in Tokyo where we lease office space totaling approximately 1,000 square feet.  This facility is primarily used for sales, marketing and support.  We also maintain small offices in other countries, primarily to support the sales and marketing support activities in those areas.

We believe that our facilities are adequate for our needs in 2014 and that, if required, additional suitable space will be available on commercially acceptable terms.
 
Item 3. Legal Proceedings
 
We are at times involved in litigation and other legal claims in the ordinary course of business. When appropriate in management’s estimation, we may record reserves in our financial statements for pending litigation and other claims.  Although it is not possible to predict with certainty the outcome of litigation, we do not believe that any of the current pending legal proceedings to which we are a party or to which any of our property is subject will have a material impact on our results of operations or financial condition.
 
Item 4. Mine Safety and Disclosures

Not applicable.

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Our common stock is listed on the NASDAQ Global Select Market under the symbol “PKT”.  The following table sets forth, for the periods indicated, the high and low intraday prices per share of our common stock, as reported by The NASDAQ Stock Market LLC, for the periods indicated.
 
 
Common Stock
 
 
2013
 
2012
 
 
High
 
Low
 
High
 
Low
 
First Quarter
 
$
19.57
   
$
11.70
   
$
23.46
   
$
14.18
 
Second Quarter
 
$
14.79
   
$
10.39
   
$
24.65
   
$
17.78
 
Third Quarter
 
$
15.69
   
$
12.04
   
$
25.99
   
$
20.91
 
Fourth Quarter
 
$
15.27
   
$
13.49
   
$
24.86
   
$
16.83
 
 
On March 7, 2014, the closing price of our common stock was $11.37.
 
Dividend Policy
 
We have not declared or paid any cash dividends on our common stock or other securities and do not anticipate paying any cash dividends in the foreseeable future.  Any future determination to pay cash dividends will be at the discretion of the Board of Directors and will be dependent upon our financial condition, results of operations, capital requirements and such other factors as the Board of Directors deems relevant.
 
Recent Sales of Unregistered Securities
 
None.
 
Issuer Purchases of Equity Securities
 
None.

Stockholders
 
There were 167 stockholders of record of our common stock as of March 7, 2014.

Performance Graph

The graph below compares our cumulative five-year total stockholder return on common stock with the cumulative total returns of the NASDAQ Composite Index and the NASDAQ Computer Index.  The graph below tracks the performance of a $100 investment in our common stock and in each index (assuming the reinvestment of all dividends) from December 31, 2008 to December 31, 2013.
 
The information under the heading “Performance Graph” is not “soliciting material,” and shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or incorporated by reference in any filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date hereof and irrespective of any general incorporation language in any such SEC filing except to the extent we specifically incorporate this section by reference.

 
 
   
12/08
     
12/09
     
12/10
     
12/11
     
12/12
     
12/13
 
 
                                               
Procera Networks, Inc.
 
$
100.00
   
$
48.36
   
$
68.14
   
$
171.23
   
$
203.87
   
$
165.07
 
NASDAQ Composite Index
 
$
100.00
   
$
144.88
   
$
170.58
   
$
171.30
   
$
199.99
   
$
283.39
 
NASDAQ Computer Index
 
$
100.00
   
$
174.88
   
$
204.64
   
$
211.47
   
$
241.57
   
$
327.45
 

The stock price performance included in this graph is not necessarily indicative of future stock price performance.

Item 6. Selected Financial Data
 
The following selected financial information has been derived from our audited consolidated financial statements.  The information set forth below is not necessarily indicative of results of future operations and should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and notes thereto included in Item 8 of this Annual Report on Form 10-K in order to fully understand factors that may affect the comparability of the information presented below.
 
 
 
Fiscal Year Ended December 31,
 
 
 
2013 (1)
   
2012 (2)
   
2011 (3)
   
2010 (4)
   
2009
 
 
 
(in thousands, except per share data)
 
STATEMENT OF OPERATIONS DATA:
 
   
   
   
   
 
Net sales
 
$
74,673
   
$
59,627
   
$
44,404
   
$
20,323
   
$
20,129
 
Gross profit
 
$
40,813
   
$
40,158
   
$
26,323
   
$
11,510
   
$
8,184
 
Total operating expenses
 
$
58,835
   
$
34,853
   
$
22,380
   
$
14,247
   
$
14,421
 
Income (loss) from operations
 
$
(18,022
)
 
$
5,305
   
$
3,943
   
$
(2,737
)
 
$
(6,237
)
Net income (loss)
 
$
(16,284
)
 
$
5,331
   
$
3,755
   
$
(2,894
)
 
$
(7,384
)
Net income (loss) per share, basic
 
$
(0.81
)
 
$
0.30
   
$
0.29
   
$
(0.27
)
 
$
(0.82
)
Net income (loss) per share, diluted
 
$
(0.81
)
 
$
0.29
   
$
0.28
   
$
(0.27
)
 
$
(0.82
)
 
                                       
BALANCE SHEET DATA:
                                       
Cash, cash equivalents and short-term investments
 
$
106,563
   
$
131,695
   
$
37,404
   
$
7,876
   
$
3,192
 
Working capital
 
$
126,876
   
$
144,195
   
$
44,654
   
$
12,607
   
$
7,314
 
Total assets
 
$
179,436
   
$
167,038
   
$
60,156
   
$
24,517
   
$
16,323
 
Deferred revenue
 
$
14,906
   
$
9,831
   
$
6,378
   
$
4,437
   
$
2,103
 
Long-term liabilities
 
$
5,106
   
$
2,878
   
$
873
   
$
705
   
$
452
 
Total stockholders’ equity
 
$
148,671
   
$
146,805
   
$
46,567
   
$
13,754
   
$
8,515
 
 
(1) On January 9, 2013, we acquired Vineyard for an aggregate consideration of approximately $26.8 million, consisting of $20.9 million in purchase consideration for 100% of the outstanding securities of Vineyard and $5.9 million in deferred compensation to Vineyard’s founders.  Of the total of $26.8 million consideration, we paid $12.5 million in cash and issued 825,060 unregistered shares of our common stock with a value of approximately $14.3 million.

(2) On April 25, 2012, we completed a registered offering of 4.5 million shares of common stock.  The shares were sold to the public at $21.00 per share for gross proceeds of $94.5 million.  We received net proceeds of approximately $88.0 million after deducting underwriting commissions and other offering expenses.
 
(3) On June 24, 2011, we completed a registered offering of 3.0 million shares of our common stock, which included the exercise in full of the underwriters’ overallotment option to purchase 0.4 million additional shares of our common stock.  The shares were sold to the public at $9.50 per share for gross proceeds of $28.8 million.  We received net proceeds of approximately $26.5 million after deducting underwriting commissions and other offering expenses.

(4) On March 4, 2010, we closed a registered placement of our common stock primarily to institutional investors. We sold 1.8 million shares of our common stock at an offering price to the public of $4.00 per share for gross proceeds of $7.2 million, and received net proceeds of approximately $6.5 million after deducting the placement agent’s commission and legal and other offering costs.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. We use words such as “may,” “will,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “predict,” “potential,” “believe,” “should” and similar expressions to identify forward-looking statements. These statements appearing throughout our Annual Report on Form 10-K are statements regarding our intent, belief, or current expectations, primarily regarding our operations.  You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Annual Report on Form 10-K. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including those set forth under “Business,” “Risk Factors” and elsewhere in this Annual Report on Form 10-K.
 
Overview

We are a leading provider of Internet Intelligence solutions designed for network operators worldwide.  Procera’s PacketLogic solutions provide actionable intelligence and policy enforcement to ensure a high quality experience for any Internet connected devices.  Network operators deploy our technology to enable real-time visibility, superior performance and scalability, and deliver personalized services for millions of enterprises and consumers.  Enterprises utilize our embedded NAVL solutions to ensure that they can deliver “bring your own device” and cloud services to their employees.  We believe that the intelligence our products provide about users and their usage enables our network operator customers to make informed business decisions.  Our network operator customers include service provider customers and enterprises.  Our service provider customers include mobile service providers and broadband service providers, which include cable MSOs and ISPs.  Our enterprise customers include educational institutions, commercial enterprises, government and municipal agencies.  We sell our products directly to network operators; through partners, value added resellers and system integrators; and to other network solution suppliers for incorporation into their network solutions.
 
Our IPE products are part of the high-growth market for mobile packet and broadband core products.  Our bundled products containing hardware and software elements deliver a solution that is a key element of the mobile packet and broadband core ecosystems.  Our solutions are often integrated with additional elements in the mobile packet and broadband core, including Policy Management and Charging functions, and are compliant with the widely adopted 3GPP standard.  In order to respond to rapidly increasing demand for network capacity due to increasing subscribers and usage, network operators are seeking higher degrees of intelligence, optimization, network management, service creation and delivery in order to differentiate their offerings and deliver a high quality of experience to their subscribers.  We believe the need to create more intelligent and innovative mobile and broadband networks will continue to drive demand for our products.

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

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

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

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

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

In accordance with SEC guidance, the material accounting policies that we believe are the most critical to an investor’s understanding of our financial results and condition are discussed below.
 
Revenue Recognition
 
We recognize product revenue when all of the following have occurred: (1) we have entered into a legally binding arrangement with a customer resulting in the existence of persuasive evidence of an arrangement; (2) delivery has occurred, evidenced when product title transfers to the customer; (3) customer payment is deemed fixed or determinable and free of contingencies and significant uncertainties; and (4) collection is probable.

Sales of our PacketLogic products typically involve the integration of software and hardware appliance, where the hardware and software work together to deliver the essential functionality of the product.  Product revenue consists of revenue from sales of appliances and software licenses. PacketLogic product sales include a perpetual license to our software that is essential to the functionality of the hardware, and on occasion include licenses to additional software.  NAVL sales include term software licenses sold as a subscription. Revenue from sales of term licenses are recognized ratably over the subscription term, generally one year.  Shipping charges billed to customers are included in product revenue and the related shipping costs are included in cost of product revenue.  Virtually all sales include post-contract support, or PCS, services (included in support revenue) which consist of software updates and customer support.  Software updates provide customers access to a growing library of electronic Internet traffic identifiers (signatures) and rights to non-specific software product upgrades, maintenance releases and patches released during the term of the support period.   Support includes Internet access to technical content, telephone and Internet access to technical support personnel and hardware support.

Receipt of a customer purchase order is the primary method of determining that persuasive evidence of an arrangement exists.

Delivery of PacketLogic products generally occurs when a product is delivered to a common carrier F.O.B. shipping point.  However, product revenue based on channel partner purchase orders is recorded based on sell-through to the end user customers until such time as we have established significant experience with the channel partner’s ability to complete the sales process, which requires judgment.  Additionally, when we introduce new products for which there is no historical evidence of acceptance history, revenue is recognized on the basis of end-user acceptance until such history has been established.  Delivery of PacketLogic license upgrades and NAVL licenses occur when such licenses are made available to customers.

Fees are typically considered to be fixed or determinable at the inception of an arrangement, generally based on specific products and quantities to be delivered.  Substantially all of our contracts do not include rights of return or acceptance provisions. To the extent that agreements contain such terms, we recognize revenue once the acceptance provisions or right of return lapses. Payment terms to customers generally range from net 30 to 90 days.  Certain customers are occasionally granted longer terms based on our assessment of their credit risk.  In the event payment terms are provided that differ from standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized when the payments become due, provided the remaining criteria for revenue recognition have been met.

We assess the ability to collect from our customers based on a number of factors, including credit worthiness of the customer and past transaction history of the customer.  If the customer is not deemed credit worthy, we defer all of the revenue from the arrangement until payment is received and all other revenue recognition criteria have been met.

Customer orders normally contain multiple items. The initial PacketLogic product delivery consists of the hardware and software elements and these elements have standalone value to the customer.  Through the year ended December 31, 2013, the elements that remained undelivered at the time of product delivery were PCS services.  Orders for our NAVL product consists of term software licenses and PCS services which are recognized ratably over the term of the arrangement, typically one year.
 
We allocate revenue to each element in an arrangement based on relative selling price using a selling price hierarchy.  The selling price for a deliverable is based on its VSOE if available, third party evidence, or TPE, if VSOE is not available, or our best estimate of selling price, or ESP, if neither VSOE nor TPE is available.  The maximum revenue recognized on a delivered element is limited to the amount that is not contingent upon the delivery of additional items. In arrangements that include NAVL or non-essential software, or software deliverables, revenue is allocated to each separate unit of accounting for the non-software deliverables and to the software deliverables as a group using the relative selling prices of each of the deliverables in the arrangement.  Revenue allocated to the software deliverables as a group is then allocated first to the PCS services based on VSOE, and then to the software, using the residual method under the software revenue recognition guidance.
We determine VSOE for PCS based on a percentage of invoice price, with different rates based on service level.  We determined that these rates represent VSOE for PCS based on our history of charging these rates for PCS to customers upon renewal.  We have a history of such renewals, the vast majority of which are at the VSOE rate on a customer by customer basis. PCS revenue is recognized ratably over the life of the contract.  A small portion of service revenue is derived from providing training on products and we use the completed-contract method to recognize such revenue.

As our PacketLogic hardware and software products are rarely sold separately, we generally do not have VSOE for these products, and TPE is not available. We determine the ESP for these hardware and software deliverables by considering internal factors such as discounting and pricing policies and external factors such as market conditions in different geographies and competitive positioning.

In certain contracts, billing terms may be agreed upon based on performance milestones such as the execution of a measurement test, a partial delivery or the completion of a specified service.  Payments received before the unconditional acceptance of a specific set of deliverables are recorded as deferred revenue until the conditional acceptance has been waived.

Valuation of Long-Lived Assets and Goodwill
 
We review our long-lived assets including property and equipment and purchased intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.  Such events or circumstances that could trigger an impairment review include a significant disposal of a portion of such assets, an adverse change in the market involving the business employing the related asset, a significant decrease in the benefits realized from an acquired business, difficulties or delays in integrating the business or a significant change in the operations of an acquired business.
 
An impairment test involves a comparison of undiscounted cash flows from the use of the asset to the carrying value of the asset.  Measurement of an impairment loss is based on the amount by which the carrying value of the asset exceeds its fair value.  No impairment losses were incurred in the periods presented.

We review our goodwill for impairment annually during the fourth quarter of the year or more frequently if an event or circumstance indicates that an impairment loss has occurred.  The identification and measurement of goodwill impairment involves the estimation of fair value at a reporting unit level.  

Goodwill impairment is determined using a two-step process.  The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill.  If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired and the second step of the impairment test is unnecessary.  If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any.

The second step of the goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess.  The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination.  That is, the fair value of the reporting unit is allocated to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the purchase price paid to acquire the reporting unit.
 
As of December 31, 2013, we completed the first step of our annual impairment test, pursuant to which each reporting unit’s fair value exceeded its carrying value, indicating there was no goodwill impairment.  Therefore, the second step of the impairment test was not necessary.
 
Inventory Valuation
 
Inventories consist primarily of finished goods and are stated at the lower of cost (on a first-in, first-out basis) or market. We record inventory write-downs for excess and obsolete inventories based on historical usage and forecasted demand, as well as determining what inventory, if any, is not saleable. Factors which could cause our forecasted demand to prove inaccurate include reliance on indirect sales channels and the variability of our sales cycle; the potential of announcements of new products or enhancements to replace or shorten the life cycle of current products, or cause customers to defer their purchases; and the potential of new or alternative technologies achieving widespread market acceptance and thereby rendering our existing products obsolete. If future demand or market conditions are less favorable than projections, additional inventory write-downs may be required and would be reflected in cost of sales in the period the revision is made.

Stock-Based Compensation

We apply the provisions of FASB Accounting Standards Codification, or ASC, Topic 718, which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and non-employee directors based on estimated fair values.  Under the fair value recognition provisions of this standard, our stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as an expense on a straight-line basis over the requisite service period, which is the vesting period.  We calculate the fair value of stock options using the Black-Scholes option-pricing model.  The determination of the fair value of stock-based payment awards using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables.  These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.
 
We estimate the expected volatility of our common stock price based on its historical volatility over a period equivalent to the expected term of the option.  We estimate the expected term of stock options using historical exercise data.  We use the exact number of days between the grant and the exercise dates to calculate a weighted average of the holding periods for all awards (i.e., the average interval between the grant and exercise or post-vesting cancellation dates), adjusted as appropriate.  We determine the risk-free interest rate for a period equivalent to the expected term of the option by extrapolating from the U.S. Treasury yield curve in effect at the time of the grant.  We have never paid cash dividends and do not anticipate paying cash dividends in the foreseeable future.  We estimate forfeitures based on our historical experience.
 
Accounting for Income Taxes
 
We record a tax provision for the anticipated tax consequences of the reported results of operations. In accordance with ASC Topic 740, the provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for the operating losses and tax credit carryforwards.  Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those assets are expected to be realized or settled.  We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized.  Management believes that sufficient uncertainty exists regarding the future realization of deferred tax assets and, accordingly, a full valuation allowance has been provided against net deferred tax assets.  Tax expense has taken into account any change in the valuation allowance for deferred tax assets where the realization of various deferred tax assets is subject to uncertainty.
 
 Recent Accounting Pronouncements

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

In February 2013, the FASB issued ASU No. 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income,” or ASU 2013-02.  ASU 2013-02 finalizes the requirements of ASU 2011-05 that ASU 2011-12 deferred, clarifying how to report the effect of significant reclassifications out of accumulated other comprehensive income. ASU 2013-02 is to be applied prospectively. We adopted ASU 2013-02 prospectively as required on January 1, 2013 by electing to present the required information in a single footnote.  Adoption of this new amended guidance did not have a material impact on our disclosures in our financial statements.

Results of Operations
 
Revenue
 
 
Year Ended December 31,
Year Ended December 31,
 
Increase
(Decrease)
Increase
(Decrease)
 
2013
2012
Amount
Percent
2012
2011
Amount
Percent
 
($ in thousands)
($ in thousands)
 
Net product revenue
 
$
56,520
   
$
47,723
   
$
8,797
     
18
%
 
$
47,723
   
$
37,450
   
$
10,273
     
27
%
Net support revenue
   
18,153
     
11,904
     
6,249
     
52
%
   
11,904
     
6,954
     
4,950
     
71
%
Total revenue
 
$
74,673
   
$
59,627
   
$
15,046
     
25
%
 
$
59,627
   
$
44,404
   
$
15,223
     
34
%

Our revenue is derived from two sources: (1) product revenue, which includes sales of our hardware appliances bundled with software licenses, separate software or term licenses or software upgrades; and (2) service revenue, which consists primarily of software maintenance and customer support revenue and secondarily of professional services.  Maintenance and customer support revenue is recognized over the support period, which is typically twelve months.  Our product revenues tend to vary seasonally and are typically higher in the second half of the year as compared to the first half of the year.

2013 Compared to 2012.  Total revenue in 2013 was $74.7 million, an increase of 25% compared to $59.6 million in 2012, and reflected an 18% increase in net product revenue and a 52% increase in net support revenue.  The increase in net product revenue in 2013 compared to 2012 reflected orders from new Tier 1 service provider customers and follow-on orders from existing customers and continued sales to our network operator customers, including mobile service providers, fixed line service providers and cable MSOs, as well as NAVL revenue following the acquisition of Vineyard in January 2013.  We also continued to add new enterprise and higher education customers.  Additionally, the increase in revenue reflected our continued expansion in international markets, including the Middle East, Japan and Latin America.  Net product revenue reflected increased sales of our mid-range PL8000 series products and PacketLogic Subscriber Management software, and the ramp up in sales of our high-end PL20000 series products.  The increase in net support revenue in 2013 compared to 2012 reflected the continued expansion of the installed base of our product to which we have sold ongoing support services, as well as growth in professional services revenue.  For the year ended December 31, 2013, Vineyard or NAVL revenue contributed $1.7 million and $0.9 million in product and support revenue, respectively.  There was no revenue in our 2012 results attributable to Vineyard as the acquisition was completed in early 2013.  For the year ended December 31, 2013, revenue from three customers, Shaw Communications, Inc., British Telecommunications plc and Itochu Techno-Solutions Corp., represented 13%, 12% and 10% of net revenues, respectively, with no other single customer accounting for more than 10% of net revenues.

2012 Compared to 2011.  Total revenue in 2012 was $59.6 million, an increase of 34% compared to $44.4 million in 2011, and reflected a 27% increase in net product revenue and a 71% increase in net support revenue.  The increase in net product revenue in 2012 compared to 2011 reflected revenue from network operator customer relationships and follow-on orders from existing customers.  During the year, we added a number of new large network operator customers, including  mobile service providers, fixed line service providers and cable multiple system operators; and we continued to add new higher education customers.  In part, new network operator customers reflected our geographic sales expansion in Japan and the Middle East.  Product revenue reflected increased sales of our mid-range PL8000 series products and PacketLogic Subscriber Management software, as well as initial sales of our high-end PL20000 series products.  The increase in support revenue in 2012 reflected the continued expansion of the installed base of our product to which we have sold ongoing support services and an increase in professional services revenue.  In 2012, revenue from one customer, Shaw Communications, Inc., represented 16% of net revenues.

Sales to customers located in the United States as a percentage of total revenues were 23%, 33% and 24% for the years ended December 31, 2013, 2012 and 2011, respectively.

For the year ending December 31, 2014, we expect total revenue to increase approximately 15% compared to total revenue for the year ended December 31, 2013.
 
Cost of Sales

Cost of sales includes: (i) material costs and direct labor for products sold, (ii) costs for warranty, (iii) adjustments to inventory values, including the write-down of slow moving or obsolete inventory, and (iv) costs for support and professional service personnel.

The following table presents the breakdown of cost of sales by category for the years ended December 31, 2013 and 2012:
 
 
 
Year Ended December 31,
   
Year Ended December 31,
 
 
 
2013
   
2012
   
Increase
(Decrease)
   
2012
   
2011
   
Increase
(Decrease)
 
 
 
($ in thousands)
   
   
($ in thousands)
   
 
 
 
   
   
   
   
   
 
Product Costs
 
$
30,461
   
$
17,720
   
$
12,741
   
$
17,720
   
$
17,358
   
$
362
 
Percent of net product revenue
   
54
%
   
37
%
   
17
%
   
37
%
   
46
%
   
(9
)%
 
                                               
Support costs
   
3,399
     
1,749
     
1,650
     
1,749
     
723
     
1,026
 
Percent of net support revenue
   
19
%
   
15
%
   
4
%
   
15
%
   
10
%
   
5
%
 
                                               
Total costs of sales
 
$
33,860
   
$
19,469
   
$
14,391
   
$
19,469
   
$
18,081
   
$
1,388
 
Percent of net total revenue
   
45
%
   
33
%
   
12
%
   
33
%
   
41
%
   
(8
)%
 
2013 compared to 2012.  Total cost of sales in 2013 increased by $14.4 million compared to 2012, and increased as a percentage of total revenue by 12 percentage points.  The increase in cost of sales in 2013 reflected higher material costs associated with increased product sales and higher support costs for increased customer support and professional services headcount.  The increase also reflected amortization of developed technology intangible assets acquired as part of the Vineyard acquisition in January 2013 of $1.1 million in the year ended December 31, 2013.  The increase in cost of sales as a percentage of net total revenue primarily reflected a higher proportion of hardware sales bundled with software sales, including greater chassis-based hardware sales in 2013 as compared to 2012. Stock-based compensation recorded to cost of sales in the year ended December 31, 2013 was $0.4 million, compared to $0.2 million in the year ended December 31, 2012.

2012 compared to 2011. Total cost of sales in 2012 increased by $1.4 million compared to 2011, and decreased as a percentage of total revenue by 8 percentage points.  The increase in cost of sales in 2012 reflected higher material costs associated with increased product sales and higher support costs for increased customer support and professional services headcount.  The decrease in cost of sales as a percentage of net total revenue primary reflected increased sales of our PL8000 series products, which have lower material costs compared to our other bundled hardware products, and a greater proportion of software licenses bundled with hardware sales.

Gross Profit
 
 
Year Ended December 31,
 
Year Ended December 31,
 
 
2013
 
2012
 
Increase
(Decrease)
 
2012
 
2011
 
Increase
(Decrease)
 
Amount
   
Percent
 
Amount
   
Percent
 
 
($ in thousands)
 
 
 
($ in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
Gross profit
 
$
40,813
   
$
40,158
   
$
655
     
2
%
 
$
40,158
   
$
26,323
   
$
13,837
     
53
%
Percent of total net revenue
   
55
%
   
67
%
                   
67
%
   
59
%
               
 
2013 compared to 2012. Our gross margin for 2013 decreased by 12 percentage points to 55% from 67% in 2012.  The decrease resulted from a higher proportion of hardware sales bundled with software sales, particularly from sales of our chassis-based PL20000 series products, which were sold with low initial quantities of bundled software licenses in 2013, higher support and service costs and amortization of acquired intangible assets.  Gross profit in 2013 reflected increased sales of our chassis-based products, which typically have a lower margin compared with our appliance-based products.
 
2012 compared to 2011. Our gross margin for 2012 increased by 8 percentage points to 67% from 59% in 2011.  The improvement resulted primarily from a greater proportion of software licenses bundled with hardware sales and increased sales of our appliance-based PL8000 series products.    In 2012, we sold increased quantities of our PacketLogic Subscriber Manager software licenses bundled with hardware and higher levels of license upgrades to existing customers.  In addition, we introduced higher capacity PL8000 series products, which enabled the usage of a higher level of bundled software licenses. These items resulted in a higher proportion of software license sales in comparison to 2011.  Revenue in 2012 also reflected increased sales of our appliance-based PL8000 series products, which have a higher margin compared to our chassis-based products.  

Our gross margin rate in any given period is impacted by the product mix in that period, and we expect variability in our gross margin rate to continue in the future.  We expect gross profit to be higher in total as a percentage of revenue in 2014 compared to 2013.

Operating Expenses
 
 
Year Ended December 31,
Year Ended December 31,
 
2013
2012
Increase
(Decrease)
2012
2011
Increase
(Decrease)
 
Amount
Percent
Amount
Percent
 
($ in thousands)
($ in thousands)
 
Research and development
 
$
17,548
   
$
7,472
   
$
10,076
     
135
%
 
$
7,472
   
$
4,647
   
$
2,825
     
61
%
Sales and marketing
   
29,251
     
18,158
     
11,093
     
61
%
   
18,158
     
12,026
     
6,132
     
51
%
General and administrative
   
12,036
     
9,223
     
2,813
     
30
%
   
9,223
     
5,707
     
3,516
     
62
%
Total
 
$
58,835
   
$
34,853
   
$
23,982
     
69
%
 
$
34,853
   
$
22,380
   
$
12,473
     
56
%

2013 compared to 2012.  In 2013, our total operating expenses increased to support growth in the scale of our operations and we hired additional employees in each function of our company, added employees from the Vineyard acquisition, invested in testing equipment for the development of our products, continued investing in our operating and accounting system, and increased the use of outside services, including legal, audit and accounting services.

2012 compared to 2011.  In 2012, our total operating expenses increased to support growth in the scale of our operations and we hired additional employees in each function of our company, invested in testing equipment for the development of our products, replaced our operating and accounting system, and increased the use of outside services, including legal, audit and accounting services.

In total, we anticipate that new employee and contractor hiring in 2014 will be substantially reduced compared with the hiring in 2013, and that our headcount will flatten-out at a level near the level reported as of the year ended December 31, 2013.

Research and Development

Research and development expenses include costs associated with personnel focused on the development or improvement of our products, prototype materials, initial product certifications, testing equipment and software costs.  Research and development costs include sustaining and enhancement efforts for products already released and development costs associated with planned new products.

 
Year Ended December 31,
 
Year Ended December 31,
 
 
2013
 
2012
 
Increase
(Decrease)
 
2012
 
2011
 
Increase
(Decrease)
 
Amount
   
Percent
 
Amount
   
Percent
 
 
($ in thousands)
 
 
 
($ in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
Research and development
 
$
17,548
   
$
7,472
   
$
10,076
     
135
%
 
$
7,472
   
$
4,647
   
$
2,825
     
61
%
As a percentage of net revenue
   
23
%
   
12
%
                   
12
%
   
10
%
               

2013 compared to 2012.  Research and development expenses for 2013 increased by $10.1 million compared to 2012 as a result of increased research and development personnel hired during 2013, the addition of employees from our acquisition of Vineyard, and the corresponding additional employee compensation costs, as well as higher depreciation costs related to increased investments in testing equipment and software.  We also recognized $3.0 million in compensation costs related to retention agreements with the founders of Vineyard Networks Inc.  The additional personnel hired are expected to allow us to enhance our core product features and functionality in order to support new sales and to achieve follow-on sales to our current customers. Stock-based compensation recorded to research and development expenses was $1.2 million in 2013 compared to $0.3 million in 2012.

2012 compared to 2011. Research and development expenses for 2012 increased by $2.8 million compared to 2011 as a result of increased research and development personnel hired during 2012, and corresponding additional employee compensation costs and higher depreciation related to testing equipment and software.   Stock-based compensation recorded to research and development expenses was $0.3 million in 2012 compared to $0.1 million in 2011.

Sales and Marketing
 
Sales and marketing expenses primarily include personnel costs, sales commissions and marketing expenses, such as trade shows, channel development and product marketing and promotional literature.

 
Year Ended December 31,
 
Year Ended December 31,
 
 
2013
 
2012
 
Increase
(Decrease)
 
2012
 
2011
 
Increase
(Decrease)
 
Amount
   
Percent
 
Amount
   
Percent
 
 
($ in thousands)
 
 
 
($ in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
Sales and marketing
 
$
29,251
   
$
18,158
   
$
11,093
     
61
%
 
$
18,158
   
$
12,026
   
$
6,132
     
51
%
As a percentage of net revenue
   
39
%
   
31
%
                   
31
%
   
27
%
               

2013 compared to 2012.  Sales and marketing expenses for 2013 increased by $11.1 million compared to 2012.  The increase reflected the addition of sales and marketing personnel in 2013, including the addition of employees from our acquisition of Vineyard, and the corresponding higher compensation costs and higher commission costs as a result of the increase in revenue.  We also recognized $2.9 million in compensation costs related to retention agreements with the founders of Vineyard Networks Inc.  Stock-based compensation recorded to sales and marketing expense was $1.7 million in 2013 compared to $1.2 million in 2012.
 
2012 compared to 2011.  Sales and marketing expenses for 2012 increased by $6.1 million compared to 2011.  The increase reflected the addition of sales and marketing personnel in 2012 and the corresponding higher compensation costs and higher commission costs as a result of the increase in revenue.  Stock-based compensation recorded to sales and marketing expense was $1.2 million in 2012 compared to $0.5 million in 2011.
 
General and Administrative
 
General and administrative expenses consist primarily of personnel costs related to our executives, our finance function, and outside fees for professional services.  Professional services include costs for legal advice and services, independent auditors and investor relations.
 
 
Year Ended December 31,
Year Ended December 31,
 
Increase
(Decrease)
Increase
(Decrease)
 
2013
2012
Amount
Percent
2012
2011
Amount
Percent
 
($ in thousands)
($ in thousands)
 
General and administrative
 
$
12,036
   
$
9,223
   
$
2,813
     
30
%
 
$
9,223
   
$
5,707
   
$
3,516
     
62
%
As a percentage of net revenue
   
16
%
   
16
%
                   
16
%
   
13
%
               
 
2013 compared to 2012.  General and administrative expenses for 2013 increased by $2.8 million compared to 2012, reflecting increased accounting and human resource personnel and personnel related costs, increased legal and audit fees, and an increased use of contractors and outside services.  The increase also reflects $1.6 million in business development costs including costs associated with the Vineyard acquisition for legal, accounting and investment banking fees in the year ended December 31, 2013, compared to $1.2 million in such costs in 2012.  Stock-based compensation recorded to general and administrative expense was $1.8 million in 2013, compared to $1.1 million in 2012.

2012 compared to 2011. General and administrative expenses for 2012 increased by $3.5 million compared to 2011, reflecting increased accounting and human resource personnel and personnel related costs, business development expenses, increased legal and audit fees, and an increased use of contractors and outside services that related, in part, to the replacement of our operating and accounting system.  During 2012, we incurred business development costs of approximately $1.2 million related to potential mergers, acquisitions and other significant partnership arrangements.  Stock-based compensation recorded to general and administrative expense was $1.1 million in 2012, compared to $1.0 million in 2011.

Interest and Other Expense
 
 
Year Ended December 31,
Year Ended December 31,
 
Increase
(Decrease)
Increase
(Decrease)
  2013 2012
Amount
Percent
2012 2011
Amount
Percent
 
($ in thousands)
($ in thousands)
 
Interest and other income
 
$
601
     
362
   
$
239
     
66
%
 
$
362
     
73
   
$
289
     
397
%
Interest expense and other
   
(40
)
   
(213
)
   
173
     
81
%
   
(213
)
   
(216
)
   
3
     
2
%
Total interest and other income (expense), net
 
$
561
   
$
149
   
$
412
     
277
%
 
$
149
   
$
(143
)
 
$
292
     
204
%

2013 Compared to 2012.  Interest and other income increased in 2013 compared to 2012 due to realized foreign currency gains offset by slightly lower interest earned on cash and investment balances in 2013.  Interest expense and other decreased in 2013 compared to 2012, reflecting reduced foreign currency transaction losses in 2013 compared to 2012.

2012 Compared to 2011.  Interest income increased in 2012 compared to 2011 due to higher cash and investment balances following our registered offering of common stock in the second quarter of 2012, for which we received net proceeds of approximately $88.0 million.  Interest expense and other decreased in 2012 compared to 2011, reflecting reduced foreign currency transaction losses in 2012 compared to 2011.
Provision for Income Taxes

 
 
Year Ended December 31,
   
Year Ended December 31,
 
 
 
2013
   
2012
   
Increase
(Decrease)
   
2012
   
2011
   
Increase
(Decrease)
 
 
 
($ in thousands)
   
   
   
($ in thousands)
   
   
 
Income tax provision
 
$
(1,177
)
 
$
123
   
$
(1,300
)
   
(1057
)%
 
$
123
   
$
45
   
$
78
     
173
%

We are subject to taxation primarily in the U.S., Canada, Australia, Japan, Singapore, and Sweden, as well as in a number of states, including California.  The decrease in income tax provision in 2013 compared to 2012 primarily relates to the deferred tax benefit following the acquisition of Vineyard and other current foreign taxes.

We have established a valuation allowance for substantially all of our deferred tax assets.  We calculated the valuation allowance in accordance with the provisions of ASC Topic 740, which requires that a valuation allowance be established or maintained when it is “more likely than not” that all or a portion of deferred tax assets will not be realized.  During 2013 and 2012, we experienced significant growth and were able to utilize a portion of our net operating loss carry-forwards and, to the extent utilized, we have reversed any previous reserve.  We will continue to reserve for substantially all net deferred tax assets until there is sufficient evidence to warrant reversal.

Liquidity and Capital Resources
 
Cash, Cash Equivalents and Short-term Investments

The following table summarizes the changes in our cash balance for the periods indicated:
 
 
Year Ended December 31,
 
2013
2012
2011
 
(in thousands)
 
Net cash provided by (used in) operating activities
 
$
(10,803
)
 
$
7,157
   
$
4,591
 
Net cash provided by (used in) investing activities
   
70,894
     
(92,087
)
   
(14,571
)
Net cash provided by financing activities
   
156
     
91,809
     
25,880
 
Effect of exchange rate changes on cash and cash equivalents
   
(406
)
   
154
     
124
 
Net increase in cash and cash equivalents
 
$
59,841
   
$
7,033
   
$
16,024
 
 
During the year ended December 31, 2013, we used $10.8 million in cash from operating activities as compared to $7.2 million generated from operating activities for the year ended December 31, 2012.  Cash used by operating activities during the year ended December 31, 2013 primarily consisted of our net loss of $16.3 million offset by non-cash charges of $16.3 million and from net working capital uses of cash of $10.9 million. Non-cash charges consisted primarily of stock-based compensation of $5.1 million, amortization of intangible assets of $1.6 million, amortization of premium on investments of $0.9 million, depreciation expense of $1.9 million, amortization of deferred compensation of $5.8 million and provision for excess and obsolete inventory of $1.0 million, partially offset by changes in deferred taxes of $1.5 million. Working capital uses of cash consisted primarily of an increase in inventory of $8.6 million resulting from material purchases in anticipation of future sales, an increase in accounts receivable of $7.9 million resulting from higher sales and certain longer payment terms, and an advance payment to escrow of $2.7 million recorded as deferred compensation related to retention agreements with Vineyard’s three founders which is payable after one year of continuous employment with us.  Working capital sources of cash included a decrease in prepaid expenses and other current assets of $2.0 million primarily resulting from the receipt of a tax credit, an increase in accounts payable of $1.7 million resulting primarily from an increase in inventory purchases, an increase in accrued liabilities of $1.5 million as a result of higher accrued commissions on the higher level of sales and increased compensation-related accruals associated with higher headcount, and a $4.6 million increase in deferred revenue as a result of initial support contracts and support renewals from our expanding customer base as well as term NAVL software licenses sold following the acquisition of Vineyard in January 2013.

Net cash provided by investing activities of $70.9 million during the year ended December 31, 2013 consisted of proceeds from net purchases, sales and maturities of short-term investments of $84.0 million, partially offset by net cash consideration for the acquisition of Vineyard of $9.0 million, and equipment purchases primarily of lab and testing equipment for use in research and development of $4.1 million.

Net cash provided by financing activities of $0.2 million included net proceeds from the exercise of stock options of $0.7 million offset by the repayment of debt acquired from the Vineyard acquisition of $0.5 million.

During 2012, we generated $7.2 million in cash from operating activities, primarily consisting of our net income of $5.3 million plus non-cash charges of $5.3 million, partially offset by net working capital uses of cash of $3.4 million.  Non-cash charges consisted primarily of stock-based compensation of $2.8 million, depreciation expense of $0.9 million, inventory write-downs of $0.7 million and amortization of premiums paid for investments of $0.8 million.  Working capital uses of cash included an increase in inventories of $4.2 million, an increase in accounts receivables of $5.0 million, and an increase in prepaid expenses and other current assets of $1.1 million.  The increase in inventories resulted from material purchases near the end of 2012 for the fulfillment of expected orders and an increase in inventories deployed at customer sites that were pending final customer acceptance.  The increase in accounts receivables reflected an increase in the receivables balance associated with higher sales, as well as timing of shipments as large orders were shipped near year end.  The increase in prepaid expenses and other current assets was due partially to interest receivable of $0.4 million from our invested capital and to increased prepaid expenses due to our growth as well as prepaid service agreements for our accounting and operating systems.  Working capital sources of cash included an increase in deferred revenue of $3.3 million, an increase in accounts payable of $2.6 million, and an increase in accrued liabilities of $1.0 million.  The increase in deferred revenue reflected support renewal orders from our growing customer base, as well as support purchased on new product shipments.  The increase in accounts payable reflected increased inventory purchases.  The increase in accrued liabilities reflected higher accrued bonuses and sales commissions as a result of increased revenue.

Net cash used in investing activities of $92.1 million in 2012 reflected purchases of short-term investments of $117.8 million using cash raised through our equity offering in the second quarter of 2012, and purchases of lab and testing equipment for use in research and development of $4.0 million, offset partially by maturities and sales of short-term investments of $22.7 million and $7.0 million, respectively.  

Net cash provided by financing activities of $91.8 million included net proceeds from the issuance of common stock of $88.0 million and proceeds from the exercise of stock options and warrants of $3.8 million.

During 2011, we generated $4.6 million in cash from operating activities, primarily consisting of our net income of $3.8 million plus non-cash charges of $2.7 million, partially offset by net working capital uses of cash of $1.8 million.  Non-cash charges consisted primarily of stock-based compensation of $1.7 million, depreciation expense of $0.4 million and inventory write-downs of $0.4 million.  Working capital uses of cash included an increase in inventories of $5.5 million and an increase in accounts receivables of $0.3 million. The increase in inventories resulted from material purchases before 2011 year end in anticipation of 2012 sales.  The increase in accounts receivables reflected an increase in the receivables balance associated with higher sales.  Working capital sources of cash included increases in deferred revenue of $2.0 million, accrued liabilities of $1.2 million and accounts payable of $0.9 million.  The increase in deferred revenue reflected support renewal orders from our growing customer base, as well as support purchased on new product shipments. The increase in accounts payable reflected increased inventory purchases.  The increase in accrued liabilities reflected higher accrued bonuses and sales commissions as a result of increased revenue, which exceeded established revenue targets.

Net cash used in investing activities of $14.6 million in 2011 reflected purchases of short-term investments of $13.6 million using cash raised through our equity offering in the second quarter of 2011, and purchases of lab and testing equipment for use in research and development of $1.0 million.  

Net cash provided by financing activities of $25.9 million included proceeds from the issuance of common stock of $26.5 million and proceeds from the exercise of stock options and warrants of $1.1 million, offset by the net repayment of the borrowings against our line of credit of $1.7 million.

Our cash, cash equivalents and short-term investments at December 31, 2013 consisted of bank deposits with third party financial institutions, money market funds and corporate bonds.  Our investments are intended to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations and delivers an appropriate yield in relationship to our investment guidelines and market conditions.  Cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the date of purchase.  Short-term investments have a remaining maturity of greater than three months at the date of purchase and a weighted average maturity of less than one year.  All investments are classified as available for sale.

On December 10, 2009, we entered into a two-year loan and security agreement for a secured credit facility of $2.0 million for short-term working capital purposes with Silicon Valley Bank. Borrowings under the facility bore interest at the prime rate plus 1%, but not less than 5% per annum.  On February 3, 2012, the agreement was amended and restated to increase the credit facility from $2.0 million to $10.0 million for an additional two-year period beginning on that date.  Borrowings under the amended credit facility bear interest at the prime rate plus 1%, but not less than 4.25% on an annual basis.  At December 31, 2013, we had no borrowings under this credit facility.  The credit facility expired on February 2, 2014.

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

In January 2013, we acquired Vineyard in Canada.  The aggregate consideration of approximately $26.8 million USD, consisted of $12.5 million in cash and 825,060 shares of our common stock with a gross value of $14.3 million.
 
Off-Balance Sheet Arrangements
 
As of December 31, 2013, we had no off-balance sheet arrangements as described by Item 303(a)(4) of Regulation S-K.  We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments or other contingent arrangements that expose us to material continuing risks, contingent liabilities, or any other obligations under a variable interest in an unconsolidated entity that provide us with financing, liquidity, market risk or credit risk support.

Contractual Obligations

The following table summarizes the contractual obligations that we were reasonably likely to incur as of December 31, 2013 and the effect that such obligations are expected to have on our liquidity and cash flows in future periods.
 
 
Payments Due by Period
In thousands
Total
< 1 Year
1-3 Years
3-5 Years
> 5 Years
Operating leases
 
$
2,640
   
$
772
   
$
1,225
   
$
643
   
$
-
 
Unconditional purchase obligations
   
7,361
     
7,361
     
-
     
-
     
-
 
Total
 
$
10,001
   
$
8,133
   
$
1,225
   
$
643
   
$
-
 
 
We use third-party suppliers to assemble and test our hardware products.  In order to reduce manufacturing lead-times and ensure an adequate supply of inventories, our agreements with some of these suppliers allow them to procure long lead-time component inventory based on rolling production forecasts provided by us.  We may be contractually obligated to purchase long lead-time component inventory procured by certain suppliers in accordance with our forecasts. In addition, we issue purchase orders to our third-party suppliers that may not be cancelable at any time.  As of December 31, 2013, we had open non-cancelable purchase orders amounting to approximately $7.4 million, primarily with our third-party suppliers.
 
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
 
Foreign Currency Risk

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

Interest Rate Sensitivity

We had unrestricted cash, cash equivalents and short term investments totaling approximately $106.6 million at December 31, 2013.  Cash equivalents and short-term investments are composed of money market funds and commercial paper. Our investment policy requires investments to be of high credit quality, primarily rated A/A2, with the objective of minimizing the potential risk of principal loss.  All short-term investments have a weighted average maturity of less than one year and are classified as available-for sale, and, consequently, are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive income (loss). Because of the short weighted-average maturity of our investment portfolio at December 31, 2013, we believe that the fair value of our investment portfolio would not be significantly impacted by either a hypothetical 100 basis point increase or decrease in market interest rates.

Item 8. Financial Statements and Supplementary Data
 
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
 
Page
 
 
Report of Independent Registered Public Accounting Firm
47
Report of Independent Registered Public Accounting Firm
48
Consolidated Balance Sheets as of December 31, 2013 and 2012
49
Consolidated Statements of Operations for the years ended December 31, 2013, 2012 and 2011
50
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2013, 2012 and 2011
51
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2013, 2012 and 2011
52
Consolidated Statements of Cash Flows for the years ended December 31, 2013, 2012 and 2011
53
Notes to Consolidated Financial Statements
54

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
The Board of Directors and Stockholders of Procera Networks, Inc.
 
We have audited the accompanying consolidated balance sheet of Procera Networks, Inc. as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for each of the years then ended. Our audit also included the financial statement schedule listed in the Index at Item 15(b)(2) for the years ended December 31, 2013 and 2012. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audit.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Procera Networks, Inc., at December 31, 2013 and 2012, and the consolidated results of its operations and its cash flows for each of the years then ended, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Procera Networks, Inc.’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) and our report dated March 11, 2014 expressed an unqualified opinion thereon.
 
/s/  Ernst & Young LLP
 
Redwood City, California
March 11, 2014

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Stockholders
Procera Networks, Inc.
 
We have audited the accompanying consolidated statements of operations, comprehensive income (loss), stockholders’ equity and cash flows for the fiscal year ended December 31, 2011of Procera Networks, Inc. (the “Company”). Our audit also included the financial statement schedule as of December 31, 2011 listed in the accompanying index at Item 15(b)2. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of its operations and its cash flows for the year ended December 31, 2011, in conformity with generally accepted accounting principles in the United States. Also in our opinion, the related financial statement schedule as of December 31, 2011 present fairly, in all material respects, the information set therein when considered in relation to the basic consolidated financial statements.
 
 /s/ PMB Helin Donovan, LLP
PMB Helin Donovan, LLP
San Francisco, California
 
March 15, 2012

PROCERA NETWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except par value)

 
 
December 31,
 
 
 
2013
   
2012
 
 
 
   
 
ASSETS
 
   
 
Current assets:
 
   
 
Cash and cash equivalents
 
$
90,774
   
$
30,933
 
Short-term investments
   
15,789
     
100,762
 
Accounts receivable, net of allowance of $129 and $96 at December 31, 2013 and 2012, respectively
   
25,008
     
16,603
 
Inventories, net
   
18,836
     
11,240
 
Prepaid expenses and other
   
2,128
     
2,012
 
Total current assets
   
152,535
     
161,550
 
 
               
Property and equipment, net
   
7,121
     
4,474
 
Intangible assets, net
   
6,270
     
-
 
Goodwill
   
12,326
     
960
 
Deferred tax asset
   
1,101
     
-
 
Other non-current assets
   
83
     
54
 
Total assets
 
$
179,436
   
$
167,038
 
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
 
$
7,305
   
$
5,453
 
Deferred revenue
   
11,633
     
6,953
 
Accrued liabilities
   
6,721
     
4,949
 
Total current liabilities
   
25,659
     
17,355
 
 
               
Non-current liabilities:
               
Deferred revenue
   
3,273
     
2,878
 
Deferred tax liability
   
1,690
     
-
 
Deferred rent
   
143
     
-
 
Total liabilities
   
30,765
     
20,233
 
 
               
Commitments and contingencies (Note 11)
               
 
               
Stockholders’ equity:
               
Preferred stock, $0.001 par value; 15,000 shares authorized; none issued and outstanding
   
-
     
-
 
Common stock, $0.001 par value; 32,500 shares authorized; 20,652 and 19,696 shares issued and outstanding at December 31, 2013 and 2012, respectively
   
21
     
20
 
Additional paid-in capital
   
219,763
     
199,793
 
Accumulated other comprehensive loss
   
(1,897
)
   
(76
)
Accumulated deficit
   
(69,216
)
   
(52,932
)
Total stockholders’ equity
   
148,671
     
146,805
 
Total liabilities and stockholders’ equity
 
$
179,436
   
$
167,038
 
 
The accompanying notes are an integral part of these consolidated financial statements.

PROCERA NETWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

 
 
Year Ended December 31,
 
 
 
2013
   
2012
   
2011
 
 
 
   
   
 
Sales:
 
   
   
 
Product sales
 
$
56,520
   
$
47,723
   
$
37,450
 
Support sales
   
18,153
     
11,904
     
6,954
 
Total sales
   
74,673
     
59,627
     
44,404
 
Cost of sales:
                       
Product cost of sales
   
30,461
     
17,720
     
17,358
 
Support cost of sales
   
3,399
     
1,749
     
723
 
Total cost of sales
   
33,860
     
19,469
     
18,081
 
 
                       
Gross profit
   
40,813
     
40,158
     
26,323
 
 
                       
Operating expenses:
                       
Research and development
   
17,548
     
7,472
     
4,647
 
Sales and marketing
   
29,251
     
18,158
     
12,026
 
General and administrative
   
12,036
     
9,223
     
5,707
 
Total operating expenses
   
58,835
     
34,853
     
22,380
 
 
                       
Income (loss) from operations
   
(18,022
)
   
5,305
     
3,943
 
 
                       
Interest and other income (expense):
                       
Interest and other income
   
601
     
362
     
73
 
Interest and other expense
   
(40
)
   
(213
)
   
(216
)
Total other income (expense), net
   
561
     
149
     
(143
)
 
                       
Income (loss) before income taxes
   
(17,461
)
   
5,454
     
3,800
 
Income tax provision (benefit)
   
(1,177
)
   
123
     
45
 
Net income (loss)
 
$
(16,284
)
 
$
5,331
   
$
3,755
 
 
                       
Net income (loss) per share - basic
 
$
(0.81
)
 
$
0.30
   
$
0.29
 
Net income (loss) per share - diluted
 
$
(0.81
)
 
$
0.29
   
$
0.28
 
 
                       
Shares used in computing net income (loss) per share:
                       
Basic
   
20,091
     
17,842
     
12,932
 
Diluted
   
20,091
     
18,337
     
13,219
 
 
The accompanying notes are an integral part of these consolidated financial statements.

PROCERA NETWORKS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)

 
 
Year Ended December 31,
 
 
 
2013
   
2012
   
2011
 
 
 
   
   
 
Net income (loss)
 
$
(16,284
)
 
$
5,331
   
$
3,755
 
 
                       
Unrealized gain (loss) on short-term investments, net of tax of $0
   
(7
)
   
21
     
(1
)
Foreign currency translation adjustments
   
(1,814
)
   
293
     
(57
)
Other comprehensive income (loss)
   
(1,821
)
   
314
     
(58
)
 
                       
Comprehensive income (loss)
 
$
(18,105
)
 
$
5,645
   
$
3,697
 

The accompanying notes are an integral part of these consolidated financial statements.

PROCERA NETWORKS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands)
 
 
 
Common Stock
   
Additional
Paid-In
   
Accumulated
Other
Comprehensive
Income
   
Accumulated
   
Total
Stockholders’
 
 
 
Shares
   
Amount
   
Capital
   
(Loss)
   
Deficit
   
Equity
 
Balances at December 31, 2010
   
11,315
   
$
11
   
$
76,093
   
$
(332
)
 
$
(62,018
)
 
$
13,754
 
 
                                               
Net income
                           
-
     
3,755
     
3,755
 
Other comprehensive loss
                           
(58
)
   
-
     
(58
)
Exercise of stock options
   
110
     
1
     
750
     
-
     
-
     
751
 
Exercise of warrants
   
100
     
-
     
183
     
-
     
-
     
183
 
Stock-based compensation
   
-
     
-
     
1,725
     
-
     
-
     
1,725
 
Issuance of common stock in registered placement, net of issuance costs
   
3,027
     
3
     
26,454
     
-
     
-
     
26,457
 
Issuance of restricted stock
   
76
     
-
     
-
     
-
     
-
     
-
 
Balances at December 31, 2011
   
14,628
     
15
     
105,205
     
(390
)
   
(58,263
)
   
46,567
 
 
                                               
Net income
                           
-
     
5,331
     
5,331
 
Other comprehensive income
                           
314
     
-
     
314
 
Exercise of stock options
   
372
     
-
     
3,756
     
-
     
-
     
3,756
 
Exercise of warrants
   
44
     
-
     
27
     
-
     
-
     
27
 
Stock-based compensation
   
-
     
-
     
2,784
     
-
     
-
     
2,784
 
Issuance of common stock in registered placement, net of issuance costs
   
4,500
     
5
     
88,021
     
-
     
-
     
88,026
 
Issuance of restricted stock
   
152
     
-
     
-
     
-
     
-
     
-
 
Balances at December 31, 2012
   
19,696
     
20
     
199,793
     
(76
)
   
(52,932
)
   
146,805
 
 
                                               
Net loss
                           
-
     
(16,284
)
   
(16,284
)
Other comprehensive loss
                           
(1,821
)
   
-
     
(1,821
)
Exercise of stock options
   
87
     
-
     
653
     
-
     
-
     
653
 
Stock-based compensation
   
-
     
-
     
5,057
     
-
     
-
     
5,057
 
Issuance of common stock as part of the Vineyard acquisition, net of issuance costs
   
825
     
1
     
14,260
     
-
     
-
     
14,261
 
Issuance of restricted stock
   
44
     
-
     
-
     
-
     
-
     
-
 
Balances at December 31, 2013
   
20,652
   
$
21
   
$
219,763
   
$
(1,897
)
 
$
(69,216
)
 
$
148,671
 

The accompanying notes are an integral part of these consolidated financial statements.

PROCERA NETWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
 
 
Year Ended December 31,
 
 
 
2013
   
2012
   
2011
 
Cash flows from operating activities:
 
   
   
 
Net income (loss)