10-Q 1 d261302d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

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

For the quarterly period ended September 30, 2016

OR

 

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

For the transition period from                      to                     

Commission File Number: 001-36131

 

 

Endurance International Group Holdings, Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

Delaware   46-3044956

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

 

10 Corporate Drive, Suite 300

Burlington, Massachusetts

  01803
(Address of Principal Executive Offices)   (Zip Code)

(781) 852-3200

(Registrant’s Telephone Number, Including Area Code)

 

 

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer      Accelerated filer  
Non-accelerated filer   ☐  (Do not check if a smaller reporting company)    Smaller reporting company  

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

As of October 31, 2016, there were 141,511,981 shares of the issuer’s common stock, $0.0001 par value per share, outstanding.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

     Page  

PART I. FINANCIAL INFORMATION

  

Item 1. Financial Statements (unaudited)

  

Consolidated Balance Sheets as of December  31, 2015 and September 30, 2016

     3   

Consolidated Statements of Operations and Comprehensive Loss for the three and nine months ended September 30, 2015 and 2016

     4   

Consolidated Statements of Cash Flows for the nine months ended September 30, 2015 and 2016

     5   

Notes to Consolidated Financial Statements

     6   

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

     37   

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     59   

Item 4. Controls and Procedures

     60   

PART II. OTHER INFORMATION

  

Item 1. Legal Proceedings

     61   

Item 1A. Risk Factors

     62   

Item 5. Other Information

     92   

Item 6. Exhibits

     93   

Signatures

     94   

 

2


Table of Contents

Endurance International Group Holdings, Inc.

Consolidated Balance Sheets

(unaudited)

(in thousands, except share and per share amounts)

 

     December 31, 2015     September 30, 2016  

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 33,030      $ 63,148   

Restricted cash

     1,048        3,483   

Accounts receivable

     12,040        11,193   

Prepaid domain name registry fees

     55,793        55,444   

Prepaid expenses and other current assets

     15,675        32,274   
  

 

 

   

 

 

 

Total current assets

     117,586        165,542   

Property and equipment—net

     75,762        97,093   

Goodwill

     1,207,255        1,859,671   

Other intangible assets—net

     359,786        650,770   

Deferred financing costs

     —          5,345   

Investments

     27,905        20,710   

Prepaid domain name registry fees, net of current portion

     9,884        10,114   

Other assets

     4,322        4,428   
  

 

 

   

 

 

 

Total assets

   $ 1,802,500      $ 2,813,673   
  

 

 

   

 

 

 

Liabilities, redeemable non-controlling interest and stockholders’ equity

    

Current liabilities:

    

Accounts payable

   $ 12,280      $ 13,977   

Accrued expenses

     50,869        81,815   

Deferred revenue

     285,945        356,747   

Current portion of notes payable

     77,500        69,200   

Current portion of capital lease obligations

     5,866        7,108   

Deferred consideration—short term

     51,488        13,153   

Other current liabilities

     3,973        3,507   
  

 

 

   

 

 

 

Total current liabilities

     487,921        545,507   

Long-term deferred revenue

     79,682        91,855   

Notes payable—long term, net of original issue discounts of $0 and $26,707, and deferred financing costs of $990 and $44,681, respectively

     1,014,885        1,961,512   

Capital lease obligations—long term

     7,215        2,082   

Deferred tax liability

     28,786        31,081   

Deferred consideration—long term

     813        7,324   

Other liabilities

     3,524        9,892   
  

 

 

   

 

 

 

Total liabilities

     1,622,826        2,649,253   
  

 

 

   

 

 

 

Redeemable non-controlling interest

     —          14,129   

Commitments and contingencies

    

Stockholders’ equity:

    

Preferred Stock—par value $0.0001; 5,000,000 shares authorized; no shares issued or outstanding

     —          —     

Common Stock—par value $0.0001; 500,000,000 shares authorized; 132,024,558 and 133,786,885 shares issued at December 31, 2015 and September 30, 2016, respectively; 131,938,485 and 133,786,885 outstanding at December 31, 2015 and September 30, 2016, respectively

     14        14   

Additional paid-in capital

     848,740        858,195   

Accumulated other comprehensive loss

     (1,718     (2,589

Accumulated deficit

     (667,362     (705,329
  

 

 

   

 

 

 

Total stockholders’ equity

     179,674        150,291   
  

 

 

   

 

 

 

Total liabilities, redeemable non-controlling interest and stockholders’ equity

   $ 1,802,500      $ 2,813,673   
  

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

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Endurance International Group Holdings, Inc.

Consolidated Statements of Operations and Comprehensive Loss

(unaudited)

(in thousands, except share and per share amounts)

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2015     2016     2015     2016  

Revenue

   $ 188,523      $ 291,193      $ 548,272      $ 819,019   

Cost of revenue

     110,773        149,427        316,684        438,980   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     77,750        141,766        231,588        380,039   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating expense:

        

Sales and marketing

     37,523        75,341        109,791        234,944   

Engineering and development

     7,902        23,988        19,906        67,930   

General and administrative

     21,751        33,399        58,429        108,508   

Transactions expenses

     1,461        159        4,602        32,257   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expense

     68,637        132,887        192,728        443,639   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) from operations

     9,113        8,879        38,860        (63,600
  

 

 

   

 

 

   

 

 

   

 

 

 

Other income (expense):

        

Other income (loss)

     —          (4,845     5,440        6,565   

Interest income

     107        162        316        438   

Interest expense

     (14,624     (41,208     (42,956     (112,573
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other expense—net

     (14,517     (45,891     (37,200     (105,570
  

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) before income taxes and equity earnings of unconsolidated entities

     (5,404     (37,012     1,660        (169,170

Income tax expense (benefit)

     5,397        (7,387     9,082        (121,220
  

 

 

   

 

 

   

 

 

   

 

 

 

Loss before equity earnings of unconsolidated entities

     (10,801     (29,625     (7,422     (47,950

Equity loss of unconsolidated entities, net of tax

     4,550        173        9,116        1,197   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

     (15,351     (29,798     (16,538     (49,147
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss attributable to non-controlling interest

     —          (1,206     —          (14,326

Excess accretion of non-controlling interest

     —          3,145        —          3,145   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total net income (loss) attributable to non-controlling interest

     —          1,939        —          (11,181
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss attributable to Endurance International Group Holdings, Inc.

   $ (15,351   $ (31,737   $ (16,538   $ (37,966
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income (loss):

        

Foreign currency translation adjustments

     (836     112        (1,358     994   

Unrealized gain (loss) on cash flow hedge, net of taxes of $0 and ($65), and $0 and ($889) for the three and nine months ended September 30, 2015 and 2016, respectively

     —          72        —          (1,866
  

 

 

   

 

 

   

 

 

   

 

 

 

Total comprehensive loss

   $ (16,187   $ (31,553   $ (17,896   $ (38,838
  

 

 

   

 

 

   

 

 

   

 

 

 

Basic and Diluted net loss per share attributable to Endurance International Group Holdings, Inc.

   $ (0.12   $ (0.24   $ (0.13   $ (0.29
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted-average common shares used in computing net loss per share attributable to Endurance International Group Holdings, Inc.:

        

Basic and Diluted

     131,398,446        133,550,168        131,195,109        133,038,542   
  

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

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Endurance International Group Holdings, Inc.

Consolidated Statements of Cash Flows

(unaudited)

(in thousands)

 

     Nine Months Ended September 30,  
     2015     2016  

Cash flows from operating activities:

    

Net loss

   $ (16,538   $ (49,147

Adjustments to reconcile net loss to net cash provided by operating activities:

    

Depreciation of property and equipment

     24,649        46,942   

Amortization of other intangible assets

     67,191        105,679   

Impairment of long lived assets

     —          8,285   

Amortization of deferred financing costs

     62        4,322   

Amortization of net present value of deferred consideration

     488        2,426   

Dividend from equity method investment

     —          50   

Amortization of original issue discounts

     —          2,116   

Stock-based compensation

     20,272        48,218   

Deferred tax expense (benefit)

     5,621        (124,547

Gain on sale of assets

     (155     (168

Gain from unconsolidated entities

     (5,440     (6,565

Loss of unconsolidated entities

     9,116        1,197   

(Gain) loss from change in deferred consideration

     1,083        (33

Changes in operating assets and liabilities, net of acquisitions:

    

Accounts receivable

     (1,742     1,376   

Prepaid expenses and other current assets

     (9,254     (9,206

Accounts payable and accrued expenses

     9,257        12,294   

Deferred revenue

     29,204        58,565   
  

 

 

   

 

 

 

Net cash provided by operating activities

     133,814        101,804   
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Businesses acquired in purchase transactions, net of cash acquired

     (73,212     (889,634

Cash paid for minority investment

     (7,250     (5,600

Purchases of property and equipment

     (23,267     (29,317

Proceeds from note receivable

     3,454        —     

Proceeds from sale of assets

     284        242   

Purchases of intangible assets

     (44     (27

Deposits (withdrawals) of principal balances in restricted cash accounts

     (109     (738
  

 

 

   

 

 

 

Net cash used in investing activities

     (100,144     (925,074
  

 

 

   

 

 

 

Cash flows from financing activities:

    

Proceeds from issuance of term loan and notes, net of original issue discounts

     —          1,056,178   

Repayments of term loans

     (7,875     (42,775

Proceeds from borrowing of revolver

     109,000        49,500   

Repayment of revolver

     (89,000     (83,000

Payment of financing costs

     —          (52,561

Payment of deferred consideration

     (10,591     (43,080

Payment of redeemable non-controlling interest

     (30,543     (33,425

Principal payments on capital lease obligations

     (2,827     (4,372

Capital investment from minority partner

     —          2,776   

Proceeds from exercise of stock options

     1,147        2,304   
  

 

 

   

 

 

 

Net cash (used in) provided by financing activities

     (30,689     851,545   
  

 

 

   

 

 

 

Net effect of exchange rate on cash and cash equivalents

     (1,198     1,843   
  

 

 

   

 

 

 

Net increase in cash and cash equivalents

     1,783        30,118   

Cash and cash equivalents:

    

Beginning of period

     32,379        33,030   
  

 

 

   

 

 

 

End of period

   $ 34,162      $ 63,148   
  

 

 

   

 

 

 

Supplemental cash flow information:

    

Interest paid

   $ 42,449      $ 91,181   

Income taxes paid

   $ 3,974      $ 3,399   

See accompanying notes to consolidated financial statements.

 

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Endurance International Group Holdings, Inc.

Notes to Consolidated Financial Statements

(unaudited)

1. Nature of Business

Formation and Nature of Business

Endurance International Group Holdings, Inc. (“Holdings”) is a Delaware corporation which, together with its wholly owned subsidiary company, EIG Investors Corp. (“EIG Investors”), its primary operating subsidiary company, The Endurance International Group, Inc. (“EIG”), and other subsidiary companies of EIG, collectively form the “Company.” The Company is a leading provider of cloud-based platform solutions designed to help small- and medium-sized businesses succeed online.

EIG and EIG Investors were incorporated in April 1997 and May 2007, respectively, and Holdings was originally formed as a limited liability company in October 2011 in connection with the acquisition by investment funds and entities affiliated with Warburg Pincus and Goldman, Sachs & Co. on December 22, 2011 of a controlling interest in EIG Investors, EIG and EIG’s subsidiary companies. On November 7, 2012, Holdings reorganized as a Delaware limited partnership and on June 25, 2013, Holdings converted into a Delaware C-corporation and changed its name to Endurance International Group Holdings, Inc.

2. Summary of Significant Accounting Policies

Basis of Preparation

The accompanying consolidated financial statements, which include the accounts of the Company and its subsidiaries, have been prepared using accounting principles generally accepted in the United States of America (“U.S. GAAP”). All intercompany transactions have been eliminated on consolidation. The Company has reviewed the criteria of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 280-10, Segment Reporting, and determined that the Company is comprised of two operating segments, and those segments meet the aggregation criteria to be treated as one reportable segment.

Use of Estimates

U.S. GAAP requires management to make certain estimates, judgments and assumptions that affect the reported amounts of assets, liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. These estimates, judgments and assumptions used in preparing the accompanying consolidated financial statements are based on the relevant facts and circumstances as of the date of the consolidated financial statements. Although the Company regularly assesses these estimates, judgments and assumptions used in preparing the consolidated financial statements, actual results could differ from those estimates. Changes in estimates are recorded in the period in which they become known. The more significant estimates reflected in these consolidated financial statements include estimates of fair value of assets acquired and liabilities assumed under purchase accounting related to the Company’s acquisitions and when evaluating goodwill and long-lived assets for potential impairment, the estimated useful lives of intangible and depreciable assets, revenue recognition for multiple-element arrangements, stock-based compensation, contingent consideration, derivative instruments, certain accruals, reserves and deferred taxes.

Unaudited Interim Financial Information

The accompanying interim consolidated balance sheet as of September 30, 2016, and the related consolidated statements of operations and comprehensive loss for the three and nine months ended September 30, 2015 and 2016, cash flows for the nine months ended September 30, 2015 and 2016, and the notes to consolidated financial statements are unaudited. These unaudited consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements. The unaudited consolidated financial statements include, in the opinion of management, all adjustments, consisting only of normal recurring adjustments that are necessary for a fair presentation of the Company’s financial position at September 30, 2016, results of operations for the three and nine months ended September 30, 2015 and 2016 and cash flows for the nine months ended September 30, 2015 and 2016. The consolidated results in the consolidated statements of operations and comprehensive loss are not necessarily indicative of the results of operations to be expected for the full fiscal year ending December 31, 2016.

Accounts Receivable

Accounts receivable is primarily composed of cash due from credit card companies for unsettled transactions charged to subscribers’ credit cards. As these amounts reflect authenticated transactions that are fully collectible, the Company does not maintain an allowance for doubtful accounts. The Company also accrues for earned referral fees and commissions, which are governed by reseller or affiliate agreements, when the amount is reasonably estimable.

 

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Prepaid Domain Name Registry Fees

Prepaid domain name registry fees represent amounts that are paid in full at the time a domain is registered by one of the Company’s registrars on behalf of a customer. The registry fees are recognized on a straight-line basis over the term of the domain registration period.

Derivative Instruments and Hedging Activities

FASB ASC 815, Derivatives and Hedging, or ASC 815, provides the disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how the entity accounts for derivative instruments and related hedged items, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Further, qualitative disclosures are required that explain the Company’s objectives and strategies for using derivatives, as well as quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

As required by ASC 815, the Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Derivatives may also be designated as hedges of the foreign currency exposure of a net investment in a foreign operation. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. The Company may enter into derivative contracts that are intended to economically hedge certain of its risks, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.

In accordance with the FASB’s fair value measurement guidance in ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements, the Company made an accounting policy election to measure the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio.

Property and Equipment

Property and equipment is recorded at cost or fair value if acquired in an acquisition. The Company also capitalizes the direct costs of constructing additional computer equipment for internal use, as well as upgrades to existing computer equipment which extend the useful life, capacity or operating efficiency of the equipment. Capitalized costs include the cost of materials, shipping and taxes. Materials used for repairs and maintenance of computer equipment are expensed and recorded as a cost of revenue. Materials on hand and construction-in-process are recorded as property and equipment. Assets recorded under capital lease are depreciated over the lease term. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets as follows:

 

Building   Thirty-five years
Software   Two to three years
Computers and office equipment   Three years
Furniture and fixtures   Five years
Leasehold improvements   Shorter of useful life or remaining term of the lease

Software Development Costs

The Company accounts for software development costs for internal-use software under the provisions of ASC 350-40, Internal-Use Software. Accordingly, certain costs to develop internal-use computer software are capitalized, provided these costs are expected to be recoverable. The Company capitalized internal-use software development costs of $1.7 million and $4.5 million, during the three and nine months ended September 30, 2015, respectively, and $2.9 million and $9.3 million, during the three and nine months ended September 30, 2016, respectively.

 

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Goodwill

Goodwill relates to amounts that arose in connection with the Company’s various business combinations and represents the difference between the purchase price and the fair value of the identifiable intangible and tangible net assets when accounted for using the purchase method of accounting. Goodwill is not amortized, but is subject to periodic review for impairment. Events that would indicate impairment and trigger an interim impairment assessment include, but are not limited to, current economic and market conditions, including a decline in the equity value of the business, a significant adverse change in certain agreements that would materially affect reported operating results, business climate or operational performance of the business and an adverse action or assessment by a regulator. Additionally, the reorganization or change in the number of reporting units could result in the reassignment of goodwill between reporting units and may trigger an impairment assessment.

In accordance with ASC 350, Intangibles—Goodwill and Other, or ASC 350, the Company is required to review goodwill by reporting unit for impairment at least annually or more often if there are indicators of impairment present. Under U.S. GAAP, a reporting unit is either the equivalent of, or one level below, an operating segment. As of December 31, 2015, the Company determined that it had one reporting unit. Following the acquisition of Constant Contact, Inc. (“Constant Contact”), the Company determined it has two reporting units, “Constant Contact”, which consists of the goodwill pertaining to our acquisition of Constant Contact, and “Flagship”, which consists of the remaining goodwill balance of the Company. Historically, the Company has performed its annual impairment analysis during the fourth quarter of each year. The provisions of ASC 350 require that a two-step impairment test be performed for goodwill. In the first step, the Company compares the fair value of its reporting unit to which goodwill has been allocated to its carrying value. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that reporting unit, goodwill is considered not impaired and the Company is not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then the Company must perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then the Company would record an impairment loss equal to the difference.

At December 31, 2015, the Company had one reporting unit. The goodwill impairment assessment as of December 31, 2015 was based on then-current market capitalization. As of December 31, 2015, the fair value of the Company’s reporting unit exceeded the carrying value of the reporting unit’s net assets. Therefore, no impairment existed as of that date. For the nine months ended September 30, 2016, the Company determined that there were no factors to indicate that the fair value of its reporting units could be impaired, therefore, no impairment testing was performed during this period.

Determining the fair value of a reporting unit, if applicable, requires the Company to make judgments and involves the use of significant estimates and assumptions. These estimates and assumptions relate to, among other things, revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions and determination of appropriate market comparables. The Company bases its fair value estimates on assumptions it believes to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates.

The Company had goodwill of $1,207.3 million and $1,859.7 million as of December 31, 2015 and September 30, 2016, respectively, and no impairment charges have been recorded.

Long-Lived Assets

The Company’s long-lived assets consist primarily of intangible assets, including acquired subscriber relationships, trade names, intellectual property, developed technology, domain names available for sale and in-process research and development (“IPR&D”). The Company also has long-lived tangible assets, primarily consisting of property and equipment. The majority of the Company’s intangible assets are recorded in connection with its various acquisitions. The Company’s intangible assets are recorded at fair value at the time of their acquisition. The Company amortizes intangible assets over their estimated useful lives.

Determination of the estimated useful lives of the individual categories of intangible assets is based on the nature of the applicable intangible asset and the expected future cash flows to be derived from the intangible asset. Amortization of intangible assets with finite lives other than developed technology is recognized in accordance with their estimated projected cash flows. Developed technology is amortized on a straight line basis over the estimated useful economic life which has a weighted average useful life of 7 years.

The Company evaluates long-lived intangible and tangible assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If indicators of impairment are present and undiscounted future cash flows are less than the carrying amount, the fair value of the assets is determined and compared to the carrying value. If the fair value is less than the carrying value, then the carrying value of the asset is reduced to the estimated fair value and an impairment loss is charged to expense in the period the impairment is identified.

 

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During the nine months ended September 30, 2016, the Company determined that a portion of an internally developed software tool would not meet its needs following the acquisition of Constant Contact, resulting in an impairment charge of $2.0 million which was recorded in engineering and development expense in the consolidated statements of operations and comprehensive loss. Additionally, during the nine months ended September 30, 2016, the Company recognized an impairment charge of $0.5 million relating to internally developed software relating to Webzai Ltd. (“Webzai”), and another impairment charge of $4.4 million relating to developed technology acquired in the Webzai acquisition, for a total impairment charge relating to this software of $4.9 million, which was recorded in engineering and development expense in the consolidated statements of operations and comprehensive loss. Refer to Note 4: Property and Equipment and Capital Lease Obligations and Note 7: Goodwill and Other Intangible Assets for further details.

Furthermore, during the nine months ended September 30, 2016, the Company incurred impairment charges of $8.3 million, which includes the $2.0 million charge to abandon a portion of the internally developed software tool and the $4.9 million charge relating to the Webzai software and developed technology, both mentioned above, and a charge of $1.4 million to impair certain acquired IPR&D projects from the Webzai acquisition that were abandoned during the three months ended March 31, 2016. Refer to Note 4: Property and Equipment and Capital Lease Obligations, Note 7: Goodwill and Other Intangible Assets, and Acquired In-Process Research and Development (IPR&D) below for further details.

Indefinite life intangible assets include domain names that are available for sale which are recorded at cost to acquire. These assets are not being amortized and are being tested for impairment annually and whenever events or changes in circumstance indicate that their carrying value may not be recoverable. When a domain name is sold, the Company records the cost of the domain in cost of revenue.

Acquired In-Process Research and Development (IPR&D)

Acquired IPR&D represents the fair value assigned to research and development assets that the Company acquires in connection with business combinations that have not been completed at the date of acquisition. The acquired IPR&D is capitalized as an intangible asset and reviewed on a quarterly basis to determine future use. Any impairment loss of the acquired IPR&D is charged to expense in the period the impairment is identified. No such impairment loss was identified for the three and nine months ended September 30, 2015. In March 2016, the Company identified that the acquired fair value of the remaining IPR&D acquired in connection with its acquisition of Webzai was impaired. At that time, the Company recorded a $1.4 million impairment charge, which is reflected in engineering and development expense during the nine months ended September 30, 2016 in the Company’s consolidated statements of operations and comprehensive loss.

Revenue Recognition

The Company generates revenue primarily from selling subscriptions for cloud-based products and services. The subscriptions are similar across all of the Company’s brands and are provided under contracts pursuant to which the Company has ongoing obligations to support the subscriber. These contracts are generally for service periods of up to 36 months and typically require payment in advance. The Company recognizes the associated revenue ratably over the service period, whether the associated revenue is derived from a direct subscriber or through a reseller. Deferred revenue represents the liability to subscribers for advance billings for services not yet provided and the fair value of the assumed liability outstanding for subscriber relationships purchased in an acquisition.

The Company sells domain name registrations that provide a subscriber with the exclusive use of a domain name. These domains are primarily obtained by one of the Company’s registrars on the subscriber’s behalf, or to a lesser extent by the Company from third-party registrars on the subscriber’s behalf. Domain registration fees are non-refundable.

Revenue from the sale of a domain name registration by a registrar within the Company is recognized ratably over the subscriber’s service period as the Company has the obligation to provide support over the domain term. Revenue from the sale of a domain name registration purchased by the Company from a third-party registrar is recognized when the subscriber is billed on a gross basis as there are no remaining Company obligations once the sale to the subscriber occurs, and the Company has full discretion on the sales price and bears all credit risk.

Revenue from the sale of premium domains is recognized when persuasive evidence of an arrangement to sell such domains exists, delivery of an authorization key to access the domain name has occurred, the fee for the sale of the premium domain is fixed or determinable, and collection of the fee for the sale of the premium domain is deemed probable.

 

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Revenue from the sale of non-term based applications and services, such as certain online security products and professional technical services, referral fees and commissions, is recognized when the product is purchased, the service is provided or the referral fee or commission is earned, respectively.

A substantial amount of the Company’s revenue is generated from transactions that are multiple-element service arrangements that may include hosting plans, domain name registrations, and other cloud-based products and services.

The Company follows the provisions of the FASB, Accounting Standards Update (“ASU”) No. 2009-13 (“ASU 2009-13”), Revenue Recognition (Topic 605), Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force, and allocates revenue to each deliverable in a multiple-element service arrangement based on its respective relative selling price.

Under ASU 2009-13, to treat deliverables in a multiple-element service arrangement as separate units of accounting, the deliverables must have standalone value upon delivery. If the deliverables have standalone value upon delivery, the Company accounts for each deliverable separately. Hosting services, domain name registrations, and other cloud-based products and services have standalone value and are often sold separately.

When multiple deliverables included in a multiple-element service arrangement are separated into different units of accounting, the total transaction amount is allocated to the identified separate units based on a relative selling price hierarchy. The Company determines the relative selling price for a deliverable based on vendor specific objective evidence (“VSOE”) of fair value, if available, or best estimate of selling price (“BESP”), if VSOE is not available. The Company has determined that third-party evidence of selling price (“TPE”) is not a practical alternative due to differences in its multi-brand offerings compared to competitors and the lack of availability of relevant third-party pricing information. The Company has not established VSOE for its offerings due to lack of pricing consistency, the introduction of new products, services and other factors. Accordingly, the Company generally allocates revenue to the deliverables in the arrangement based on the BESP. The Company determines BESP by considering its relative selling prices, competitive prices in the marketplace and management judgment; these selling prices, however, may vary depending upon the particular facts and circumstances related to each deliverable. The Company analyzes the selling prices used in its allocation of transaction amount, at a minimum, on a quarterly basis. Selling prices are analyzed on a more frequent basis if a significant change in the business necessitates a more timely analysis.

The Company maintains a reserve for refunds and chargebacks related to revenue that has been recognized and is expected to be refunded. The Company had a refund and chargeback reserve of $0.5 million and $0.6 million as of December 31, 2015 and September 30, 2016, respectively. The portion of deferred revenue that is expected to be refunded at December 31, 2015 and September 30, 2016 was $1.8 million and $2.0 million, respectively. Based on refund history, approximately 80% of all refunds happen in the same fiscal month that the contract starts or renews, and approximately 92% of all refunds happen within 45 days of the contract start or renewal date.

Income Taxes

Income taxes are accounted for in accordance with ASC 740, Accounting for Income Taxes, or ASC 740. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

ASC 740 clarifies the accounting for income taxes by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. The Company recognizes the effect of income tax positions only if those positions are more likely than not to be sustained. Recognized income tax positions are measured at the largest amount that is more likely than not to be realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. There were no unrecognized tax benefits in the three or nine months ended September 30, 2015 and 2016.

The Company records interest related to unrecognized tax benefits in interest expense and penalties in operating expenses. During the three and nine months ended September 30, 2015 and 2016, the Company did not recognize any interest and penalties related to unrecognized tax benefits.

 

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Stock-Based Compensation

The Company may issue restricted stock units, restricted stock awards and stock options which vest upon the satisfaction of a performance condition and/or a service condition. The Company follows the provisions of ASC 718, Compensation—Stock Compensation, or ASC 718, which requires employee stock-based payments to be accounted for under the fair value method. Under this method, the Company is required to record compensation cost based on the estimated fair value for stock-based awards granted over the requisite service periods for the individual awards, which generally equals the vesting periods, net of estimated forfeitures. The Company uses the straight-line amortization method for recognizing stock-based compensation expense. In addition, for stock-based awards where vesting is dependent upon achieving certain performance goals, the Company estimates the likelihood of achieving the performance goals against established performance targets.

The Company estimates the fair value of employee stock options on the date of grant using the Black-Scholes option-pricing model, which requires the use of highly subjective estimates and assumptions. For restricted stock awards granted, the Company estimates the fair value of each restricted stock award based on the closing trading price of its common stock on the date of grant.

Net Loss per Share

The Company considered ASC 260-10, Earnings per Share, or ASC 260-10, which requires the presentation of both basic and diluted earnings per share in the consolidated statements of operations and comprehensive loss. The Company’s basic net loss per share is computed by dividing net loss by the weighted average number of shares of common stock outstanding for the period, and, if there are dilutive securities, diluted income per share is computed by including common stock equivalents which includes shares issuable upon the exercise of stock options, net of shares assumed to have been purchased with the proceeds, using the treasury stock method.

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2015      2016      2015      2016  
     (unaudited)  
     (in thousands, except share amounts and per share data)  

Net loss attributable to Endurance International Group Holdings, Inc.

   $ (15,351    $ (31,737    $ (16,538    $ (37,966
  

 

 

    

 

 

    

 

 

    

 

 

 

Net loss per share attributable to Endurance International Group Holdings, Inc.:

           

Basic and diluted

   $ (0.12    $ (0.24    $ (0.13    $ (0.29
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted-average common shares outstanding used in computing net loss per share attributable to Endurance International Group Holdings, Inc.

           

Basic and diluted

     131,398,446         133,550,168         131,195,109         133,038,542   
  

 

 

    

 

 

    

 

 

    

 

 

 

The following number of weighted average potentially dilutive shares were excluded from the calculation of diluted loss per share because the effect of including such potentially dilutive shares would have been anti-dilutive:

 

     Three Months Ended September 30,      Nine Months Ended September 30,  
     2015      2016      2015      2016  
     (unaudited)  

Restricted stock awards and units

     2,641,996         9,554,260         2,205,577         8,605,808   

Options

     7,340,592         12,050,726         6,511,464         10,673,967   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     9,982,588         21,604,986         8,717,041         19,279,775   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Reclassification

During the three months ended September 30, 2016, the Company reclassified a payment of $15.4 million made during the three months ended June 30, 2016, from “Businesses acquired in purchase transactions, net of cash acquired” to “Payment of redeemable non-controlling interest.” During the three months ended September 30, 2016, the Company also made an $18.0 million payment which is included in “Payment of redeemable non-controlling interest.” Each of these two payments, in the aggregate amount of $33.4 million, were paid as partial redemption of non-controlling interest in WZ (UK) Ltd. (“WZ UK”).

Recent Accounting Pronouncements

The Company adopted ASU No. 2015-03, “Simplifying the Presentation of Debt Issuance Cost” beginning on January 1, 2016, and retrospectively for all periods presented. ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The unamortized value of deferred financing costs associated with our revolving credit facility were not affected by the ASU and continue to be presented as an asset on the Company’s consolidated balance sheets.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), or ASU 2014-09, which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. Since then, the FASB has also issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606), Principals versus Agent Considerations and ASU 2016-10, Revenue from Contracts with Customers (Topic 606), Identifying Performance Obligations and Licensing, which further elaborate on the original ASU No. 2014-09. The core principle of these updates is to recognize revenue when promised goods or services are transferred to customers in an amount that reflects the consideration to which the entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgments and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. In July 2015, the FASB approved a one-year deferral of the effective date to January 1, 2018, with early adoption to be permitted as of the original effective date of January 1, 2017. Once this standard becomes effective, companies may use either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). The Company is currently evaluating the impact of its pending adoption of ASU 2014-09 on its consolidated financial statements and has not yet determined the method by which it will adopt the standard.

In November 2015, the FASB issued ASU No. 2015-17, Income Taxes: Balance Sheet Classification of Deferred Taxes, or ASU 2015-17. This new guidance requires that deferred tax liabilities and assets be classified as noncurrent in the balance sheet, in order to simplify the presentation of deferred income taxes. ASU 2015-17 is effective for annual reporting periods beginning after December 15, 2016. The Company adopted ASU 2015-17 as of the fourth quarter in 2015, on a prospective basis, and it did not have a material impact on its consolidated financial statements.

In February 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases. The new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Company is currently evaluating the impact of its pending adoption of the new standard on its consolidated financial statements.

In March 2016, the FASB issued Accounting Standards Update No. 2016-07, Investments—Equity Method and Joint Ventures: Simplifying the Transition to the Equity Method of Accounting. This new guidance removes the requirement for retroactive adjustment when an increase or decrease in the level of ownership qualifies an investment for the equity method. This amendment is effective for fiscal years beginning after December 15, 2016. The Company is currently evaluating the impact of its pending adoption of the new standard on its consolidated financial statements.

In March 2016, the FASB issued Accounting Standards Update No. 2016-09, Compensation-Stock Compensation: Improvements to Employee Share-Based Payment Accounting. This new standard simplifies the accounting tax aspects, eliminates complex accounting for excess tax deductions, permits higher withholdings for cashless exercises, and eliminates the requirement to estimate a forfeiture rate. This amendment is effective for annual periods beginning after December 15, 2016, and early adoption is permitted. The Company is currently evaluating the impact of its pending adoption of the new standard on its consolidated financial statements.

 

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In August 2016, the FASB issued Accounting Standards Update No. 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments. This new standard clarifies certain statement of cash flow presentation issues. This amendment is effective for annual periods beginning after December 15, 2017, and early adoption is permitted. The Company is currently evaluating the impact of its pending adoption of the new standard on its consolidated financial statements.

3. Acquisitions

The Company accounts for the acquisitions of businesses using the purchase method of accounting. The Company allocates the purchase price to the tangible and identifiable intangible assets and liabilities assumed based on their estimated fair values. Purchased identifiable intangible assets typically include subscriber relationships, trade names, domain names held for sale, developed technology and IPR&D. The methodologies used to determine the fair value assigned to subscriber relationships and domain names held for sale are typically based on the excess earnings method that considers the return received from the intangible asset and includes certain expenses and also considers an attrition rate based on the Company’s internal subscriber analysis and an estimate of the average life of the subscribers. The fair value assigned to trade names is typically based on the income approach using a relief from royalty methodology that assumes that the fair value of a trade name can be measured by estimating the cost of licensing and paying a royalty fee for the trade name that the owner of the trade name avoids. The fair value assigned to developed technology typically uses the cost approach. The fair value assigned to IPR&D is based on the cost approach. If applicable, the Company estimates the fair value of contingent consideration payments in determining the purchase price. The contingent consideration is then adjusted to fair value in subsequent periods as an increase or decrease in current earnings in general and administrative expense in the consolidated statements of operations and comprehensive loss.

WZ (UK) Ltd.

In August 2014, the Company made an aggregate investment of $3.9 million for a joint venture with a 49% ownership interest in WZ UK, which is a provider of technology and sales and marketing services associated with web builder solutions. The Company and the other shareholders of WZ UK entered into a put and call option for the Company to acquire additional equity interests WZ UK under certain circumstances.

On January 6, 2016, the Company partially exercised this option, which increased its stake in WZ UK from 49% to 57.5%. Upon the exercise of the option, the Company estimated the fair value of the assets and liabilities in accordance with the guidance for business combinations and estimated that the value of the non-controlling interest (“NCI”) on January 6, 2016 was $10.8 million. The estimated aggregate purchase price of $22.2 million included a gain of $11.4 million that was calculated based on the implied fair value of the Company’s 49% equity investment and the NCI of $10.8 million, which were allocated on a preliminary basis to goodwill of $21.6 million, intangible assets consisting of subscriber relationships of $4.9 million, and property, plant and equipment of $0.3 million, offset by deferred revenue of $3.3 million and negative working capital of $1.3 million. Goodwill related to the acquisition, which is part of the Company’s “Flagship” reporting unit, is not deductible for tax purposes.

The Company recognized the $11.4 million gain in other income in the Company’s consolidated statements of operations and comprehensive loss. As the NCI is subject to a put option that is outside the control of the Company, it is deemed a redeemable non-controlling interest and not recorded in permanent equity, and is being presented as mezzanine redeemable non-controlling interest on the consolidated balance sheet. The difference between the initial fair value of the redeemable non-controlling interest and the value expected to be paid on exercise, which is estimated to be $30.0 million, was being accreted over the period commencing January 6, 2016, and up to the end of the second call option period which was August 14, 2016. Adjustments to the carrying amount of the redeemable non-controlling interest were charged to additional paid-in capital.

On May 16, 2016, the Company amended the put and call option described above to allow it to acquire an additional equity interest in WZ UK earlier than August 2016. Pursuant to this amended option, on the same date the Company acquired an additional 20% stake in WZ UK for $15.4 million, thus increasing its ownership interest from 57.5% to 77.5%.

On July 13, 2016, WZ UK completed a restructuring pursuant to which the Company and the minority shareholders of Pseudio Limited and Resume Labs Limited sold their shares in these entities to WZ UK, in exchange for shares in WZ UK. As a result of the restructuring, Pseudio Limited and Resume Labs Limited became wholly-owned subsidiaries of WZ UK, and the Company’s ownership of WZ UK was diluted from 77.5% to 76.4%. Immediately subsequent to the restructuring, the Company acquired an additional 10% equity interest in WZ UK for $18.0 million, thereby increasing the Company’s ownership interest to 86.4%.

Concurrent with the restructuring, the Company amended the put and call option described above so as to allow the Company to acquire the remaining 13.6% equity interest in WZ UK for $25.0 million under certain circumstances. The put option is exercisable beginning on July 1, 2017. The Company started accreting to the $25.0 million starting in July 2016. Refer to Note 13: Redeemable for Non-controlling Interest for further details.

 

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Constant Contact, Inc.

On October 30, 2015, the Company entered into a definitive agreement pursuant to which it agreed to acquire all of the outstanding shares of common stock of Constant Contact for $32.00 per share in cash, for a total purchase price of approximately $1.1 billion. Constant Contact is a leading provider of online marketing tools that are designed for small organizations, including small businesses, associations and non-profits. The acquisition closed on February 9, 2016.

The aggregate purchase price of $1.1 billion, which was paid in cash at the closing, is being allocated on a preliminary basis to intangible assets consisting of subscriber relationships, developed technology and trade names of $263.0 million, $83.0 million and $52.0 million, respectively, goodwill of $603.9 million, property and equipment of $40.7 million, and working capital of $184.2 million, offset by net a net deferred tax liability of $125.8 million and deferred revenue of $25.2 million. The goodwill reflects the value of expected synergies.

Goodwill related to the acquisition, which is included in the Company’s “Constant Contact” reporting unit, is not deductible for tax purposes.

Pro Forma Disclosure

The Company acquired Constant Contact on February 9, 2016, and the results of Constant Contact have been included in the results of the Company since February 10, 2016. The following unaudited information is presented as if the Constant Contact acquisition was completed as of January 1, 2015. The Company has not presented unaudited pro forma results for the quarterly periods following March 31, 2016, as Constant Contact is included for the entire fiscal periods after that date. The unaudited pro forma results are not necessarily indicative of the actual results that would have occurred had the transaction actually taken place at the beginning of the period indicated. Unaudited pro forma revenue for the three months ended September 30, 2015 was $279.6 million. Unaudited pro forma net loss attributable to Endurance International Group Holdings, Inc. for the three months ended September 30, 2015 was $30.7 million.

Unaudited pro forma revenue for the nine months ended September 30, 2015 and 2016 was $819.7 million and $859.7 million, respectively. Unaudited pro forma net loss attributable to Endurance International Group Holdings, Inc. for the nine months ended September 30, 2015 and 2016 was $81.8 million and $24.2 million, respectively.

Unaudited pro forma net loss includes adjustments for additional interest expense related to the debt incurred in connection with the acquisition of Constant Contact.

Pro forma revenue for the three and nine months ended September 30, 2016 has been reduced by $0.6 million and $14.8 million, respectively, due to the application of purchase accounting for Constant Contact, which reduced the fair value of deferred revenue as of the closing date. Additionally, pro forma net loss for the three and nine months ended September 30, 2016 includes restructuring charges of approximately $5.7 million and $22.0 million, respectively, as the Company implemented plans to reduce the cost structure of the combined businesses.

AppMachine B.V.

In December 2014, the Company made an aggregate investment of $15.2 million to acquire a 40% ownership interest in AppMachine B.V. (“AppMachine”), which is a developer of software that allows users to build mobile applications for smart devices such as phones and tablets. Under the terms of the investment agreement for AppMachine, the Company was obligated to purchase the remaining 60% of AppMachine in three tranches of 20% within specified periods if AppMachine achieved a specified minimum revenue threshold within a designated timeframe. The consideration for each of those three tranches was to be calculated as the product of AppMachine’s revenue, as defined in that investment agreement, for the trailing twelve-month period prior to the applicable determination date times a specified multiple based upon year over year revenue growth multiplied by 20%.

On July 27, 2016, the Company acquired the remaining 60% equity interest in AppMachine, increasing the Company’s stake to 100%. In connection with the acquisition, the parties terminated the prior investment agreement pursuant to which the Company was obligated to purchase the remaining shares in AppMachine in three tranches. The total consideration based on the new agreement was $22.5 million, of which $5.5 million was paid upon closing, and the remaining $17.0 million (which includes $4.0 million of post-acquisition compensation expense) will be paid in annual installments over a period of four years, commencing with June 21, 2017. The net present value of the additional consideration is $11.5 million, which is included in the aggregate purchase price and recorded as deferred consideration in the Company’s consolidated balance sheets as of September 30, 2016. The remaining $1.5 million is being accreted as interest expense. The $4.0 million relating to retention bonuses is being accrued over the employment term associated with these employees.

 

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On the date of acquisition, the Company recognized a loss of $4.9 million that was calculated based on the implied fair value of the investment, which was recorded in other income (expense) in the Company’s consolidated statements of operations and comprehensive loss.

The purchase price of $25.7 million, which consists of the purchase consideration of $13.0 million, at a present value of $11.5 million, and the carrying value of the existing investment of $13.6 million, partially offset by the loss of $4.9 million, is being allocated on a preliminary basis to intangible assets consisting of subscriber relationships of $0.1 million, developed technology of $1.7 million, and technology in the process of development of $1.7 million, goodwill of $20.3 million, property and equipment of $0.6 million, and working capital of approximately $2.3 million, offset by a deferred tax liability of $0.6 million, deferred revenue of $0.2 million, and other long term liabilities of $0.1 million. Goodwill related to the acquisition, which is included in the Company’s “Flagship” reporting unit, is not deductible for tax purposes. The goodwill reflects the value of expected synergies and technology know-how.

Financial Performance

The Company recorded revenue attributable to its 2016 acquisitions in its consolidated statements of operations and comprehensive loss for the three and nine months ended September 30, 2016 of $99.4 million and $239.1 million, respectively. The acquisitions 2016 generated income (loss) for the three and nine months ended September 30, 2016 of $5.7 million and ($36.5) million which is recorded in the Company’s consolidated statements of operations and comprehensive loss. The $32.3 million of transaction expenses in the Company’s consolidated statements of operations and comprehensive loss included a $16.8 million charge related to the accelerated vesting of certain Constant Contact equity awards, and approximately $15.5 million in advisor, legal, and other acquisition-related fees.

For the intangible assets acquired in connection with all acquisitions completed during the three and nine months ended September 30, 2016, developed technology has a weighted-useful life of 4.1 years, subscriber relationships have a weighted-useful life of 4.4 years and trade names have a weighted-useful life of 4.7 years.

Summary of Deferred Consideration Related to Acquisitions

Components of short-term and long-tern deferred consideration as of December 31, 2015 and September 30, 2016, consisted of the following:

 

     December 31, 2015      September 30, 2016  
     Short-
term
     Long-
term
     Short-
term
     Long-
term
 
     (in thousands)  

Mojoness, Inc. (Acquired in 2012)

   $ 657       $ 813       $ 768         —     

Typepad Holdings LLC (Acquired in 2013)

     2,800         —           2,800         —     

Webzai Ltd. (Acquired in 2014)

     2,848         —           —           —     

BuyDomains (Acquired in 2014)

     4,283         —           —           —     

Verio (Acquired in 2015)

     2,474         —           1,051         —     

World Wide Web Hosting (Acquired in 2015)

     4,600         —           —           —     

Ace Data Center (Acquired in 2015)

     29,626         —           —           —     

Ecommerce LLC (Acquired in 2015)

     4,200         —           4,200         —     

Social Booster (Acquired in 2016)

     —           —           40         25   

AppMachine (Acquired in 2016)

     —           —           4,294         7,299   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 51,488       $ 813       $ 13,153       $ 7,324   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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4. Property and Equipment and Capital Lease Obligations

Components of property and equipment consisted of the following:

 

     December 31, 2015      September 30, 2016  
     (in thousands)  

Land

   $ 713       $ 713   

Building

     5,091         5,304   

Software

     40,336         50,675   

Computers and office equipment

     97,332         134,696   

Furniture and fixtures

     5,914         10,705   

Leasehold improvements

     7,126         21,314   

Construction in process

     6,137         5,374   
  

 

 

    

 

 

 

Property and equipment—at cost

     162,649         228,781   

Less accumulated depreciation

     (86,887      (131,688
  

 

 

    

 

 

 

Property and equipment—net

   $ 75,762       $ 97,093   
  

 

 

    

 

 

 

Depreciation expense related to property and equipment for the three months ended September 30, 2015 and 2016 was $8.5 million and $17.0 million, respectively. Depreciation expense related to property and equipment for the nine months ended September 30, 2015 and 2016 was $24.6 million and $46.9 million, respectively.

The Company evaluates long-lived assets such as property plant and equipment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If indicators of impairment are present and undiscounted future cash flows are less than the carrying amount, the fair value of the assets is determined and compared to the carrying value. If the fair value is less than the carrying value, then the carrying value of the asset is reduced to the estimated fair value and an impairment loss is charged to expense in the period the impairment is identified. During the nine months ended September 30, 2016, the Company determined that a portion of an internally developed software tool would not meet its needs following the acquisition of Constant Contact. As a result, the Company recorded a $2.0 million impairment charge in engineering and development expense in the Company’s consolidated statements of operations and comprehensive loss. Additionally, in the nine months ended September 30, 2016, the Company recorded an impairment charge of $0.5 million in engineering and development expense relating to internally developed software, developed after the Webzai acquisition, which closed in August 2014, after evaluating it for impairment in accordance with ASC 360, Property, Plant and Equipment. This software is also linked to certain developed technology that was acquired as part of the Webzai acquisition and was also determined to be impaired. Refer to Note 7: Goodwill and Other Intangible Assets for further details.

Property under capital lease with a cost basis of $21.5 million was included in software as of September 30, 2016. The net carrying value of property under capital lease as of September 30, 2016 was $8.3 million.

5. Fair Value Measurements

The following valuation hierarchy is used for disclosure of the valuation inputs used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows:

 

    Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities.

 

    Level 2 inputs are quoted prices for similar assets or liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument.

 

    Level 3 inputs are unobservable inputs based on the Company’s own assumptions used to measure assets and liabilities at fair value.

A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement.

As of December 31, 2015 and September 30, 2016, the Company’s financial assets or liabilities required to be measured on a recurring basis are accrued earn-out consideration payable in connection with the 2012 acquisition of certain assets of Mojoness, Inc., or Mojo, and the 2015 interest rate cap. The Company has classified its interest rate cap discussed in Note 6 below within Level 2 of the fair value hierarchy. The Company has classified its liabilities for contingent earn-out consideration related to Mojo within Level 3 of the fair value hierarchy because the fair value is determined using significant unobservable inputs, which include probability weighted cash flows. During the nine months ended September 30, 2016, the Company paid $0.7 million related to the earn-out provisions for the Mojo acquisition.

 

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Basis of Fair Value Measurements

 

     Balance      Quoted Prices
in Active Markets
for Identical Items
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 
     (in thousands)  

Balance at December 31, 2015:

           

Financial assets:

           

Interest rate cap (included in other assets)

   $ 3,130         —         $ 3,130       $ —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total financial assets

   $ 3,130       $ —         $ 3,130       $ —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Financial liabilities:

           

Contingent earn-out consideration (included in deferred consideration)

   $ 1,469         —           —         $ 1,469   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total financial liabilities

   $ 1,469       $ —         $ —         $ 1,469   
  

 

 

    

 

 

    

 

 

    

 

 

 

Balance at September 30, 2016:

           

Financial assets:

           

Interest rate cap (included in other assets)

   $ 375         —         $ 375       $ —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total financial assets

   $ 375       $ —         $ 375       $ —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Financial liabilities:

           

Contingent earn-out consideration (included in deferred consideration)

   $ 768         —           —         $ 768   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total financial liabilities

   $ 768       $ —         $ —         $ 768   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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The following table summarizes the changes in the financial liabilities measured on a recurring basis using Level 3 inputs as of September 30, 2016:

 

     Amount  
     (in thousands)  

Financial liabilities measured using Level 3 inputs at December 31, 2015

   $ 1,469   

Payment of contingent earn-outs related to 2012 acquisition

     (668

Change in fair value of contingent earn-outs

     (33
  

 

 

 

Financial liabilities measured using Level 3 inputs at September 30, 2016

   $ 768   
  

 

 

 

6. Derivatives and Hedging Activities

Risk Management Objective of Using Derivatives

The Company is exposed to certain risk arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its debt funding and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s investments and borrowings.

Cash Flow Hedges of Interest Rate Risk

The Company entered into a three-year interest rate cap on December 9, 2015 as part of its risk management strategy. The objective of the interest rate cap, designated as a cash flow hedge, involves the receipt of variable amounts from a counterparty if interest rates rise above the strike rate on the contract in exchange for an upfront premium. Therefore, this derivative limits the Company’s exposure if the rate rises, but also allows the Company to benefit when the rate falls.

The effective portion of changes in the fair value of derivatives that qualify as cash flow hedges is recorded in AOCI, and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. Amounts reported in AOCI related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt. Any ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. There was no ineffectiveness recorded in earnings for the three and nine months ended September 30, 2016.

As of September 30, 2016, the Company had one interest rate cap with $500.0 million notional value outstanding that was designated as a cash flow hedge of interest rate risk. The fair value of the interest rate contracts included in other assets on the consolidated balance sheet as of September 30, 2016 was $0.4 million, and the Company recognized an immaterial amount of interest expense in the Company’s consolidated statement of operations for the three and nine months ended September 30, 2016, respectively. The Company recognized a $1.9 million loss, net of a tax benefit of $0.9 million in AOCI for the nine months ended September 30, 2016, of which the Company estimates that $0.3 million will be reclassified as an increase to interest expense in the next twelve months.

 

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7. Goodwill and Other Intangible Assets

The following table summarizes the changes in the Company’s goodwill balances from December 31, 2015 to September 30, 2016 for the Company’s two reporting units:

 

     Flagship Unit      Constant Contact
Unit
     Total  
     Amount      Amount      Amount  
     (in thousands)      (in thousands)      (in thousands)  

Goodwill balance at December 31, 2015

   $ 1,207,255       $ —         $ 1,207,255   

Goodwill related to 2015 acquisitions

     5,978         —           5,978   

Goodwill related to 2016 acquisitions

     41,887         603,892         645,779   

Foreign translation impact

     659         —           659   
  

 

 

    

 

 

    

 

 

 

Goodwill balance at September 30, 2016

   $ 1,255,779       $ 603,892       $ 1,859,671   
  

 

 

    

 

 

    

 

 

 

In accordance with ASC 350, the Company reviews goodwill and other indefinite-lived intangible assets for indicators of impairment on an annual basis and between tests if an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount.

At December 31, 2015, other intangible assets consisted of the following:

 

     Gross
Carrying
Amount
     Accumulated
Amortization
     Net
Carrying
Amount
     Weighted
Average
Useful Life
 
     (dollars in thousands)  

Developed technology

   $ 205,925       $ 80,795       $ 125,130         7 years   

Subscriber relationships

     397,791         256,461         141,330         5 years   

Trade-names

     81,792         42,080         39,712         6 years   

Intellectual property

     34,020         6,596         27,424         13 years   

Domain names available for sale

     27,859         3,107         24,752         Indefinite   

Leasehold interests

     314         314         —           1 year   

In-process research and development

     1,438         —           1,438         —     
  

 

 

    

 

 

    

 

 

    

Total December 31, 2015

   $ 749,139       $ 389,353       $ 359,786      
  

 

 

    

 

 

    

 

 

    

During the nine months ended September 30, 2016, the Company wrote-off acquired in-process research and development of $1.4 million related to its acquisition of Webzai in 2014, as the Company had abandoned certain research and development projects in favor of other projects. Additionally, during the nine months ended September 30, 2016, the Company recorded an impairment charge of $4.4 million relating to developed technology from the Webzai acquisition, after evaluating it for impairment in accordance with ASC 350. This developed technology is also linked to certain internally developed software that was developed at Webzai after its acquisition by the Company which was also determined to be impaired. Refer to Note 4: Property and Equipment and Capital Lease Obligations, for further details.

At September 30, 2016, other intangible assets consisted of the following:

 

     Gross
Carrying
Amount
     Accumulated
Amortization
     Net
Carrying
Amount
     Weighted
Average
Useful Life
 
     (dollars in thousands)  

Developed technology

   $ 283,455       $ 103,031       $ 180,424         7 years   

Subscriber relationships

     660,080         321,696         338,384         7 years   

Trade-names

     133,924         53,622         80,302         8 years   

Intellectual property

     34,084         9,380         24,704         13 years   

Domain names available for sale

     29,745         4,502         25,243         Indefinite   

Leasehold interests

     314         314         —           1 year   

In-process research and development

     1,713         —           1,713         —     
  

 

 

    

 

 

    

 

 

    

Total September 30, 2016

   $ 1,143,315       $ 492,545       $ 650,770      
  

 

 

    

 

 

    

 

 

    

The estimated useful lives of the individual categories of other intangible assets are based on the nature of the applicable intangible asset and the expected future cash flows to be derived from the intangible asset. Amortization of intangible assets with finite lives is recognized over the period of time the assets are expected to contribute to future cash flows. The Company amortizes finite-lived intangible assets over the period in which the economic benefits are expected to be realized based upon their estimated projected cash flows.

 

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The Company’s amortization expense is included in cost of revenue in the aggregate amounts of $23.8 million and $38.0 million for the three months ended September 30, 2015 and 2016, respectively. The Company’s amortization expense is included in cost of revenue in the aggregate amounts of $67.2 million and $105.7 million for the nine months ended September 30, 2015 and 2016, respectively.

8. Investments

As of December 31, 2015 and September 30, 2016, the Company’s carrying value of investments in privately-held companies was $27.9 million and $20.7 million, respectively.

In January 2012, the Company made an initial investment of $0.3 million to acquire a 25% interest in BlueZone Labs, LLC (“BlueZone”), a provider of “do-it-yourself” tools and managed search engine optimization services.

The Company also has an agreement with BlueZone to purchase products and services. During the three months ended September 30, 2015 and 2016, the Company purchased $0.2 million and $0.4 million, respectively, of products and services from BlueZone, which is included in cost of revenue in the Company’s consolidated statements of operations and comprehensive loss. During the nine months ended September 30, 2015 and 2016, the Company purchased $0.8 million and $1.2 million, respectively, of products and services from BlueZone, which is included in cost of revenue in the Company’s consolidated statements of operations and comprehensive loss. As of December 30, 2015 and September 30, 2016, $0.1 million and $0.1 million, respectively, relating to the Company’s investment in BlueZone was included in accounts payable and accrued expense in the Company’s consolidated balance sheet.

In May 2014, the Company made a strategic investment of $15.0 million in Automattic, Inc. (“Automattic”), which provides content management systems associated with WordPress. The investment represents less than 5% of the outstanding shares of Automattic and better aligns the Company with an important partner.

In August 2014, the Company made an aggregate investment of $3.9 million for a joint venture with a 49% ownership interest in WZ UK, which is a provider of technology and sales marketing services associated with web builder solutions. On January 6, 2016, the Company exercised an option to increase its stake in WZ UK from 49% to 57.5%. Refer to Note 3: Acquisitions, for further details.

In December 2014, the Company made an aggregate investment of $15.2 million to acquire a 40% ownership interest in AppMachine B.V. (“AppMachine”), which is a developer of software that allows users to build mobile applications for smart devices such as phones and tablets. Under the terms of the investment agreement for AppMachine, the Company was obligated to purchase the remaining 60% of AppMachine in three tranches of 20% within specified periods if AppMachine achieved a specified minimum revenue threshold within a designated timeframe. The agreement was terminated in July 2016, when the Company negotiated and acquired the remaining 60% of the equity interest in AppMachine. Refer to Note 3: Acquisitions for further details.

On March 3, 2016, the Company purchased a $0.6 million convertible promissory note from a business that provides web and mobile money management solutions, with the potential for subsequent purchases of additional convertible notes.

On April 8, 2016, the Company made an investment of $5.0 million for a 33% equity interest in Fortifico Limited, a company providing a billing, CRM, and affiliate management solution to small and mid-sized businesses.

Investments in which the Company’s interest is less than 20% and which are not classified as available-for-sale securities are carried at the lower of cost or net realizable value unless it is determined that the Company exercises significant influence over the investee company, in which case the equity method of accounting is used. For those investments in which the Company’s voting interest is between 20% and 50%, the equity method of accounting is used. Under this method, the investment balance, originally recorded at cost, is adjusted to recognize the Company’s share of net earnings or losses of the investee company, as they occur, limited to the extent of the Company’s investment in, advances to and commitments for the investee. These adjustments are reflected in equity (income) loss of unconsolidated entities, net of tax in the Company’s consolidated statements of operations and comprehensive loss. The Company recognized net losses of $4.6 million and $0.2 million for the three months ended September 30, 2015 and 2016, respectively, and net losses of $9.1 million and $1.2 million for the nine months ended September 30, 2015 and 2016, respectively, related to its investments.

 

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From time to time, the Company may make new and follow-on investments and may receive distributions from investee companies. As of September 30, 2016, the Company was not obligated to fund any follow-on investments in these investee companies.

As of September 30, 2016, the Company did not have an equity method investment in which the Company’s proportionate share of the investees’ net income or loss exceeded 10% of the Company’s consolidated assets or income from continuing operations.

9. Notes Payable

In November 2013, following its initial public offering (“IPO”), the Company repaid in full its November 2012 second lien term loan facility of $315.0 million and increased its first lien term loan facility (“November 2013 First Lien”) by $166.2 million to $1,050.0 million. The Company also increased its revolving credit facility by $40.0 million to $125.0 million, none of which was drawn down at the time of the increase. The mandatory repayment of principal on the November 2013 First Lien was increased to approximately $2.6 million at the end of each quarter.

 

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In connection with the acquisition of Constant Contact on February 9, 2016, the Company entered into a $735.0 million incremental first lien term loan facility and a new $165.0 million revolving credit facility (which replaced its existing $125.0 million revolving credit facility), and EIG Investors issued $350.0 million aggregate principal amount of 10.875% senior notes due 2024. The Company refers to the incremental first lien term loan facility and new revolving credit facility, together with its previously existing first lien term loan facility, as the “Senior Credit Facilities,” and to the 10.875% senior notes due 2024 as the “Notes.”

Incremental First Lien Term Loan Facility

On February 9, 2016, the Company entered into an incremental first lien term loan amendment to its existing credit agreement. Pursuant to this amendment, the Company obtained a seven-year $735.0 million incremental first lien term loan facility, which is in addition to its existing first lien term loan facility. The full amount of this incremental first lien term loan facility was drawn immediately following the effectiveness of the amendment.

This incremental first lien term loan facility will mature seven years from issuance, was issued at a price of 97% of par (subject to the payment of an additional upfront fee of 1.0% on February 28, 2016 under certain circumstances), bears interest at a rate of LIBOR plus 5.0% per annum, subject to a LIBOR floor of 1.0% per annum, and has scheduled amortization of 0.50% per quarter.

As a result of the “most-favored nation” pricing provision in the Company’s existing credit agreement, the interest rate on its existing first lien term loan facility has increased to LIBOR plus 5.23% per annum (and was further stepped up to LIBOR plus 5.48% per annum on February 28, 2016 since certain circumstances materialized), subject to a LIBOR floor of 1.0% per annum. In addition, the Company is obligated to use commercially reasonable efforts to make voluntary prepayments on its existing first lien term loan facility to effectively double the amount of each scheduled amortization payment under that facility (which is 0.25% per quarter of the principal outstanding as of November 25, 2013).

Revolving Credit Facility

Also on February 9, 2016, the Company entered into a revolving facility amendment to its existing credit agreement. Pursuant to this amendment, the Company obtained a five-year $165.0 million revolving credit facility, which replaced its existing $125.0 million revolving credit facility. Loans under the facility will bear interest at a rate of LIBOR plus 4.0% per annum (subject to a leverage-based step-down), without a LIBOR floor. This revolving credit facility has a “springing” maturity date of August 10, 2019 unless the existing first lien term loan facility has been repaid in full or otherwise extended to at least 91 days after the maturity of the revolving credit facility.

Loans under the Senior Credit Facilities are also subject to a base rate option, with interest rate spreads of 1.0% per annum less than those applicable to LIBOR-based loans.

The Senior Credit Facilities have been fully and unconditionally guaranteed, an secured, by the Company and certain of its subsidiaries (including Constant Contact and certain of its subsidiaries).

10.875% Senior Notes due 2024

On February 9, 2016, EIG Investors issued $350.0 million aggregate principal amount of Notes. The Notes will mature in February 2024, were issued at a price of 98.065% of par and will bear interest at the rate of 10.875% per annum. The Notes have been fully and unconditionally guaranteed, on a senior unsecured basis, by the Company and its subsidiaries that guarantee the Senior Credit Facilities (including Constant Contact and certain of its subsidiaries).

In connection with the issuance of the Notes, the Company agreed to assist the initial purchasers of the Notes in marketing the Notes. In addition, the Company entered into a registration rights agreement with the initial purchasers of the Notes, which provides the holders of the Notes certain rights relating to registration of the Notes under the Securities Act.

Pursuant to the registration rights agreement, the Company will, among other obligations, use commercially reasonable efforts to file an exchange offer registration statement with respect to a registered offer, or the Exchange Offer, to exchange the Notes for substantially identical notes and consummate the Exchange Offer within 365 days after the issuance of the Notes. The Company will also use commercially reasonable efforts to cause to become effective a shelf registration statement to cover resales of the Notes by the beneficial owners thereof who satisfy certain conditions relating to the provision of information in connection with the shelf registration statement. A registration default will occur if, among other things, (1) the Company fails to consummate the Exchange Offer or have the shelf registration statement become effective on or before the date that is 365 days after the issue date or (2) the shelf registration statement becomes effective but thereafter ceases to be effective or usable in connection with the resale of Notes (subject to certain exceptions) during the periods specified in the registration rights agreement. If a registration default occurs with respect to the Notes, the annual interest rate of the Notes will be increased by 0.25% per annum and will increase again by 0.25% per annum 90 days thereafter until all registration defaults have been cured, up to a maximum amount of additional interest of 0.50% per annum. The Company will also use commercially reasonable efforts to cause to become effective a registration statement providing for the registration of certain secondary transactions in the Notes by Goldman, Sachs & Co. and its affiliates.

 

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At December 31, 2015 and September 30, 2016, notes payable consisted of a first lien term loan facility with a principal amount outstanding of $1,026.4 million and $994.6 million, respectively, which bore interest at a LIBOR-based rate of 5.00% and 6.48%, respectively. The current portion of the first lien term loan as of December 31, 2015 and September 30, 2016 was $10.5 million and $21.0 million, respectively. In addition, as of September 30, 2016, notes payable included a $33.5 million outstanding on its revolving credit facility, consisting of two loans of $16.0 million and $17.0 million, which each bore interest at a LIBOR-based rate of 4.52% and 4.53%, respectively, and a loan of $0.5 million which bore interest at an alternate base rate of 6.50%. As of December 31, 2015, notes payable included a bank revolver loan (“2015 Revolver loan”) of $67.0 million, consisting of a loan of $59.0 million which bore interest at a LIBOR-based rate of 7.75% and a loan of $8.0 million which bore interest at an alternate base rate of 8.50%. The amount outstanding under the 2015 Revolver loan as of December 31, 2015 and the amount outstanding under the 2016 revolving credit facility as of September 30, 2016 were classified as current notes payable on the consolidated balance sheet.

In addition, as of September 30, 2016, the notes payable included $724.0 million, net of original issue discounts related to the incremental first lien term loan facility, which bore interest at a LIBOR-based rate of 6.0%. The current portion of the incremental first lien term loan as of September 30, 2016 was $14.7 million.

As of September 30, 2016, notes payable also included the $350.0 million of 10.875% senior notes due 2024, net of original issue discounts.

During the nine months ended September 30, 2015 and 2016, the Company made aggregate mandatory repayments on the November 2013 First Lien of $7.9 million and $15.8 million, respectively. Also, during the nine months ended September 30, 2016, the Company made a voluntary payment of $16.0 million on the November 2013 First Lien, two voluntary prepayments on the incremental first lien term loan facility of $7.4 million, and a mandatory payment on the incremental first lien term loan facility for $3.7 million. During the nine months ended September 30, 2015 and 2016, the Company had drawn down an aggregate amount of $109.0 million and $49.5 million, respectively, on its Revolver loan, and repaid an aggregate amount of $89.0 million and $83.0 million, respectively, of the amounts drawn down, resulting in $70.0 million and $33.5 million outstanding under the Revolver loan at September 30, 2015 and 2016, respectively. The maturity dates of the November 2013 First Lien, the incremental first lien term loan facility and the $350.0 million of 10.875% senior notes are November 9, 2019, February 9, 2023, and February 9, 2024, respectively. There is a springing maturity related to the revolving credit facility. If the Company’s November 2013 First Lien has not been paid in full prior to August 10, 2019 and the final maturity has not been extended to May 11, 2021 or later, then the maturity date of the revolving credit facility is February 9, 2019.

Effective November 25, 2013, the interest rate for a LIBOR based interest loan was reduced to 4.00% plus the greater of the LIBOR rate or 1.00%. The interest rate for a reference rate loan was reduced to 3.00% per annum plus the greater of the prime rate, the federal funds effective rate plus 0.50%, an Adjusted LIBOR rate or 2.00%. Effective February 9, 2016, the interest rates for a revolver loan are subject to variability based on certain covenants.

Interest is payable on maturity of the elected interest period for a LIBOR-based interest loan, which can be one, two, three or six months. Interest is payable at the end of each fiscal quarter for a reference rate loan, term loan or an ABR revolver loan.

The Company adopted ASU 2015-03, “Simplifying the Presentation of Debt Issuance Costs” beginning on January 1, 2016, and retrospectively for all periods presented. ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The unamortized value of deferred financing costs associated with our revolving credit facility were not affected by the ASU and continue to be presented as an asset on the Company’s consolidated balance sheets.

Future Debt Maturities

Aggregate principal payments, exclusive of any unamortized original discounts and deferred financing fees, due on long-term debt as of September 30, 2016 are as follows:

 

Maturity Date as of December 31,    (in thousands)  

(Remainder of) 2016

   $ 8,925   

2017

   $ 35,700   

2018

   $ 35,700   

2019

   $ 962,075   

2020

   $ 14,700   

Thereafter

   $ 1,011,500   
  

 

 

 

Total

   $ 2,068,600   
  

 

 

 

 

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The table above excludes $33.5 million on the Company’s revolving credit facility, which is outstanding as of September 30, 2016 and included in the current portion of notes payable in the Company’s consolidated balance sheets. This table also excludes when the revolving credit facility due date is, which is August 2019.

Interest

The Company recorded $14.6 million and $41.2 million in interest expense for the three months ended September 30, 2015 and 2016, respectively, and $43.0 million and $112.6 million, respectively, for the nine months ended September 30, 2015 and 2016, respectively.

The following table provides a summary of interest rates and interest expense for the three and nine months ended September 30, 2015 and 2016:

 

    Three Months
Ended
September 30,
2015
    Three Months
Ended
September 30,
2016
    Nine Months
Ended
September 30,
2015
    Nine Months
Ended
September 30,
2016
 
    (dollars in thousands)  

Interest rate—LIBOR

    5.00%-7.75     4.49%-6.48     5.00%-7.75     4.49%-7.75

Interest rate—reference

    8.50     6.50     8.50     6.50%-8.75

Interest rate—Senior notes

    —          10.875     —          10.875

Non-refundable fee—unused facility

    0.50     0.50     0.50     0.50

Interest expense and service fees

  $ 14,252      $ 37,603      $ 41,931      $ 103,111   

Amortization of deferred financing fees

  $ 21      $ 1,760      $ 62      $ 4,322   

Amortization of original issue discounts

    —        $ 844        —        $ 2,116   

Amortization of net present value of deferred consideration

  $ 207      $ 844      $ 488      $ 2,426   

Other interest expense

  $ 144      $ 157      $ 475      $ 598   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total interest expense

  $ 14,624      $ 41,208      $ 42,956      $ 112,573   
 

 

 

   

 

 

   

 

 

   

 

 

 

Debt Covenants

Senior Credit Facilities

The Senior Credit Facilities require the Company to comply with a financial covenant to maintain a maximum ratio of consolidated senior secured indebtedness to an EBITDA measure adjusted for bank purposes, as defined in the Company’s existing credit agreement.

The Senior Credit Facilities contain covenants that limit the Company’s ability to, among other things, incur additional debt or issue certain preferred shares; pay dividends on or make other distributions in respect of capital stock; make other restricted payments; make certain investments; sell or transfer certain assets; create liens on certain assets to secure debt; consolidate, merge, sell or otherwise dispose of all or substantially all of its assets; and enter into certain transactions with affiliates. Additionally, the Senior Credit Facilities require the Company to comply with certain negative covenants and specify certain events of default that could result in amounts becoming payable, in whole or in part, prior to their maturity dates. The Company was in compliance with all covenants at September 30, 2016.

With the exception of certain equity interests and other excluded assets under the terms of the Senior Credit Facilities, substantially all of the Company’s assets are pledged as collateral for the obligations under the Senior Credit Facilities.

Notes

The indenture with respect to the Notes contains covenants that limit the Company’s ability to, among other things, incur additional debt or issue certain preferred shares; pay dividends on or make other distributions in respect of capital stock; make other restricted payments; make certain investments; sell or transfer certain assets; create liens on certain assets to secure debt; consolidate, merge, sell or otherwise dispose of all or substantially all of its assets; and enter into certain transactions with affiliates. Upon a change of control as defined in the Indenture, the Company or EIG Investors must offer to repurchase the Notes at 101% of the aggregate principal amount thereof, plus accrued and unpaid interest, if any, up to, but not including, the repurchase date. These covenants are subject to a number of important limitations and exceptions.

 

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The indenture also provides for events of default, which, if any of them occurs, may permit or, in certain circumstances, require the principal, premium, if any, interest and any other monetary obligations on all the then outstanding Notes to be due and payable immediately.

10. Stockholders’ Equity

Voting Rights

All holders of common stock are entitled to one vote per share.

The following table presents the changes in total stockholders’ equity:

 

     Total
Stockholders’
Equity
 
     (in thousands)  

Balance, December 31, 2015

   $ 179,674   

Stock-based compensation

     48,218   

Stock option exercises

     2,304   

Foreign currency translation adjustment

     994   

Unrealized loss on derivative

     (1,866

Non-controlling interest accretion

     (30,844

Non-controlling interest accretion in excess over Fair Value

     (3,145

Investment in Constant Contact

     5,395   

Income tax from the exercise of stock options

     (1,292

Net loss

     (49,147
  

 

 

 

Balance, September 30, 2016

   $ 150,291   
  

 

 

 

11. Stock-Based Compensation

2013 Stock Incentive Plan

The Amended and Restated 2013 Stock Incentive Plan (the “2013 Plan”) of the Company became effective upon the closing of its IPO. The 2013 Plan provides for the grant of options, stock appreciation rights, restricted stock, restricted stock units and other stock-based awards to employees, officers, directors, consultants and advisors of the Company. Under the 2013 Plan, the Company may issue up to 38,000,000 shares of the Company’s common stock. At September 30, 2016, there were 19,193,345 shares available for grant under the 2013 Plan.

2011 Stock Incentive Plan

As of February 9, 2016, the effective date of the acquisition of Constant Contact, the Company assumed and converted certain outstanding equity awards granted by Constant Contact under the Constant Contact 2011 Stock Incentive Plan (“2011 Plan”) prior to the effective date of the acquisition (the “Assumed Awards”) into corresponding equity awards with respect to shares of the Company’s common stock. In addition, the Company assumed certain shares of Constant Contact common stock, par value $0.01 per share, available for issuance under the 2011 Plan (“the Available Shares”), which will be available for future issuance under the 2011 Plan in satisfaction of the vesting, exercise or other settlement of options and other equity awards that may be granted by the Company following the effective date of the acquisition of Constant Contact in reliance on the prior approval of the 2011 Plan by the stockholders of Constant Contact. The Assumed Awards were converted into 2,143,987 stock options and 2,202,846 restricted stock units with respect to the Company’s common stock and the Available Shares were converted into 10,000,000 shares of the Company’s common stock reserved for future awards under the 2011 Plan. At September 30, 2016, there were 10,961,108 shares available for grant under the 2011 Plan.

The Company calculated the fair value of the exchanged awards in accordance with the provisions of ASC 718 as of the acquisition date. The Company allocated the fair value of these awards between the pre-acquisition and post-acquisition stock-based compensation expense. The Company determined that the value of the awards under this plan was $22.3 million, of which $5.4 million was attributed to the pre-acquisition period and recognized as part of the purchase consideration for Constant Contact. The balance of $16.9 million has been attributed to the post-acquisition period, and was recognized in the Company’s Consolidated Statement of Operations and Comprehensive Loss in the three months ending March 31, 2016.

 

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The following table presents total stock-based compensation expense recorded in the consolidated statement of operations and comprehensive loss for all 2012 restricted stock awards and units issued prior to the IPO, and all awards granted under the Company’s 2013 Plan and the 2011 Plan:

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2015      2016      2015      2016  
     (in thousands)  

Cost of revenue

   $ 601       $ 1,643       $ 1,360       $ 4,116   

Sales and marketing

     1,107         1,850         2,342         6,249   

Engineering and development

     627         4,164         1,331         6,369   

General and administrative

     7,427         7,149         15,239         31,484   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total stock-based compensation expense

   $ 9,762       $ 14,806       $ 20,272       $ 48,218   
  

 

 

    

 

 

    

 

 

    

 

 

 

2012 Restricted Stock Awards

The following table provides a summary of the 2012 restricted stock awards activity for the nine months ended September 30, 2016 for restricted stock awards that were granted prior to the IPO, including the non-vested balance as of September 30, 2016:

 

     2012 Restricted Stock
Awards
 

Non-vested at December 31, 2015

     46,645   

Vested

     (46,348

Canceled

     —     
  

 

 

 

Non-vested at September 30, 2016

     297   
  

 

 

 

The following table provides a summary of the activity for the nine months ended September 30, 2016 for the restricted stock units that were granted in connection with the IPO, including the non-vested balance as of September 30, 2016:

 

     Restricted Stock
Units
     Weighted
Average
Grant Date
Fair Value
 

Non-vested at December 31, 2015

     22,158       $ 12.00   

Vested and unissued

     (22,158    $ 12.00   
  

 

 

    

Non-vested at September 30, 2016

     —           —     
  

 

 

    

2013 Stock Incentive Plan

The following table provides a summary of the Company’s stock options as of September 30, 2016 and the stock option activity for all stock options granted under the 2013 Plan during the nine months ended September 30, 2016:

 

     Stock
Options
     Weighted-
Average
Exercise
Price
     Weighted-
Average
Remaining
Contractual
Term

(In Years)
     Aggregate
Intrinsic
Value(3)
(in thousands)
 

Outstanding at December 31, 2015

     6,950,858       $ 13.83         

Granted

     3,412,499       $ 11.10         

Exercised

     —         $ —           

Forfeited

     (304,045    $ 14.54         

Expired

     (295,326    $ 13.09         
  

 

 

          

Outstanding at September 30, 2016

     9,763,986       $ 12.87         8.2       $ —     
  

 

 

          

Exercisable at September 30, 2016

     4,056,081       $ 13.10         7.4       $ —     

Expected to vest after September 30, 2016 (1)

     5,574,737       $ 12.73         8.8       $ —     

Exercisable as of September 30, 2016 and expected to vest thereafter (2)

     9,630,818       $ 12.88         8.2       $ —     

 

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(1) This represents the number of unvested options outstanding as of September 30, 2016 that are expected to vest in the future, which have been reduced using an estimated forfeiture rate.
(2) This represents the number of vested options as of September 30, 2016 plus the number of unvested options outstanding as of September 30, 2016 that are expected to vest in the future, which have been reduced using an estimated forfeiture rate.
(3) The aggregate intrinsic value was calculated based on the positive difference, if any, between the estimated fair value of the Company’s common stock on September 30, 2016 of $8.75 per share, or the date of exercise, as appropriate, and the exercise price of the underlying options.

Unless otherwise determined by the Company’s board of directors, restricted stock units granted under the 2013 Plan generally vest monthly over a four-year period. The following table provides a summary of the Company’s restricted stock unit activity for the 2013 Plan during the nine months ended September 30, 2016:

 

     Restricted Stock
Units
     Weighted
Average
Grant Date
Fair Value
 

Non-vested at December 31, 2015

     220,765       $ 12.00   

Vested and unissued

     (90,297    $ 12.00   
  

 

 

    

Non-vested at September 30, 2016

     130,468       $ 12.00   
  

 

 

    

Unless otherwise determined by the Company’s board of directors, restricted stock awards granted under the 2013 Plan generally vest annually over a four-year period. Performance-based restricted stock awards are earned based on the achievement of performance criteria established by the Company’s Compensation Committee and Board of Directors. The following table provides a summary of the Company’s restricted stock award activity for the 2013 Plan during the nine months ended September 30, 2016:

 

     Restricted Stock
Awards
     Weighted
Average
Grant Date
Fair Value
 

Non-vested at December 31, 2015

     4,849,290       $ 15.24   

Granted

     3,209,688       $ 10.46   

Vested

     (341,270    $ 15.76   

Canceled

     (167,453    $ 12.85   
  

 

 

    

Non-vested at September 30, 2016

     7,550,255       $ 13.24   
  

 

 

    

2015 Performance Based Award

The performance-based restricted stock award granted to the Company’s chief executive officer during 2015 provides an opportunity for the participant to earn a fully vested right to up to 3,693,754 shares of the Company’s common stock (the “Award Shares”) over a three-year period beginning July 1, 2015 and ending on June 30, 2018 (the “Performance Period”). Award Shares may be earned based on the Company achieving pre-established, threshold, target and maximum performance metrics.

Award Shares may be earned during each calendar quarter during the Performance Period (each, a “Performance Quarter”) if the Company achieves a threshold, target or maximum level of the performance metric for the Performance Quarter. If the performance metric is less than the threshold level for a Performance Quarter, no Award Shares will be earned during the Performance Quarter. Award Shares that were not earned during a Performance Quarter may be earned later during the then current twelve-month period from July 1st to June 30th during the Performance Period (each, a “Performance Year”), at a threshold, target or maximum level of the performance metric for the Performance Year. No Award Shares were earned for the Performance Quarter ending September 30, 2016 because the threshold level for the performance metric was not met.

Any Award Shares that are earned during the Performance Period will vest on June 30, 2018, provided the chief executive officer is employed by the Company on such date. The requirement that the chief executive officer be employed by the Company on June 30, 2018 is waived in the event the executive’s employment is terminated due to death, disability or by the Company without cause, if the executive terminates employment with the Company for good reason, or if the executive is employed by the Company on the date of a change in control (as such terms are defined in the executive’s employment agreement). Upon the occurrence of any of the foregoing events, additional Award Shares may be earned, as provided for in the performance-based restricted stock agreement.

 

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This performance-based award is evaluated quarterly to determine the probability of its vesting and determine the amount of stock-based compensation to be recognized. During the three and nine months ended September 30, 2016, the Company recognized $1.6 million and $9.5 million of stock-based compensation expense related to this performance-based award.

2016 Performance Based Awards

On February 16, 2016, the Compensation Committee of the Board of Directors of the Company approved the grant of performance-based restricted stock awards to the Company’s Chief Financial Officer (“CFO”), Chief Operating Officer (“COO”) and Chief Administrative Officer (“CAO”).

The CFO performance-based restricted stock award provides an opportunity to earn a fully vested right to up to 223,214 shares of the Company’s stock, with a target of 178,571 shares. The COO performance-based restricted stock award provides an opportunity to earn a fully vested right to up to 260,416 shares of the Company’s stock, with a target of 208,333 shares. The CAO performance-based restricted stock award provides an opportunity to earn a fully vested right to up to 148,810 shares of the Company’s stock, with a target of 119,048 shares.

The shares subject to the performance-based restricted stock awards will be earned based on the Company’s Constant Contact brand achieving a pre-established level of adjusted revenue (weighted 50%), adjusted EBITDA (weighted 25%) and adjusted free cash flow (weighted 25%), each as defined in the award agreement and in each case for the twelve months ending December 31, 2016, assuming for this purpose that the Company’s acquisition of Constant Contact had taken place on January 1, 2016 (the “Performance Metric”).

Each executive will earn from 0% to 125% of the target number of shares subject to their performance-based restricted stock award based on the level of achievement of the Performance Metric. Shares that are earned based on the achievement of the Performance Metric will vest on March 31, 2017 and any unearned shares as of that date will be forfeited.

These performance-based awards are evaluated quarterly to determine the probability of vesting and determine the amount of stock-based compensation to be recognized. During the three and nine months ended September 30, 2016, the Company recognized $1.2 million and $2.9 million of stock-based compensation expense related to these performance-based awards.

2011 Stock Incentive Plan

The following table provides a summary of the Company’s stock options as of September 30, 2016 and the stock option activity for all stock options granted under the 2011 Plan during the nine months ended September 30, 2016:

 

     Stock
Options
     Weighted-
Average
Exercise
Price
     Weighted-
Average
Remaining
Contractual Term
(In Years)
     Aggregate
Intrinsic
Value(3)
(in thousands)
 

Outstanding at December 31, 2015

     —           —           

Granted/ Exchanged

     2,936,429       $ 8.29         

Exercised

     (351,668    $ 6.55         

Forfeited

     (592,417    $ 7.92         
  

 

 

          

Outstanding at September 30, 2016

     1,992,344       $ 8.71         5.4       $ 2,201   
  

 

 

          

Exercisable at September 30, 2016

     432,227       $ 7.23         4.3       $ 871   

Expected to vest after September 30, 2016 (1)

     1,229,789       $ 9.00         5.6       $ 1,157   

Exercisable as of September 30, 2016 and expected to vest thereafter (2)

     1,662,016       $ 8.54         5.3       $ 2,028   

 

(1) This represents the number of unvested options outstanding as of September 30, 2016 that are expected to vest in the future, which have been reduced using an estimated forfeiture rate.
(2) This represents the number of vested options as of September 30, 2016 plus the number of unvested options outstanding as of September 30, 2016 that are expected to vest in the future, which have been reduced using an estimated forfeiture rate.
(3) The aggregate intrinsic value was calculated based on the positive difference, if any, between the estimated fair value of the Company’s common stock on September 30, 2016 of $8.75 per share, or the date of exercise, as appropriate, and the exercise price of the underlying options.

 

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Unless otherwise determined by the Company’s board of directors, restricted stock units granted under the 2011 Plan generally vest annually over a four-year period. The following table provides a summary of the Company’s restricted stock unit activity for the 2011 Plan during the nine months ended September 30, 2016:

 

     Restricted Stock
Units
     Weighted
Average
Grant Date
Fair Value
 

Non-vested at December 31, 2015

     —         $ —     

Granted/ Exchanged

     3,103,033       $ 8.50   

Vested

     (1,109,114    $ 7.69   

Canceled

     (368,694    $ 8.11   
  

 

 

    

Non-vested at September 30, 2016

     1,625,225       $ 9.14   
  

 

 

    

12. Variable Interest Entity

The Company, through a subsidiary formed in China, has entered into various agreements with Shanghai Xiao Lan Network Technology Co., Ltd (“Shanghai Xiao”) and its shareholders that allow the Company to effectively control Shanghai Xiao, making it a variable interest entity (“VIE”). Shanghai Xiao has a technology license that allows it to provide local hosting services to customers located in China.

The shareholders of Shanghai Xiao cannot transfer their equity interests without the approval of the Company, and as a result, are considered de facto agents of the Company in accordance with ASC 810-10-25-43. The Company and its de facto agents acting together have the power to direct the activities that most significantly impact the entity’s economic performance and they have the obligation to absorb losses and the right to receive benefits from the entity. In situations where a de facto agency relationship is present, one party is required to be identified as the primary beneficiary. The factors considered include the presence of a principal/agent relationship, the relationship and significance of activities to the reporting entity, the variability associated with the VIE’s anticipated economics and the design of the VIE. The analysis is qualitative in nature and is based on weighting the relative importance on each of the factors in relation to the specifics of the VIE arrangement. Upon the execution of the agreements with Shanghai Xiao and its shareholders, the Company performed an analysis and concluded that the Company is the party that is most closely associated with Shanghai Xiao, as it is the most exposed to the variability of the VIE’s economics and therefore is the primary beneficiary of the VIE.

As of September 30, 2016, the financial position and results of operations of Shanghai Xiao are consolidated within, but are not material to, the Company’s consolidated financial position or results of operations.

13. Redeemable Non-controlling Interest

In connection with a 2014 equity investment in WZ UK, on January 6, 2016, the Company exercised its option to increase its stake in WZ UK from 49% to 57.5%, thereby acquiring a controlling interest, in exchange for a payment of approximately $2.1 million to the other shareholders of WZ UK. The agreement related to the transaction provides for a put option for the then NCI shareholders to put the remaining equity interest to the Company within pre-specified put periods. As the NCI is subject to a put option that is outside the control of the Company, it is deemed a redeemable non-controlling interest and is not recorded in permanent equity, and is presented as mezzanine redeemable non-controlling interest on the consolidated balance sheet, and is subject to the guidance of the Securities and Exchange Commission (“SEC”) under ASC 480-10-S99, Accounting for Redeemable Equity Securities. The difference between the $10.8 million fair value of the redeemable NCI and the $30.0 million value that is expected to be paid upon exercise of the put option was being accreted over the period commencing January 6, 2016 and up to the first put option period, which commenced on the 24-month anniversary of the acquisition date, August 14, 2016. Adjustments to the carrying amount of the redeemable non-controlling interest were charged to additional paid-in capital.

In January 2016, the Company obtained a controlling interest in Resume Labs Limited for $1.5 million and Pseudio Limited for $1.5 million.

The agreements related to these transactions provide for put options for the NCI shareholders of each company to put the remaining equity interest to the Company within pre-specified put periods. As the NCI for these entities are subject to put options that are outside the control of the Company, they are deemed redeemable non-controlling interests and are also not recorded in permanent equity, and are presented as part of the mezzanine redeemable non-controlling interest on the consolidated balance sheet.

On May 16, 2016, the Company amended the put option with respect to WZ UK to allow it to acquire an additional equity interest in WZ UK earlier than August 2016. Pursuant to this amended option, on the same date the Company acquired an additional 20% stake in WZ UK for $15.4 million, thus increasing its ownership interest from 57.5% to 77.5%.

 

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On July 13, 2016, WZ UK completed a restructuring pursuant to which Pseudio Limited and Resume Labs became wholly-owned subsidiaries of WZ UK. As a result of the restructuring, WZ UK became the 100% owner of Pseudio Limited and Resume Labs Limited and the Company’s ownership of WZ UK was diluted from 77.5% to 76.4%. Immediately subsequent to the restructuring, the Company acquired an additional 10% stake in WZ UK on July 13, 2016 for $18.0 million, bringing the Company’s aggregate stake in WZ UK to 86.4%. The restructuring significantly reduced the amount of the potential redemption amount payable to the minority shareholders of WZ UK, and gave the Company the flexibility to reduce investments in this business. Based on these reduced investments, the estimated value of the non-controlling interest is below the expected redemption amount of $25.0 million, which will result in $14.2 million of excess accretion that will reduce income available to common shareholders for the period starting on the date of the restructuring through the redemption date of July 1, 2017. The Company recognized excess accretion of $3.1 million for the three and nine months ended September 30, 2016, which is reflected in net loss attributable to accretion of non-controlling interest in the Company’s consolidated statements of operations and comprehensive loss. Prior to the third quarter of 2016, the Company did not have any accretion amounts in excess of fair value.

The following table presents changes in this redeemable non-controlling interest:

 

    Redeemable noncontrolling
Interest
 
    (in thousands)  

Balance as of December 31, 2015

  $ —     

Additions to non-controlling interest upon acquisition

    12,790   

Capital contribution from non-controlling interest

    1,775   

Accretion to redemption value

    30,844   

Accretion in excess of fair value

    3,145   

Adjustment to non-controlling interest

    (1,000

Redemption of non-controlling interest

    (33,425
 

 

 

 

Balance as of September 30, 2016

  $ 14,129   
 

 

 

 

The Company starts accreting non-controlling interest to its redeemable value from the date the redemption of the non-controlling interest becomes probable through the earliest redemption date. If the non-controlling interest is redeemable at an amount higher than its fair value, the excess accretion is taken into consideration in the calculation of loss per share.

14. Income Taxes

The Company files income tax returns in the United States for federal income taxes and in various state jurisdictions. The Company also files in several foreign jurisdictions. In the normal course of business, the Company is subject to examination by tax authorities throughout the world. Since the Company is in a loss carry-forward position, it is generally subject to U.S. federal and state income tax examinations by tax authorities for all years for which a loss carry-forward is utilized. The Company is currently under audit in India for fiscal years ended March 31, 2014 and 2015 and Israel for the fiscal years ended December 31, 2012, 2013 and 2014.

The statutes of limitations in the Company’s other tax jurisdictions, United Kingdom and Brazil, remain open for various periods between 2011 and the present. However, carryforward attributes from prior years may still be adjusted upon examination by tax authorities if they are used in an open period. The Company does not expect material changes as a result of the audits.

The Company recognizes, in its consolidated financial statements, the effect of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. The Company has no unrecognized tax positions at December 31, 2015 and September 30, 2016 that would affect its effective tax rate. The Company does not expect a significant change in the liability for unrecognized tax benefits in the next 12 months.

The Company regularly assesses its ability to realize its deferred tax assets. Assessing the realization of deferred tax assets requires significant management judgment. In determining whether its deferred tax assets are more likely than not realizable, the Company evaluated all available positive and negative evidence, and weighted the evidence based on its objectivity. Evidence the Company considered included:

 

    Net Operating Losses (“NOL”) incurred from the Company’s inception to September 30, 2016;

 

    Expiration of various federal and state tax attributes;

 

    Reversals of existing temporary differences;

 

    Composition and cumulative amounts of existing temporary differences; and

 

    Forecasted profit before tax.

 

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Prior to the acquisition of Constant Contact, the Company maintained a valuation allowance against certain deferred tax assets. The acquisition of Constant Contacted resulted in a significant increase in deferred tax liabilities, which far exceeded pre-acquisition deferred tax assets. The Company, with the significant deferred tax liabilities resulting from Constant Contact acquisition, scheduled out the reversal of the consolidated US deferred tax assets and liabilities as of March 31, 2016, and determined that these reversals would be sufficient to realize most domestic deferred tax assets. The deferred tax liabilities supporting the realizability of these deferred tax assets in the acquisition will reverse in the same period, are in the same jurisdiction and are of the same character as the temporary differences that gave rise to these deferred tax assets. As a result, the Company recorded a tax benefit of $72.8 million to reverse valuation allowances during the nine months ended September 30, 2016.

For the three months ended September 30, 2015 and 2016, the Company recognized tax expense of $5.4 million and a tax benefit of $7.4 million, respectively, in the consolidated statements of operations and comprehensive loss. The income tax benefit for the three months ended September 30, 2016 was primarily attributable to a federal and state deferred tax benefit of $9.1 million, a benefit for federal and state current income taxes of $0.1 million, partially offset by a $1.6 million deferred tax expense for the reversal of the valuation allowance, a foreign deferred tax expense of $0.0 million, and a foreign current tax expense of $0.3 million. The income tax expense for the three months ended September 30, 2015 is primarily attributable to federal and state current income taxes of $1.1 million, foreign current tax expense of $0.7 million, federal and state deferred tax expense of $3.0 million related to an increase in deferred liabilities and a $0.6 million increase of the valuation allowance.

For the nine months ended September 30, 2015 and 2016, the Company recognized tax expense of $9.1 million and a tax benefit of $121.2 million, respectively, in the consolidated statements of operations and comprehensive loss. The income tax benefit for the nine months ended September 30, 2016 was primarily attributable to a $72.8 million reversal of the valuation allowance, a federal and state deferred tax benefit of $49.7 million, which includes the identification and recognition of $7.3 million of U.S. federal research and development tax credits, and a foreign deferred tax benefit of $2.1 million, partially offset by a provision for federal and state current income taxes of $1.4 million and foreign current tax expense of $2.0 million. The income tax expense for the nine months ended September 30, 2015 is primarily attributable to a provision for federal and state current income taxes of $2.1 million, foreign current tax expense of $1.4 million, federal and state deferred tax expense of $5.2 million, foreign deferred tax expense of $0.1 million related to increases in deferred liabilities, and attributable to a $0.3 million increase of the valuation allowance.

The provision for income taxes shown on the consolidated statements of operations and comprehensive loss differs from amounts that would result from applying the statutory tax rates to income before taxes primarily because of state income taxes and certain expenses that were non-deductible, as well as the application of valuation allowances against U.S. and foreign assets. As mentioned above, most of the Company’s valuation allowance, on US deferred tax assets, was reversed in the first quarter of 2016.

As of December 31, 2015, the Company had NOL carry-forwards available to offset future U.S. federal taxable income of approximately $97.8 million and future state taxable income of approximately $111.2 million. These NOL carry-forwards expire on various dates through 2034. Approximately $1.6 million of the U.S. federal NOL carry-forwards and $0.7 million of the state NOL carry-forwards are from excess stock-based compensation, for which the benefit will be recorded to additional paid-in capital when recognized. As of December 31, 2015, the Company had NOL carry-forwards in foreign jurisdictions available to offset future foreign taxable income by approximately $27.4 million. The Company has loss carry-forwards in India totaling $2.9 million that begin to expire in 2021. The Company also has loss carry-forwards in the United Kingdom, Israel and Singapore of $23.4 million, $0.9 million, and $0.2 million, respectively, which have an indefinite carry-forward period.

Utilization of the NOL carry-forwards may be subject to an annual limitation due to the ownership percentage change limitations under Section 382 of the Internal Revenue Code (“Section 382 limitation”). Ownership changes can limit the amount of net operating loss and other tax attributes that a company can use each year to offset future taxable income and taxes payable. In connection with a change in control in 2011 the Company was subject to Section 382 limitations of $77.1 million against the balance of NOL carry-forwards generated prior to the change in control in 2011. Through December 31, 2013, the Company accumulated the unused amount of Section 382 limitations in excess of the amount of NOL carry-forwards that were originally subject to limitation. Therefore, these unused NOL carry-forwards are available for future use to offset taxable income. The Company has completed an analysis of changes in its ownership from 2011, through its IPO, to December 31, 2013. The Company concluded that there was not a Section 382 ownership change during this period and therefore any NOLs generated through December 31, 2013, are not subject to any new Section 382 limitations on NOL carry-forwards. On November 20, 2014, the Company completed a follow-on offering of 13,000,000 shares of common stock. The underwriters also exercised their overallotment option to purchase an additional 1,950,000 shares of common stock from the selling stockholders. The Company performed an analysis of the impact of this offering and determined that no Section 382 change in ownership had occurred.

On March 11, 2015, the Company completed a follow-on offering of its common stock, in which selling stockholders sold 12,000,000 shares of common stock at a public offering price of $19.00 per share. The underwriter also exercised its overallotment option to purchase an additional 1,800,000 shares of common stock from the selling stockholders. The Company completed an analysis of its ownership changes in the first half of 2016, which resulted in no ownership-change for tax purposes within the meaning of the Internal Revenue Code Section 382(g).

 

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As of the date of the Company’s acquisition of Constant Contact, Constant Contact had approximately $57.7 million and $31.9 million of federal and state NOLs, respectively, and approximately $10.8 million of U.S. federal research and development credits and $9.6 million of state credits.

15. Severance and Other Exit Costs

In connection with acquisitions, the Company may evaluate its data center, sales and marketing, support and engineering operations and the general and administrative function in an effort to eliminate redundant costs. As a result, the Company may incur charges for employee severance, exiting facilities and restructuring data center commitments and other related costs.

2014 Restructuring Plan

During the year ended December 31, 2014, the Company implemented plans to further integrate and consolidate its data center, support and engineering operations, resulting in severance and facility exit costs (the “2014 Restructuring Plan”). The severance charges were associated with eliminating approximately 90 positions across primarily support, engineering operations and sales and marketing. The Company incurred severance costs of $2.3 million in the year ended December 31, 2014 related to these restructuring activities. The employee-related charges associated with these restructurings were completed during the year ended December 31, 2014. As of September 30, 2016, the Company did not have any remaining accrued employee-severance related to these severance costs.

The Company had incurred facility costs associated with closing offices in Redwood City, California and Englewood, Colorado. At the time of closing these offices, the Company had remaining lease obligations of approximately $3.0 million for these vacated facilities through March 31, 2018. The Company recorded a facilities charge for these future lease payments, less expected sublease income, of $2.1 million during the year ended December 31, 2014. During the nine months ended September 30, 2016, the Company recorded an adjustment of $0.2 million relating to the lease agreement for the Englewood, Colorado facility. There were no adjustments related to the 2014 Restructuring Plan during the three months ended September 30, 2016. The Company paid $0.7 million of facility costs related to the 2014 Restructuring Plan, during the nine months ended September 30, 2016 and had a remaining accrued facility liability of $0.3 million as of September 30, 2016. The Company expects payments related to the 2014 Restructuring Plan to be completed during the year ended December 31, 2018.

2015 Restructuring Plan

During the year ended December 31, 2015, the Company implemented plans to enhance operational efficiencies across the business, resulting in severance costs (the “2015 Restructuring Plan”). The severance charges were associated with eliminating approximately 67 positions across the business. The Company incurred severance costs of $2.1 million during the year ended December 31, 2015 related to the 2015 Restructuring Plan. The Company completed employee-related charges associated with the 2015 Restructuring Plans during the year ended December 31, 2015. The Company paid $1.1 million of severance costs during the nine months ended September 30, 2016 and had a remaining accrued severance liability of $0.1 million as of September 30, 2016. The Company expects payments related to the 2015 Restructuring Plan be completed during the year ended December 31, 2016.

2016 Restructuring Plan

In connection with the Company’s acquisition of Constant Contact on February 9, 2016, the Company implemented a plan to create operational efficiencies and synergies resulting in severance costs and facility exit costs (the “2016 Restructuring Plan”).

The severance charges were associated with eliminating approximately 265 positions across the business. The Company incurred severance costs of $1.0 million and $11.3 million during the three and nine months ended September 30, 2016, respectively. The Company paid $8.5 million of severance costs during the nine months ended September 30, 2016 and had a remaining accrued severance liability of $2.8 million as of September 30, 2016.

The Company’s 2016 Restructuring Plan includes a plan to close offices in San Francisco, California, Delray Beach, Florida, New York, New York United Kingdom, Porto Alegre, Brazil and Miami, Florida, and a plan to relocate certain employees to our Austin Office. The Company is also closing a portion of the Constant Contact offices in Waltham, Massachusetts. During the three and nine months ended September 30, 2016, the Company recorded a facilities charge for future lease payments of $8.3 million and $23.5 million, respectively, less expected sublease income of $3.5 million and $12.0 million, respectively. The Company also recorded $0.6 million in relocation charges during the three and nine months ended September 30, 2016 after closing these facilities.

 

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The Company expects to incur all employee-related charges associated with the 2016 Restructuring Plan during the year ended December 31, 2016, and expects severance payments related to the 2016 Restructuring Plan to be completed during the year ended December 31, 2017.

The Company expects to complete facility-related charges associated with the 2016 Restructuring Plan during the year ended December 31, 2016, and expects to complete facility exit cost payments related to the plan during the year ended December 31, 2022.

The following table provides a summary of the aggregate activity for the nine months ended September 30, 2016 related to the Company’s combined Restructuring Plans severance accrual:

 

     Employee Severance  
     (in thousands)  

Balance at December 31, 2015

   $ 1,201   

Severance charges

     11,257   

Cash paid

     (9,625
  

 

 

 

Balance at September 30, 2016

   $ 2,833   
  

 

 

 

The following table provides a summary of the aggregate activity for the nine months ended September 30, 2016 related to the Company’s combined Restructuring Plans facilities exit accrual:

 

     Facilities  
     (in thousands)  

Balance at December 31, 2015

   $ 479   

Facility charges

     12,385   

Sublease income received

     393   

Cash paid

     (3,067
  

 

 

 

Balance at September 30, 2016

   $ 10,190   
  

 

 

 

 

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The following table presents restructuring charges recorded in the consolidated statements of operations and comprehensive loss for the periods presented:

 

    For the Three Months
Ended September 30,
    For the Three Months
Ended September 30,
    For the Nine Months
Ended September 30,
    For the Nine Months
Ended September 30,
 
    2015     2016     2015     2016  
          (in thousands)           (in thousands)  

Cost of revenue

  $ 380      $ 3,127      $ 380      $ 8,729   

Sales and marketing

    288        1,189        288        6,357   

Engineering and development

    411        1,014        411        4,256   

General and administrative

    115        1,047        115        4,300   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total restructuring charges

  $ 1,194      $ 6,377      $ 1,194      $ 23,642   
 

 

 

   

 

 

   

 

 

   

 

 

 

16. Commitments and Contingencies

From time to time, the Company is involved in legal proceedings or subject to claims arising in the ordinary course of its business. The Company is not presently involved in any such legal proceeding or subject to any such claim that, in the opinion of its management would have a material adverse effect on its business, operating results or financial condition. However, the results of such legal proceedings or claims cannot be predicted with certainty, and regardless of the outcome, can have an adverse impact on the Company because of defense and settlement costs, diversion of management resources and other factors. Neither the ultimate outcome of the matters listed below nor an estimate of any probable losses or any reasonably possible losses can be assessed at this time.

On May 4, 2015, Christopher Machado, a purported holder of the Company’s common stock, filed a civil action in the United States District Court for the District of Massachusetts against the Company and its chief executive officer and former chief financial officer, Machado v. Endurance International Group Holdings, Inc., et al, Civil Action No. 1:15-cv-11775-GAO. In a second amended complaint, filed on March 18, 2016, the plaintiff alleged claims for violations of Section 10(b) and 20(a) of the Exchange Act, on behalf of a purported class of purchasers of the Company’s securities between February 25, 2014 and February 29, 2016. Those claims challenged as false or misleading certain of the Company’s disclosures about its total number of subscribers, average revenue per subscriber, the number of customers paying over $500 per year for the Company’s products and services, the average number of products sold per subscriber, and customer churn. The plaintiff seeks, on behalf of himself and the purported class, compensatory damages and his costs and expenses of litigation. The Company filed a motion to dismiss on May 16, 2016, which remains pending. In August 2016, the parties in the Machado action and another potential claimant, who asserts that he purchased common stock in the Company’s initial public offering, agreed to toll, as of July 1, 2016, the statutes of limitation and repose for all claims under the Securities Act of 1933 that the plaintiff and claimant might bring, individually or in a representative capacity, arising from alleged actions or omissions between September 9, 2013 and February 29, 2016. The Company and the individual defendants intend to deny any liability or wrongdoing and to vigorously defend all claims asserted. The Company cannot, however, make any assurances as to the outcome of the current proceeding or any additional claims if they are brought.

The Company received a subpoena dated December 10, 2015 from the Boston Regional Office of the SEC, requiring the production of certain documents, including, among other things, documents related to its financial reporting, including operating and non-GAAP metrics, refund, sales and marketing practices and transactions with related parties. The Company is fully cooperating with the SEC’s investigation. The Company can make no assurances as to the time or resources that will need to be devoted to this investigation or its final outcome, or the impact, if any, of this investigation or any related legal or regulatory proceedings on the Company’s business, financial condition, results of operations and cash flows.

Constant Contact

On October 30, 2015, the Company entered into a definitive agreement pursuant to which it agreed to acquire all of the outstanding shares of common stock of Constant Contact. The acquisition closed on February 9, 2016. Constant Contact contingencies are noted below.

On December 10, 2015, Constant Contact received a subpoena from the Boston Regional Office of the SEC, requiring the production of documents pertaining to Constant Contact’s sales, marketing, and customer retention practices, and periodic public disclosure of financial and operating metrics. The Company is fully cooperating with the SEC’s investigation. The Company can make no assurances as to the time or resources that will need to be devoted to this investigation or its final outcome, or the impact, if any, of this investigation or any related legal or regulatory proceedings on the Company’s business, financial condition, results of operations and cash flows.

 

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On August 7, 2015, a purported class action lawsuit, William McGee v. Constant Contact, Inc., et al, was filed in the United States District Court for the District of Massachusetts against Constant Contact and two of its former officers. The lawsuit asserts claims under Sections 10(b) and 20(a) of the Exchange Act, and is premised on allegedly false and/or misleading statements, and non-disclosure of material facts, regarding Constant Contact’s business, operations, prospects and performance during the proposed class period of October 23, 2014 to July 23, 2015. This litigation remains in its early stages. The Company and the individual defendants intend to vigorously defend all claims asserted. The Company cannot, however, make any assurances as to the outcome of this proceeding.

In August 2012, RPost Holdings, Inc., RPost Communications Limited and RMail Limited, or collectively, RPost, filed a complaint in the United States District Court for the Eastern District of Texas that named Constant Contact as a defendant in a lawsuit. The complaint alleged that certain elements of Constant Contact’s email marketing technology infringe five patents held by RPost. RPost seeks an award for damages in an unspecified amount and injunctive relief. In February 2013, RPost amended its complaint to name five of Constant Contact’s marketing partners as defendants. Under Constant Contact’s contractual agreements with these marketing partners, it is obligated to indemnify them for claims related to patent infringement. Constant Contact filed a motion to sever and stay the claims against its partners and multiple motions to dismiss the claims against it. In January 2014, the case was stayed pending the resolution of certain state court and bankruptcy actions involving RPost, to which Constant Contact is not a party. The case continues to be stayed pending the state court and bankruptcy actions. Meanwhile, RPost asserted the same patents asserted against Constant Contact in litigation against Go Daddy. In June 2016, Go Daddy succeeded in invalidating all of those RPost patents. RPost has appealed, and the appellate court is expected to hear oral argument on the appeal in the Spring of 2017. The litigation against Constant Contact remains stayed, and is in its early stages. The Company believes it has meritorious defenses to any claim of infringement and intends to defend against the lawsuit vigorously.

On December 11, 2015, a putative class action lawsuit relating to the Constant Contact acquisition, captioned Irfan Chawdry, Individually and On Behalf of All Others Similarly Situated v. Gail Goodman, et al. Case No. 11797, or the Chawdry Complaint, and on December 21, 2015, a putative class action lawsuit relating to the acquisition captioned David V. Myers, Individually and On Behalf of All Others Similarly Situated v. Gail Goodman, et al. Case No. 11828, or the Myers Complaint (together with the Chawdry Complaint, the Complaints) were filed in the Court of Chancery of the State of Delaware naming Constant Contact, each of Constant Contact’s directors, Endurance and Paintbrush Acquisition Corporation as defendants. The Complaints generally allege, among other things, that in connection with the acquisition the directors of Constant Contact breached their fiduciary duties owed to the stockholders of Constant Contact by agreeing to sell Constant Contact for purportedly inadequate consideration, engaging in a flawed sales process, omitting material information necessary for stockholders to make an informed vote, and agreeing to a number of purportedly preclusive deal protection devices. The Complaints seek, among other things, to rescind the acquisition, as well as award of plaintiffs’ attorneys’ fees and costs in the action. The defendants have not yet answered or otherwise responded to either of these Complaints. The defendants believe the claims asserted in the Complaints are without merit and intend to defend against these lawsuits vigorously.

17. Related Party Transactions

The Company has various agreements in place with related parties. Below are details of related party transactions that occurred during the nine months ended September 30, 2015 and 2016.

Tregaron:

The Company has contracts with Tregaron India Holdings, LLC and its affiliates, including Diya Systems (Mangalore) Private Limited, Glowtouch Technologies Pvt. Ltd. and Touchweb Designs, LLC (collectively, “Tregaron”), for outsourced services, including email- and chat-based customer and technical support, network monitoring, engineering and development support and web design and web building services. These entities are owned directly or indirectly by family members of the Company’s chief executive officer, who is also a director and stockholder of the Company.

The following table presents the amounts of related party transactions recorded in the consolidated statements of operations and comprehensive loss for the periods presented relating to services provided by Tregaron and its affiliates under these agreements:

As of December 31, 2015, approximately $1.9 million was included in accounts payable and accrued expense relating to services provided by Tregaron. As of September 30, 2016, approximately $2.2 million was included in accounts payable and accrued expense relating to services provided by Tregaron.

 

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     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2015      2016      2015      2016  
     (in thousands)  

Cost of revenue

   $ 2,500       $ 3,000       $ 7,500       $ 9,400   

Sales and marketing

     300         150         600         350   

Engineering and development

     100         300         800         900   

General and administrative

     100         100         300         200   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total related party transaction expense, net

   $ 3,000       $ 3,550       $ 9,200       $ 10,850   
  

 

 

    

 

 

    

 

 

    

 

 

 

Innovative Business Services, LLC:

The Company also has agreements with Innovative Business Services, LLC (“IBS”), which provides multi-layered third-party security applications that are sold by the Company. IBS is indirectly majority owned by the Company’s chief executive officer and a director of the Company, each of whom are also stockholders of the Company. During the year ended December 31, 2014, the Company’s principal agreement with this entity was amended which resulted in the accounting treatment of expenses being recorded against revenue.

The following table presents the amounts of related party transactions recorded in the consolidated statements of operations and comprehensive loss for the periods presented relating to services provided by IBS and its affiliates under these agreements:

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2015      2016      2015      2016  
     (in thousands)  

Revenue

   $ (400    $ (900    $ (800    $ (2,200

Revenue (contra)

     1,700         1,800         5,200         5,900   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total related party transaction impact to revenue

   $ 1,300       $ 900       $ 4,400       $ 3,700   
  

 

 

    

 

 

    

 

 

    

 

 

 

Cost of revenue

     200         150         500         500   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total related party transaction expense, net

   $ 1,500       $ 1,050       $ 4,900       $ 4,200   
  

 

 

    

 

 

    

 

 

    

 

 

 

As of December 31, 2015 and September 30, 2016, approximately $0.2 million and $0.1 million, respectively, was included in prepaid expenses and other current assets relating to the Company’s agreements with IBS.

As of December 31, 2015 and September 30, 2016, approximately $1.1 million and $1.1 million, respectively was included in accounts payable and accrued expense relating to the Company’s agreements with IBS.

As of December 31, 2015 and September 30, 2016, approximately $0.3 million and $0.5 million, respectively, was included in accounts receivable relating to the Company’s agreements with IBS.

Goldman, Sachs & Co.

The Company entered into a three-year interest rate cap on December 9, 2015 with a subsidiary of Goldman, Sachs & Co. Goldman, Sachs & Co. is a significant shareholder of the Company. Refer to Note 5: Fair Value Measurements, for further details.

In connection with and concurrently with the acquisition of Constant Contact in February 2016, the Company entered into the $735.0 million incremental first lien term loan facility and the $165.0 million revolving credit facility, and EIG Investors Corp. issued Notes in the aggregate principal amount of $350.0 million. An affiliate of Goldman, Sachs & Co. provided loans in the aggregate principal amount of $312.4 million under the incremental first lien term loan facility and a commitment in the aggregate principal amount of $57.6 million under the revolving credit facility, and Goldman, Sachs & Co. acted as a book-running manager in the Company’s offering of the Notes and purchased approximately $148.8 million worth of the Notes. The foregoing financing arrangements were provided in accordance with a commitment letter the Company entered into with an affiliate of Goldman, Sachs & Co. and certain other investment banks in November 2015. Refer to Note 9: Notes Payable, for further details.

Goldman, Sachs & Co. also served as a financial advisor in connection with the acquisition of Constant Contact and in the nine months ended September 30, 2016, the Company paid approximately $8.6 million to Goldman, Sachs & Co. in connection with these services.

 

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In connection with the issuance of the Notes, the Company agreed to assist the initial purchasers, including Goldman, Sachs & Co., in marketing the Notes. In the three months ended September 30, 2016, the Company incurred expenses on behalf of the initial purchasers of approximately $0.8 million.

18. Subsequent Events

The Company evaluated all subsequent events occurring through November 4, 2016, to determine if any such events should be reflected in these financial statements. There were no material recognized subsequent events recorded in the September 30, 2016 financial statements.

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

You should read the following discussion of our financial condition and results of operations together with our consolidated financial statements and the related notes and other financial information included elsewhere in this Quarterly Report on Form 10-Q.

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed in the forward-looking statements. The statements contained in this report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Forward-looking statements are often identified by the use of words such as, but not limited to, “anticipate,” “believe,” “can,” “contemplate,” “continue,” “could,” “estimate,” “expect,” “intend,” “likely,” “may,” “might,” “plan,” “potential,” “predict,” “project,” “seek,” “should,” “strategy,” “target,” “will,” “would” and similar expressions or variations intended to identify forward-looking statements. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” included under Part II, Item 1A below, among others. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.

Overview

We are a leading provider of cloud-based platform solutions designed to help small- and medium-sized businesses, or SMBs, succeed online. Leveraging our proprietary technology platform, we serve approximately 5.4 million subscribers globally with a comprehensive and integrated suite of over 150 products and services that help SMBs get online, get found and grow their businesses. Historically, our products focused largely on web hosting and other basic web presence solutions such as domains, but over time we have expanded to offer security, site backup, premium domains, search engine optimization (“SEO”) and search engine marketing (“SEM”), Google Adwords, mobile solutions, social media enablement, website analytics, email marketing and productivity and e-commerce tools, among others. More recently, we have launched additional products and services, including website builders, mobile site builders and new hosting brands both to satisfy existing subscriber needs and to expand the product gateways through which new subscribers initially reach us. We refer to these newer products and services as our “gateway products”.

In February 2016, we acquired Constant Contact, Inc., or Constant Contact, a leading provider of online marketing tools that are designed for small organizations, for a total purchase price of approximately $1.1 billion. We have achieved better than expected integration-related cost synergies from our acquisition of Constant Contact, and now anticipate more than $70.0 million in annualized run rate cost savings by the end of 2016.

During the first half of 2016, we made significant investments in marketing for our gateway products. The gateway products had higher subscriber acquisition costs and higher initial subscriber churn than we originally anticipated. In response to these results, we significantly reduced our marketing investments during the third quarter of 2016 for most of our poorly performing gateway products and focused our gateway investments on our site builder products. This reduced marketing investment, combined with a higher than expected churn rate, led to a significant decrease in subscribers for certain gateway brands.

We have certain hosting and other brands to which we no longer allocate significant marketing or other funds. These brands generally have healthy free cash flow, but we do not consider them strategic or growth priorities. Subscriber counts for these non-strategic

 

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brands are decreasing. While our more strategic brands, in the aggregate, showed net subscriber adds during the quarter ended September 30, 2016, the net subscriber losses in non-strategic brands and certain gateway brands contributed to a decrease in our total subscribers of approximately 42,000 during the quarter. We expect that total subscribers will continue to decrease in the near term.

Overall, our core hosting and web presence business showed relatively slow revenue and subscriber growth during the first nine months of 2016. We believe that this is due to flat marketing expenditures relative to 2015 levels on this business in the first half of 2016 as a result of our focus on gateway products during that period, and to trends in the competitive landscape, including greater competition for referral sources and an increasing trend among consumers to search for web presence and marketing solutions using brand-related search terms rather than generic search terms such as “shared hosting” or “website builder”. We believe this trend assists competitors who have focused more heavily than we have on building consumer awareness of their brand, and that it has made it more challenging and more expensive for us to attract new subscribers. In order to address this trend, during the third quarter of 2016, we began to allocate additional marketing investment to a subset of our hosting brands, including our largest brands, Bluehost.com, HostGator and iPage. We plan to continue this increased level of marketing investment in the near term, and are evaluating different marketing strategies aimed at increasing brand awareness.

On July 13, 2016, WZ UK completed a restructuring pursuant to which Pseudio Limited and Resume Labs became wholly-owned subsidiaries of WZ UK. As a result of the restructuring, WZ UK became the 100% owner of Pseudio Limited and Resume Labs Limited and our ownership of WZ UK was diluted from 77.5% to 76.4%. Immediately subsequent to the restructuring, the Company acquired an additional 10% stake in WZ UK on July 13, 2016 for $18.0 million, bringing our aggregate stake in WZ UK to 86.4%. The restructuring significantly reduced the potential redemption amount payable to the minority shareholders, and gave us the flexibility to reduce investments in this business. Based on these reduced investments, the estimated value of the non-controlling interest is below the expected redemption amount of $25.0 million, which will result in $14.2 million of excess accretion that will reduce income available to common shareholders for the period starting on the date of the restructuring through the redemption date of July 1, 2017. We recognized excess accretion of $3.1 million for the three and nine months ended September 30, 2016, which is reflected in net income (loss) attributable to accretion of non-controlling interest in our consolidated statements of operations and comprehensive loss.

The acquisition of Constant Contact, our increase in debt service related to the Constant Contact acquisition, our investments in our gateway products, and increases in stock-based compensation and impairment charges have had a material effect on our recent financial results. Changes in several key financial metrics are summarized below (in thousands):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2015      2016      2015      2016  

Revenue

   $ 188,523       $ 291,193       $ 548,272       $ 819,019   

Net loss

   $ (15,351    $ (29,798    $ (16,538    $ (49,147

Net cash provided by operating activities

   $ 37,582       $ 36,189       $ 133,814       $ 101,804   

Our revenue grew from $188.5 million for the three months ended September 30, 2015 to $291.2 million for the three months ended September 30, 2016. Our revenue grew from $548.3 million for the nine months ended September 30, 2015 to $819.0 million for the nine months ended September 30, 2016. Substantially all of this this revenue growth was due primarily to the Constant Contact acquisition and to other acquisitions that closed since September 30, 2015.

Revenue attributable to our business, excluding the effect of Constant Contact and other acquisitions, was negatively impacted by a number of factors, including: flat marketing expenditures on core hosting and web presence brands during the first half of 2016; reallocation of marketing expenditures on gateway products due to higher than expected subscriber acquisition costs and subscriber churn; and competitive trends, as discussed above. As noted above, we are evaluating new marketing programs and strategies intended to address these issues, including programs to increase brand awareness for key strategic brands, which may include media purchases. In the near term, we expect revenue growth, excluding the impact of acquisitions, to be relatively flat.

If we are not successful in addressing the factors that have contributed to our decrease in revenue and subscriber growth, we may neither be able to return to prior levels of subscriber and revenue growth, nor be able to maintain current subscriber and revenue levels, which could result in a material adverse effect on our business and financial results.

Our net loss grew from $15.4 million for the three months ended September 30, 2015 to $29.8 million for the three months ended September 30, 2016, and from $16.5 million for the nine months ended September 30, 2015 to $49.1 million for the nine months ended September 30, 2016. These increases were primarily the result of increased costs incurred in connection with the acquisition of Constant Contact, including interest expense, transaction costs, amortization of intangible assets and restructuring costs;

 

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increased stock-based compensation expense, including expense related to a performance based grant of restricted stock to our CEO in the third quarter of 2015; increased marketing expenses, primarily related to new gateway product launches; and the impairment charges discussed above.

Cash provided by operations decreased by $1.4 million for the three months ended September 30, 2016, and decreased $32.0 million for the nine months ended September 30, 2016. The decrease for the three and nine-month period is primarily due to transaction and restructuring costs incurred to acquire Constant Contact, higher marketing costs to promote gateway products exceeding the operating cash flows contributed by Constant Contact, and increased interest expense due to the debt incurred in connection with the acquisition of Constant Contact.

Key Metrics

We use a number of metrics, including the following key metrics, to evaluate the operating and financial performance of our business, identify trends affecting our business, develop projections and make strategic business decisions:

 

    total subscribers;

 

    average revenue per subscriber (“ARPS”);

 

    adjusted EBITDA; and

 

    free cash flow.

Adjusted EBITDA and free cash flow are non-GAAP financial measures. A non-GAAP financial measure is a numerical measure of a company’s operating performance, financial position or cash flow that includes or excludes amounts that are included or excluded from the most directly comparable measure calculated and presented in accordance with GAAP. Our non-GAAP financial measures may not provide information that is directly comparable to that provided by other companies in our industry, as other companies in our industry may calculate non-GAAP financial results differently. In addition, there are limitations in using non-GAAP financial measures because they are not prepared in accordance with GAAP and exclude expenses that may have a material impact on our reported financial results. For example, adjusted EBITDA excludes interest expense, which has been and will continue to be for the foreseeable future a significant recurring expense in our business. The presentation of non-GAAP financial information is not meant to be considered in isolation from, or as a substitute for, the directly comparable financial measures prepared in accordance with GAAP. We urge you to review the additional information about adjusted EBITDA and free cash flow shown below, including the reconciliations of these non-GAAP financial measures to their comparable GAAP financial measures, and not to rely on any single financial measure to evaluate our business.

The following table summarizes these key metrics for the periods presented (in thousands, except ARPS):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2015      2016      2015      2016  

Financial and other metrics:

           

Total subscribers

     4,482         5,439         4,482         5,439   

Average subscribers for the period

     4,438         5,460         4,275         5,296   

ARPS

   $ 14.16       $ 17.78       $ 14.25       $ 17.18   

Adjusted EBITDA

   $ 53,842       $ 85,213       $ 156,768       $ 201,423   

Free cash flow

   $ 27,872       $ 26,357       $ 107,720       $ 68,115   

Figures for the nine months ended September 30, 2016 include the impact of Constant Contact since February 10, 2016, the day after the closing of the acquisition.

Total Subscribers

We define total subscribers as the approximate number of subscribers that, as of the end of a period, are identified as subscribing directly to our products on a paid basis, excluding accounts that access our solutions via resellers or that purchase only domain names from us. Subscribers of more than one brand, and subscribers with more than one distinct billing relationship or subscription with us, are counted as separate subscribers. Total subscribers for a period reflects adjustments to add or subtract subscribers as we integrate acquisitions and/or are otherwise able to identify subscribers that meet, or do not meet, this definition of total subscribers.

 

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Our total subscriber base increased from 4.5 million as of September 30, 2015 to 5.4 million as of September 30, 2016, an increase of approximately 0.9 million. Of this 0.9 million increase, approximately 724,000, or 76%, consisted of subscribers we acquired from companies we purchased between September 30, 2015 and September 30, 2016, including approximately 566,000 subscribers acquired in our Constant Contact acquisition; approximately 85,000, or 9%, consisted of the adjustments described above; and approximately 147,000, or 15%, was attributable primarily to new product introductions and marketing efforts.

We experienced a decrease of approximately 42,000 in total subscribers during the three months ended September 30, 2016, as compared to a net increase in total subscribers for the three months ended September 30, 2015, and a lower net increase in total subscribers during the nine months ended September 30, 2016, as compared to the nine months ended September 30, 2015. We believe several factors contributed to the decrease in total subscribers during the third quarter of 2016: the reallocation of our marketing spend away from underperforming gateway products in the first half of the year; higher than expected churn in certain gateway products; higher than expected customer acquisition costs; the impact of less strategic brands as discussed in the “Overview” section above; and competitive factors, including trends toward brand rather than generic search terms, which has favored companies who have invested more heavily than we have in building brand awareness. We expect that our total subscribers will continue to decrease in the near term.

If we are not successful in addressing the factors that have contributed to our decrease in total subscribers or in maintaining or improving our current levels of subscriber churn, we may not be able to return to or maintain positive subscriber or revenue growth in the future, which could result in a material adverse effect on our business and financial results.

Average Revenue per Subscriber

Average revenue per subscriber, or ARPS, is a non-GAAP financial measure that we calculate as the amount of revenue we recognize in a period, including marketing development funds and other revenue not received from subscribers, divided by the average of the number of total subscribers at the beginning of the period and at the end of the period, which we refer to as average subscribers for the period. We believe ARPS is an indicator of our ability to optimize our mix of products and services and pricing and sell products and services to new and existing subscribers. As we on-board new subscribers, we typically on-board them at introductory prices, which negatively impacts ARPS. Furthermore, ARPS can be impacted by our acquisitions due to acquisition-related purchase accounting charges and since the acquired subscribers may have higher or lower than average ARPS, and by adjustments to our total subscribers figure as described above.

ARPS does not represent an exact measure of the average amount a subscriber spends with us each month, since our calculation of ARPS is impacted by revenue generated by non-subscribers. We have three principal sources of non-subscriber revenue: revenue attributable to customers who purchase only a domain name from us and do not purchase any other products, or domain-only customers, domain monetization revenue, and marketing development funds.

Domain monetization revenue consists principally of revenue from our BuyDomains brand, which provides premium domain name products and services, and, to a lesser extent, revenue from advertisements placed on unused domains (often referred to as “parked” pages) owned by us or our customers. Historically, the contribution of domain monetization activities to our revenue and adjusted revenue has been insignificant, but increased starting in 2014 primarily due to our acquisition of BuyDomains in September 2014. Our domain monetization revenue was $10.2 million and $6.4 million for the three months ended September 30, 2015 and 2016, respectively, and its exclusion from our ARPS calculation would have resulted in ARPS being $0.76 and $0.39 lower for those periods, respectively. Our domain monetization revenue was $29.7 million and $22.4 million for the nine months ended September 30, 2015 and 2016, respectively, and its exclusion from our ARPS calculation would have resulted in ARPS being $0.77 and $0.47 lower for those periods, respectively.

Marketing development funds are amounts that certain of our partners pay us to assist in and incentivize our marketing of their products. Our marketing development fund revenue was $3.3 million and $2.1 million for the three months ended September 30, 2015 and 2016, respectively, and its exclusion from our ARPS calculation would have resulted in ARPS being $0.25 and $0.13 lower for those periods, respectively. Our marketing development fund revenue was $8.8 million and $6.9 million for the nine months ended September 30, 2015 and 2016, respectively, and its exclusion from our ARPS calculation would have resulted in ARPS being $0.23 and $0.14 lower for those periods, respectively.

Although we are able to measure the total amount of our revenue from domains, we are not able to further break down domain revenue into revenue from domain-only customers versus revenue from customers who purchase domains from us in addition to other products. Total revenue from domains was $31.8 million and $31.8 million for the three months ended September 30, 2015 and 2016, respectively. Total revenue from domains was $92.9 million and $97.0 million for the nine months ended September 30, 2015 and 2016, respectively.

 

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A portion of our revenue is generated from customers that resell our services. We refer to these customers as “resellers.” We consider these resellers (rather than the end user customers of these resellers) to be subscribers under our total subscribers’ definition, because we do not have a billing relationship with the end users and cannot determine the number of end users acquiring our services through a reseller. Additionally, a majority of our reseller revenues is for the purchase of domains and are included in the figures for adjusted revenue from domains shown above. Total revenue from resellers, excluding the portion that relates to domains, for the three months ended September 30, 2015 and 2016 was $5.5 million and $6.8 million, respectively. Total revenue from resellers, excluding the portion that relates to domains, for the nine months ended September 30, 2015 and 2016 was $18.8 million and $19.9 million, respectively.

ARPS increased from $14.16 to $17.78 for the three months ended September 30, 2015 and 2016, respectively, and $14.25 to $17.18 for the nine months ended September 30, 2015 and 2016, respectively. This increase in ARPS was driven by the acquisition of Constant Contact, which has higher ARPS than the rest of our business, partially offset by positive adjustments to our total subscriber figure, a decrease in domain monetization revenues, and subscribers coming to our platform through gateway products and simplified web presence solutions, most of which are lower priced than our core hosting and web presence offerings,.

ARPS excluding Constant Contact decreased from $14.16 to $13.25 for the three months ended September 30, 2015 and 2016, respectively, and $14.25 to $13.58 for the nine months ended September 30, 2015 and 2016. This decrease in ARPS was primarily driven by a decrease in domain monetization and marketing development funds revenue, subscribers coming to our platform through gateway products and simplified web presence solutions, most of which are lower priced than our core hosting and web presence offerings.

The following table reflects the calculation of ARPS (all data in thousands, except ARPS data):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2015      2016      2015      2016  

Revenue

   $ 188,523       $ 291,193       $ 548,272       $ 819,019   

Total subscribers

     4,482         5,439         4,482         5,439   

Average subscribers for the period

     4,438         5,460         4,275         5,296   

Average revenue per subscriber (ARPS)

   $ 14.16       $ 17.78       $ 14.25       $ 17.18   

Revenue attributable to Constant Contact

   $ —         $ 95,918       $ —         $ 229,655   
  

 

 

    

 

 

    

 

 

    

 

 

 

Revenue excluding Constant Contact

   $ 188,523       $ 195,275       $ 548,272       $ 589,364   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total subscribers excluding Constant Contact

     4,482         4,893         4,482         4,893   

Average subscribers excluding Constant Contact

     4,438         4,911         4,275         4,821   

ARPS excluding Constant Contact

   $ 14.16       $ 13.25       $ 14.25       $ 13.58   

 

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Adjusted EBITDA

Adjusted EBITDA is a non-GAAP financial measure that we now calculate as net income (loss), excluding the impact of interest expense (net), income tax expense (benefit), depreciation, amortization of other intangible assets, stock-based compensation, restructuring expenses, transaction expenses and charges, (gain) loss of unconsolidated entities, and impairment of other long-lived assets. We view adjusted EBITDA as a performance measure and believe it helps investors evaluate and compare our core operating performance from period to period.

The following table reflects a reconciliation of net loss calculated in accordance with GAAP to adjusted EBITDA (all data in thousands):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2015      2016      2015      2016  
     (in thousands)  

Net loss

   $ (15,351    $ (29,798    $ (16,538    $ (49,147

Interest expense, net (including impact of amortization of deferred financing costs and original issuance discounts)

     14,517         41,046         42,640         112,135   

Income tax expense (benefit)

     5,397         (7,387      9,082         (121,220

Depreciation

     8,554         17,010         24,649         46,942   

Amortization of other intangible assets

     23,758         37,982         67,191         105,679   

Stock-based compensation

     9,762         14,806         20,272         48,218   

Restructuring expenses

     1,194         6,377         1,194         23,642   

Transaction expenses and charges

     1,461         159         4,602         32,257   

(Gain) loss of unconsolidated entities (1)

     4,550         5,018         3,676         (5,368

Impairment of other long-lived assets

     —           —           —           8,285   

Adjusted EBITDA

   $ 53,842       $ 85,213       $ 156,768       $ 201,423   

 

(1) The (gain) loss of unconsolidated entities is reported on a net basis for the three and nine months ended September 30, 2016. The three months ended September 30, 2016 includes a loss of $4.8 million on our investment in AppMachine. This loss was generated on July 27, 2016, when we increased our ownership stake in AppMachine from 40% to 100%, which required a revaluation of our existing investment to its implied fair value. The three months ended September 30, 2016 also includes a net loss of $0.2 million from our proportionate share of net losses from unconsolidated entities. The nine months ended September 30, 2016 includes an $11.4 million gain on our investment in WZ UK. This gain was generated on January 6, 2016, when we increased our ownership stake in WZ UK from 49% to 57.5%, which required a revaluation of our existing investment to its implied fair value. This $11.4 million gain was partially offset by the loss on AppMachine and by our proportionate share of net losses from unconsolidated entities of $1.2 million.

Net loss grew from $15.4 million for the three months ended September 30, 2015 to $29.8 million for the three months ended September 30, 2016. This increase was primarily the result of costs incurred in connection with our acquisition of Constant Contact, including increased interest expense of $26.5 million, increased amortization of intangible assets of $14.2 million and increased restructuring expenses of $5.2 million. Additionally, we incurred stock-based compensation expenses of $5.0 million during the period due to increased grants of awards, including a performance based grant of restricted stock to our CEO in the third quarter of 2015. We also increased our marketing expenses, primarily related to new gateway product launches, resulting in $15.2 million of higher marketing costs (excluding marketing costs related to Constant Contact). These increases in our expenses have been partially offset by an income tax benefit of $7.4 million, and by increased operating profit due to the acquisition of Constant Contact.

Net loss grew from $16.5 million for the nine months ended September 30, 2015 to $49.1 million for the nine months ended September 30, 2016. Most of this increase was the result of increased costs incurred primarily in connection with our acquisition of Constant Contact, including increased interest expense of $69.5 million, increased transaction costs of $27.7 million, increased amortization of intangible assets of $38.5 million and restructuring expenses of $22.4 million to integrate operations. Additionally, we incurred higher stock-based compensation expenses of $27.9 million due to increased grants of awards, including a performance based grant of restricted stock to our CEO in the third quarter of 2015. We have also increased our marketing expenses, primarily related to new gateway product launches, resulting in $53.2 million of higher marketing costs (excluding marketing costs related to Constant Contact), and incurred impairment charges totaling $8.3 million. These increases in our costs have been partially offset by an income tax benefit of $121.2 million and by increased operating profit due primarily to the acquisition of Constant Contact, and to a lesser extent to growth in other parts of our business.

 

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Adjusted EBITDA increased from $53.8 million for the three months ended September 30, 2015 to $85.2 million for the three months ended September 30, 2016. Substantially all of this increase is attributable to the acquisition of Constant Contact. This increase was partially offset by increased marketing and other operating expenses related to gateway products.

Adjusted EBITDA increased from $156.8 million for the nine months ended September 30, 2015 to $201.4 million for the nine months ended September 30, 2016. This increase is primarily attributable to the acquisition of Constant Contact, and to a lesser extent, growth in other parts of the business. This increase was partially offset by increased marketing and other operating expenses to launch new gateway products.

Adjusted EBITDA for the three and nine months ended September 30, 2016 was adversely impacted by a purchase accounting adjustment for acquisitions, primarily related to the acquisition of Constant Contact, to reflect the reduction of post-acquisition revenue from the write-down of deferred revenue to fair value as of the acquisition date. This purchase accounting adjustment was $1.5 million and $19.2 million for the three and nine months ended September 30, 2016 as compared to $1.8 million and $4.0 million for the three and nine months ended September 30, 2015, respectively. We do not expect a material impact to adjusted EBITDA from the Constant Contact purchase accounting adjustment in future periods.

Free Cash Flow

For a discussion of free cash flow, see Liquidity and Capital Resources.

Components of Operating Results

Revenue

We generate revenue primarily from selling subscriptions for our cloud-based products and services. The subscriptions we offer are similar across all of our brands and are provided under contracts pursuant to which we have ongoing obligations to support the subscriber. These contracts are generally for service periods of up to 36 months and typically require payment in advance at the time of initiating the subscription for the entire subscription period. Typically, we also have arrangements in place to automatically renew a subscription at the end of the subscription period. Due to factors such as introductory pricing, our renewal fees may be higher than our initial subscription. We sell more subscriptions with 12 month terms than with any other term length. We also earn revenue from the sale of domain name registrations, premium domains and non-term based products and services, such as certain online security products and professional technical services as well as through referral fees and commissions.

Cost of Revenue

Cost of revenue includes costs of operating our subscriber support organization, fees we pay to register domain names for our subscribers, costs of operating our data center infrastructure, such as technical personnel costs associated with monitoring and maintaining our network operations, fees we pay to third-party product and service providers, and merchant fees we pay as part of our billing processes. We also allocate to cost of revenue the depreciation and amortization related to these activities and the intangible assets we have acquired, as well as a portion of our overhead costs attributable to our employees engaged in subscriber support activities. In addition, cost of revenue includes stock-based compensation expense for employees engaged in support and network operations. Cost of revenue may increase or decrease as a percentage of revenue in a given period, depending on our ability to manage our infrastructure costs, in particular with respect to data centers and support, the amount of third-party product and services that we sell and as a result of our amortization expense related to acquisitions.

Gross Profit

Gross profit is the difference between revenue and cost of revenue. Gross profit has fluctuated from period to period in large part as a result of revenue and cost of revenue adjustments from purchase accounting impacts related to acquisitions, as well as revenue and cost of revenue impacts from growth in our business. With respect to revenue, the application of purchase accounting requires us to record purchase accounting adjustments for acquired deferred revenue, which reduces the revenue recorded from acquisitions for a period of time after the acquisition. The impact generally normalizes within a year following the acquisition. With respect to cost of revenue, the application of purchase accounting requires us to defer domain registration costs, which reduces cost of revenue, and record long-lived assets at fair value, which increases cost of revenue through an increase in amortization expense over the estimated useful life of the long-lived assets. In addition, our revenue and our cost of revenue have increased in recent years as our subscriber base has expanded. For a new subscriber that we bring on to our platform, we typically recognize revenue over the term of the subscription, even though we collect the subscription fee at the initial billing. As a result, our gross profit may be affected by the prices we charge for our subscriptions, as well as by the number of new subscribers and the terms of their subscriptions.

 

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Operating Expense

We classify our operating expense into three categories: sales and marketing, engineering and development, and general and administrative. Although our operating expenses have increased as a result of the Constant Contact acquisition, we are implementing programs that we expect to result in over $70.0 million of annual run rate cost reductions for the combined business. We anticipate that these cost reductions will be fully implemented by the end of 2016, with a majority impacting operating expenses. In connection with these cost reduction plans, we have incurred approximately $22.0 million of restructuring charges through September 30, 2016. We expect that a significant majority of the restructuring charges will be incurred in fiscal year 2016.

Sales and Marketing

Sales and marketing expense primarily consists of costs associated with bounty payments to our network of online partners, SEM and SEO, general awareness and brand building activities, as well as the cost of employees engaged in sales and marketing activities. Sales and marketing expense also includes costs associated with sales of products as well as stock-based compensation expense for employees engaged in sales and marketing activities. Sales and marketing expense as a percentage of revenue may increase or decrease in a given period, depending on the cost of attracting new subscribers to our solutions, changes in how we invest in different subscriber acquisition channels, changes in how we approach search engine marketing and search engine optimization and the extent of general awareness and brand building activities we may undertake, as well as the efficiency of our sales and support personnel and our ability to sell more products and services to our subscribers and drive favorable returns on invested marketing dollars.

Engineering and Development

Engineering and development expense includes the cost of employees engaged in enhancing our technology platform and our systems, developing and expanding product and service offerings, and integrating technology capabilities from our acquisitions. Engineering and development expense includes stock-based compensation expense for employees engaged in engineering and development activities. Our engineering and development expense does not include costs of leasing and operating our data center infrastructure, such as technical personnel costs associated with monitoring and maintaining our network operations and fees we pay to third-party product and service providers, which are included in cost of revenue.

General and Administrative

General and administrative expense includes the cost of employees engaged in corporate functions, such as finance, human resources, legal affairs and general management. General and administrative expense also includes all facility and related overhead costs not allocated to cost of revenue, as well as insurance premiums and professional service fees. General and administrative expense includes stock-based compensation expense for employees engaged in general and administrative activities.

Other Income (Expense)

Other income (expense) consists primarily of costs related to, and interest paid on, our indebtedness. We include the cash cost of interest payments and loan financing fees, the amortization of deferred financing costs and the amortization of the net present value adjustment which we may apply to some deferred consideration payments related to our acquisitions in our calculation of interest expense. Interest income consists primarily of interest income earned on our cash and cash equivalents balances. Our interest expense may increase in future periods if we continue to finance acquisitions through the issuance of debt. We expect our interest expense to increase in future periods, as compared to our interest expense in previous years, as a result of the financing transactions we entered into in connection with our acquisition of Constant Contact. Other income (expense) also includes gains or losses recognized on investments in unconsolidated entities.

Income Tax Expense (Benefit)

We estimate our income taxes in accordance with the asset and liability method, under which deferred tax assets and liabilities are recognized based on temporary differences between the assets and liabilities in our consolidated financial statements and the financial statements that are prepared in accordance with tax regulations for the purpose of filing our income tax returns, using statutory tax rates. This methodology requires us to record a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

 

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Critical Accounting Policies and Estimates

We prepare our consolidated financial statements in accordance with U.S. GAAP. The preparation of our consolidated financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expense during the reported periods. We base our estimates, judgments and assumptions on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our actual results may differ from the estimates, judgments and assumptions made by our management. To the extent that there are differences between our estimates, judgments and assumptions and our actual results, our future financial statement presentation, financial condition, results of operations and cash flows may be affected.

We believe that our critical accounting policies and estimates are the assumptions and estimates associated with the following:

 

    revenue recognition,

 

    goodwill,

 

    long-lived assets,

 

    derivative instruments,

 

    depreciation and amortization,

 

    income taxes, and

 

    stock-based compensation arrangements.

There have been no material changes to our critical accounting policies since December 31, 2015. For further information on our critical accounting policies and estimates, see Note 2 to the consolidated financial statements appearing in Part I, Item 1 in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K filed with the Securities and Exchange Commission, or the SEC, on February 29, 2016.

 

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Results of Operations

The following tables set forth our results of operations for the periods presented. The period-to-period comparison of financial results is not necessarily indicative of future results.

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2015      2016      2015      2016  

Revenue

   $ 188,523       $ 291,193       $ 548,272       $ 819,019   

Cost of revenue

     110,773         149,427         316,684         438,980   
  

 

 

    

 

 

    

 

 

    

 

 

 

Gross profit

     77,750         141,766         231,588         380,039   
  

 

 

    

 

 

    

 

 

    

 

 

 

Operating expense:

           

Sales and marketing

     37,523         75,341         109,791         234,944   

Engineering and development

     7,902         23,988         19,906         67,930   

General and administrative

     21,751         33,399         58,429         108,508   

Transactions and expenses

     1,461         159         4,602         32,257   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total operating expense

     68,637         132,887         192,728         443,639   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income (loss) from operations

     9,113         8,879         38,860         (63,600
  

 

 

    

 

 

    

 

 

    

 

 

 

Other income (expense):

           

Other income (expense)

     —           (4,845      5,440         6,565   

Interest income

     107         162         316         438   

Interest expense

     (14,624      (41,208      (42,956      (112,573
  

 

 

    

 

 

    

 

 

    

 

 

 

Total other expense—net

     (14,517      (45,891      (37,200      (105,570
  

 

 

    

 

 

    

 

 

    

 

 

 

Income (loss) before income taxes and equity earnings of unconsolidated entities

     (5,404      (37,012      1,660         (169,170

Income tax expense (benefit)

     5,397         (7,387      9,082         (121,220
  

 

 

    

 

 

    

 

 

    

 

 

 

Loss before equity earnings of unconsolidated entities

     (10,801      (29,625      (7,422      (47,950

Equity loss of unconsolidated entities, net of tax

     4,550         173         9,116         1,197   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net loss

   $ (15,351    $ (29,798    $ (16,538    $ (49,147

Net loss attributable to non-controlling interest

     —           (1,206      —           (14,326

Excess accretion of non-controlling interest

     —           3,145         —           3,145   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total net income (loss) attributable to non-controlling interest

     —           1,939         —           (11,181
  

 

 

    

 

 

    

 

 

    

 

 

 

Net loss attributable to Endurance International Group Holdings, Inc.

   $ (15,351    $ (31,737    $ (16,538    $ (37,966
  

 

 

    

 

 

    

 

 

    

 

 

 

Comparison of Three Months Ended September 30, 2015 and 2016

Revenue

 

     Three Months Ended
September 30,
     Change  
     2015      2016      Amount      %  
     (dollars in thousands)  

Revenue

   $ 188,523       $ 291,193       $ 102,670         54

Revenue increased by $102.7 million, or 54%, from $188.5 million for the three months ended September 30, 2015 to $291.2 million for the three months ended September 30, 2016. Almost all of this increase, or $102.1 million, is attributable to revenue, including growth and synergies, from acquisitions of businesses that were not part of our business for the three months ended September 30, 2015, principally Constant Contact. See “Overview” for further information on our year-over-year revenue growth rate for our business excluding the impact of Constant Contact and other acquisitions.

Our revenue is generated primarily from our products and services delivered on a subscription basis, which include web hosting, domains, website builders, search engine marketing and other similar services. We also generate non-subscription revenue through domain monetization and marketing development funds. Non-subscription revenue decreased from $13.5 million, or 7% of total revenue for the three months ended September 30, 2015 to $8.5 million, or 3% of total revenue for the three months ended September 30, 2016, due primarily to a decrease in domain monetization revenue. Domain monetization revenue has decreased primarily due to a reduced portfolio of premium domains available for sale.

 

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Cost of Revenue

 

     Three Months Ended
September 30,
       
     2015     2016     Change  
     Amount      % of
Revenue
    Amount      % of
Revenue
    Amount      %  
     (dollars in thousands)  

Cost of revenue

   $ 110,773         59   $ 149,427         51   $ 38,654         35

Cost of revenue increased by $38.7 million, or 35%, from $110.8 million for the three months ended September 30, 2015 to $149.4 million for the three months ended September 30, 2016. Of this increase, $42.8 million was due to increases in cost of revenue attributable to Constant Contact, including amortization expense of $18.3 million. This increase was partially offset by a $4.0 million decrease in amortization expense related to acquisitions before January 1, 2016.

Our cost of revenue contains a significant portion of non-cash expenses, in particular amortization expense for the intangible assets we have acquired through our acquisitions and the acquisition in December 2011 by investment funds and entities affiliated with Warburg Pincus and Goldman, Sachs & Co. of a controlling interest in us. The following table sets forth the significant non-cash components of cost of revenue.

 

     Three Months Ended
September 30,
 
     2015      2016  
     (in thousands)  

Amortization expense

   $ 23,758       $ 37,982   

Depreciation expense

   $ 7,801       $ 12,512   

Stock-based compensation expense

   $ 601       $ 1,643   

Gross Profit

 

     Three Months Ended
September 30,
              
     2015     2016     Change  
     Amount      % of
Revenue
    Amount      % of
Revenue
    Amount      %  
     (dollars in thousands)  

Gross profit

   $ 77,750         41   $ 141,766         49   $ 64,016         82

Gross profit increased by $64.0 million, or 82%, from $77.8 million for the three months ended September 30, 2015 to $141.8 million for the three months ended September 30, 2016. Of this increase, $53.2 million was due to gross profit contribution attributable to Constant Contact. Of the remaining $10.8 million increase, $6.8 million is primarily attributable to increases in our subscriber base, including acquired subscribers from acquisitions other than Constant Contact, $4.0 million is attributable to a decrease in amortization expense related to acquisitions before January 1, 2016, and $3.5 million is attributable to a decrease in integration and synergy charges, excluding Constant Contact. Our gross profit as a percentage of revenue increased by eight percentage points from 41% for the three months ended September 30, 2015 to 49% for the three months ended September 30, 2016, mainly due to the acquisition of Constant Contact, since Constant Contact products generally have a higher gross profit percentage as compared to our other products.

The following table sets forth gross profit and the significant non-cash components of cost of revenue as a percentage of revenue:

 

     Three Months Ended
September 30,
 
     2015     2016  
     (dollars in thousands)  

Revenue

   $ 188,523      $ 291,193   

Gross profit

   $ 77,750      $ 141,766   

Gross profit as % of revenue

     41     49

Amortization expense as % of revenue

     13     13

Depreciation expense as % of revenue

     4     4

Stock-based compensation expense as % of revenue

              

 

* Less than 1%.

 

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Operating Expense

 

     Three Months Ended September 30,              
     2015     2016     Change  
     Amount      %
of Revenue
    Amount      %
of Revenue
    Amount     %  
     (dollars in thousands)  

Sales and marketing

   $ 37,523         20   $ 75,341         26   $ 37,818        101

Engineering and development

   $ 7,902         4   $ 23,988         8     16,086        204

General and administrative

   $ 21,751         12   $ 33,399         11     11,648        54

Transaction expenses

   $ 1,461         1   $ 159         0     (1,302     (89 )% 
  

 

 

      

 

 

      

 

 

   

Total

   $ 68,637         36   $ 132,887         46   $ 64,250        94
  

 

 

      

 

 

      

 

 

   

Sales and Marketing. Sales and marketing expense increased by $37.8 million, or 101%, from $37.5 million for the three months ended September 30, 2015 to $75.3 million for the three months ended September 30, 2016. Of this increase, $22.6 million was due to increases in sales and marketing expense attributable to Constant Contact. Of the remaining $15.2 million increase, $13.7 million was primarily attributable to launches of new products. In addition, the increase included a $0.7 million increase in stock-based compensation expense.

Engineering and Development. Engineering and development expense increased by $16.1 million, or 204%, from $7.9 million for the three months ended September 30, 2015 to $24.0 million for the three months ended September 30, 2016. Of this increase, $13.0 million was due to increases in engineering and development expense attributable to Constant Contact. The remaining increase of $3.1 million was primarily due to increase in stock-based compensation expense of $3.5 million.

General and Administrative. General and administrative expense increased by $11.6 million, or 54%, from $21.8 million for the three months ended September 30, 2015 to $33.4 million for the three months ended September 30, 2016. Of this increase, $6.8 million was due to increases in general and administrative expense attributable to Constant Contact. The remaining period-over-period increase of $4.8 million was primarily due to $2.0 million in additional payroll and labor costs due to an increase in headcount, and additional legal fees of $1.3 million, principally related to expenses for the Endurance and Constant Contact SEC subpoenas and securities class action lawsuits.

Transaction Expenses. Transaction expenses decreased by $1.3 million, or 89%, from $1.5 million for the three months ended September 30, 2015 to $0.2 million for the three months ended September 30, 2016. The period-over-period decrease was primarily attributable to the fact that we reduced our acquisition spending following the purchase of Constant Contact.

Other Income (Expense), Net

 

     Three Months Ended September 30,      Change  
     2015      2016      Amount      %  
     (dollars in thousands)  

Other income (expense), net

   $ (14,517    $ (45,891    $ (31,374      216

Other expense, net increased by $31.4 million, or 216%, from $14.5 million for the three months ended September 30, 2015 to $45.9 million for the three months ended September 30, 2016. The increase was primarily due to a $23.4 million increase in interest expense, including service fees, related to our Senior Credit Facilities and Notes during the three months ended September 30, 2016 as compared with the three months ended September 30, 2015. Additionally, there was an increase of $1.7 million in amortization of deferred financing fees, an increase of $0.8 million of original issue discounts, and an increase in the of accretion of present value for the deferred consideration related to the Webzai, BuyDomains and Ace Data Center acquisitions of $0.6 million. Additionally, upon the acquisition of AppMachine, we recognized a loss of $4.9 million that was calculated based on the implied fair value of the investment, which was recorded in other income.

 

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Income Tax Expense (Benefit)

 

     Three Months Ended
September 30,
     Change  
     2015      2016      Amount      %  
     (dollars in thousands)  

Income tax expense (benefit)

   $ 5,397         (7,387    $ (12,784      (237 )% 

Prior to the acquisition of Constant Contact, we maintained a valuation allowance against certain deferred tax assets. The acquisition of Constant Contact resulted in a significant increase in deferred tax liabilities, which far exceeded pre-acquisition deferred tax assets. With the significant deferred tax liabilities resulting from Constant Contact acquisition, we scheduled out the reversal of the consolidated US deferred tax assets and liabilities as of March 31, 2016, and determined that these reversals would be sufficient to realize most domestic deferred tax assets. The deferred tax liabilities supporting the realizability of these deferred tax assets in the acquisition will reverse in the same period, are in the same jurisdiction and are of the same character as the temporary differences that gave rise to these deferred tax assets. As a result, we recorded a tax benefit of $72.8 million to reverse valuation allowances during the nine months ended September 30, 2016.

For the three months ended September 30, 2015 and 2016, we recognized tax expense of $5.4 million and a tax benefit of $7.4 million, respectively, in the consolidated statements of operations and comprehensive loss. The income tax benefit for the three months ended September 30, 2016 was primarily attributable to a federal and state deferred tax benefit of $9.1 million and a benefit for federal and state current income taxes of $0.1 million, partially offset by a $1.6 million deferred tax expense for the reversal of the valuation allowance, a foreign deferred tax expense of $0.0 million and a foreign current tax expense of $0.3 million. The income tax expense for the three months ended September 30, 2015 is primarily attributable to federal and state current income taxes of $1.1 million, foreign current tax expense of $0.7 million, federal and state deferred tax expense of $3.0 million related to an increase in deferred liabilities and a $0.6 million increase of the valuation allowance.

Comparison of Nine Months Ended September 30, 2015 and 2016

Revenue

 

     Nine Months Ended
September 30,
     Change  
     2015      2016      Amount      %  
     (dollars in thousands)  

Revenue

   $ 548,272       $ 819,019       $ 270,747         49

Revenue increased by $270.7 million, or 49%, from $548.3 million for the nine months ended September 30, 2015 to $819.0 million for the nine months ended September 30, 2016. Of this increase, $257.2 million is attributable to revenue, including growth and synergies, from the acquisitions of other businesses that were not part of our business for the nine months ended September 30, 2015. The remaining balance of the increase, or $13.5 million, is primarily attributable to growth from other parts of our business.

Our revenue is generated primarily from our products and services delivered on a subscription basis, which include web hosting, domains, website builders, search engine marketing and other similar services. We also generate non-subscription revenue through domain monetization and marketing development funds. Non-subscription revenue decreased from $38.5 million, or 7% of total revenue for the nine months ended September 30, 2015 to $29.3 million, or 4% of revenue for the nine months ended September 30, 2016, due primarily to a decrease in domain monetization revenue. Domain monetization revenue has decreased primarily due to a reduced portfolio of premium domains available for sale.

Cost of Revenue

 

     Nine Months Ended September 30,               
     2015     2016     Change  
     Amount      %
of
Revenue
    Amount      %
of
Revenue
    Amount      %  
     (dollars in thousands)  

Cost of revenue

   $ 316,684         58   $ 438,980         54   $ 122,296         39

Cost of revenue increased by $122.3 million, or 39%, from $316.7 million for the nine months ended September 30, 2015 to $439.0 million for the nine months ended September 30, 2016. Of this increase, $114.0 million was due to increases in cost of revenue attributable to Constant Contact, including amortization expense of $46.4 million. Of the remaining $8.3 million, data center and support costs increased by $5.5 million, merchant fees and domain registration fees increased by $3.3 million and $3.4 million, respectively, and stock-based compensation increased by $2.8 million. These increases were offset by a decrease of $7.9 million attributable to a net decrease in amortization expense related to acquisitions before January 1, 2016.

 

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Our cost of revenue contains a significant portion of non-cash expenses, in particular amortization expense for the intangible assets we have acquired through our acquisitions and the acquisition by investment funds and entities affiliated with Warburg Pincus and Goldman, Sachs & Co on December 22, 2011 of a controlling interest in us. The following table sets forth the significant non-cash components of cost of revenue:

 

     Nine Months Ended
September 30,
 
     2015      2016  
     (dollars in thousands)  

Amortization expense

   $ 67,191       $ 105,679   

Depreciation expense

   $ 22,593       $ 36,818   

Stock-based compensation expense

   $ 1,360       $ 4,116   

Gross Profit

 

     Nine Months Ended September 30,               
     2015     2016     Change  
     Amount      %
of Revenue
    Amount      %
of Revenue
    Amount      %  
     (dollars in thousands)  

Gross profit

   $ 231,588         42   $ 380,039         46   $ 148,451         64

Gross profit increased by $148.5 million, or 64%, from $231.6 million for the nine months ended September 30, 2015 to $380.0 million for the nine months ended September 30, 2016. Approximately $115.7 million of this increase was attributable to Constant Contact. Of the remaining balance of $32.8 million, $40.7 million was due to an increase in our subscriber base, including acquired subscribers from acquisitions other than Constant Contact and subscribers resulting from the launch of new products. This increase was offset by a decrease of $7.9 million attributable to a net decrease in amortization expense related to acquisitions before January 1, 2016. Our gross profit as a percentage of revenue increased by four percentage points from 42% for the three months ended September 30, 2015 to 46% for the nine months ended September 30, 2016, mainly due to the acquisition of Constant Contact, since Constant Contact products generally have a higher gross profit percentage as compared to our other products. The following table sets forth gross profit and the significant non-cash components of cost of revenue as a percentage of revenue:

 

     Nine Months Ended
September 30,
 
     2015     2016  
     (dollars in thousands)  

Revenue

   $ 548,272      $ 819,019   

Gross profit

   $ 231,588      $ 380,039   

Gross profit % of revenue

     42     46

Amortization expense % of revenue

     12     13

Depreciation expense % of revenue

     4     4

Stock-based compensation expense % of revenue

            

 

* Less than 1%.

Operating Expense

 

     Nine Months Ended September 30,               
     2015     2016     Change  
     Amount      %
of Revenue
    Amount      %
of Revenue
    Amount      %  
     (dollars in thousands)  

Sales and marketing

   $ 109,791         20   $ 234,944         29   $ 125,153         114

Engineering and development

     19,906         4     67,930         8     48,024         241

General and administrative

     58,429         11     108,508         13     50,079         86

Transaction expense

     4,602         1     32,257         4     27,655         601
  

 

 

      

 

 

      

 

 

    

Total

   $ 192,728         35   $ 443,639         54   $ 250,911         130
  

 

 

      

 

 

      

 

 

    

 

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Sales and Marketing. Sales and marketing expense increased by $125.2 million, or 114%, from $109.8 million for the nine months ended September 30, 2015 to $234.9 million for the nine months ended September 30, 2016. Of this increase, $72.0 million was due to increases in sales and marketing expense attributable to Constant Contact. The remaining increase of $53.2 million was primarily attributable to $53.6 million of increased marketing program spending primarily aimed at the launches of new gateway products, offset by a decrease in our marketing spend on our other products as we focused on the new ones. In addition, the increase included a $3.9 million increase in stock-based compensation expense.

Engineering and Development. Engineering and development expense increased by $48.0 million, or 241%, from $19.9 million for the nine months ended September 30, 2015 to $67.9 million for the nine months ended September 30, 2016. Of this increase, $33.9 million was due to increases in engineering and development expense attributable to Constant Contact. The remaining increase of $14.1 million, was primarily due to the following impairment charges: an impairment write off of acquired in-process research and development of $1.4 million in the first quarter of 2016; an impairment write off of $2.0 million for an internally developed software tool that we determined no longer meets our needs; and an impairment charge of $4.9 million, of which $0.5 million relates to internally developed software from the Webzai acquisition, and $4.4 million relates to developed technology acquired in the Webzai acquisition. An additional $5.0 million in stock-based compensation also contributed to the increases.

General and Administrative. General and administrative expense increased by $50.1 million, or 86%, from $58.4 million for the nine months ended September 30, 2015 to $108.5 million for the nine months ended September 30, 2016. Of this increase, $21.3 million was due to increases in general and administrative expense attributable to Constant Contact. The remaining period-over-period increase of $28.8 million was primarily due to a $16.2 million increase in stock-based compensation expense, due in part to the performance-based restricted stock award granted to our CEO, $3.8 million in additional payroll and labor costs due to an increase in headcount, additional audit and tax fees of $2.9 million, and additional legal fees of $2.1 million.

Transaction Expenses. Transaction expenses increased by $27.7 million, or 601%, from $4.6 million for the nine months ended September 30, 2015 to $32.3 million for the nine months ended September 30, 2016. The period-over-period increase was primarily attributable to costs related to our acquisition of Constant Contact in February 2016.

Other Income (Expense), Net

 

     Nine Months Ended
September 30,
     Change  
     2015      2016      Amount      %  
     (dollars in thousands)  

Other income (expense), net

   $ (37,200    $ (105,570    $ (68,370      184

Other expense, net increased by $68.4 million, or 184%, from $37.2 million for the nine months ended September 30, 2015 to $105.6 million for the nine months ended September 30, 2016. The increase is primarily due to a $61.2 million increase in interest expense, including service fees, related to our Senior Credit Facilities and Notes during the nine months ended September 30, 2016 as compared with the nine months ended September 30, 2015. Additionally, there was an increase of $4.3 million in amortization of deferred financing fees and a $2.1 million increase in original issue discounts, as well as an increase of $1.9 million of accretion of present value for the deferred consideration related to the Webzai, BuyDomains and Ace Data Center acquisitions.

Income Tax Expense (Benefit)

 

     Nine Months Ended
September 30,
     Change  
     2015      2016      Amount      %  
     (dollars in thousands)  

Income tax expense

   $ 9,082       $ (121,220    $ (130,302      -1435

For the nine months ended September 30, 2015 and 2016, we recognized tax expense of $9.1 million and a tax benefit of $121.2 million, respectively, in the consolidated statements of operations and comprehensive loss. The income tax benefit for the nine months ended September 30, 2016 was primarily attributable to a $72.8 million reversal of the valuation allowance, a federal and state deferred tax benefit of $49.7 million, which includes the identification and recognition of $7.3 million of U.S. federal research and development tax credits, and a foreign deferred tax benefit of $2.1 million, partially offset by a provision for federal and state current income taxes of $1.4 million and foreign current tax expense of $2.0 million. The income tax expense for the nine months ended September 30, 2015 is primarily attributable to a provision for federal and state current income taxes of $2.1 million, foreign current tax expense of $1.4 million, federal and state deferred tax expense of $5.2 million, foreign deferred tax expense of $0.1 million related to increases in deferred liabilities, and attributable to a $0.3 million increase of the valuation allowance.

 

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Liquidity and Capital Resources

Sources of Liquidity

In November 2013, we entered into a first lien term loan facility of $1,050.0 million. On February 9, 2016, in connection with our acquisition of Constant Contact, we entered into a $735.0 million incremental first lien term loan facility and a new $165.0 million revolving credit facility, and our wholly owned subsidiary EIG Investors issued $350.0 million aggregate principal amount of 10.875% senior notes due 2024. We refer to the incremental first lien term loan facility and new revolving credit facility, together with our previously existing first lien term loan facility, as the “Senior Credit Facilities” and to the 10.875% senior notes due 2024 as the “Notes”.

As a result of the “most-favored nation” pricing provision in our existing credit agreement, the interest rate on our existing first lien term loan facility increased to LIBOR plus 5.48% per annum on February 28, 2016, subject to a LIBOR floor of 1.0% per annum. In addition, we are obligated to use commercially reasonable efforts to make voluntary prepayments on our existing first lien term loan facility to effectively double the amount of each scheduled amortization payment under that facility (which is 0.25% per quarter of the principal outstanding as of November 25, 2013).

The incremental first lien term loan facility will mature in seven years, and bears interest at a rate of LIBOR plus 5.0% per annum, subject to a LIBOR floor of 1.0% per annum, and has scheduled amortization of 0.50% per quarter.

Revolving Credit Facility

Loans under the new $165.0 million revolving credit facility will bear interest at a rate of LIBOR plus 4.0% per annum (subject to a leverage-based step-down), without a LIBOR floor. This revolving credit facility has a “springing” maturity date of August 10, 2019 unless the existing first lien term loan facility has been repaid in full or otherwise extended to at least 91 days after the maturity of the revolving credit facility.

Loans under the Senior Credit Facilities are also subject to a base rate option, with interest rate spreads of 1.0% per annum less than those applicable to LIBOR-based loans.

The Senior Credit Facilities have been fully and unconditionally guaranteed, and secured by us and certain of our subsidiaries (including Constant Contact and its subsidiaries).

10.875% Senior Notes due 2024

The Notes will mature in February 2024, were issued at a price of 98.065% of par and will bear interest at the rate of 10.875% per annum. The Notes have been fully and unconditionally guaranteed, on a senior unsecured basis, by us and our subsidiaries that guarantee the Senior Credit Facilities (including Constant Contact and its subsidiaries).

In connection with the issuance of the Notes, we agreed to assist the initial purchasers of the Notes in marketing the Notes. In addition, we entered into a registration rights agreement with the initial purchasers of the Notes, which provides the holders of the Notes certain rights relating to registration of the Notes under the Securities Act.

Pursuant to the registration rights agreement, we will, among other obligations, use commercially reasonable efforts to file an exchange offer registration statement with respect to a registered offer, or the Exchange Offer, to exchange the Notes for substantially identical notes and consummate the Exchange Offer within 365 days after the issuance of the Notes. We will also use commercially reasonable efforts to cause to become effective a shelf registration statement to cover resales of the Notes by the beneficial owners thereof who satisfy certain conditions relating to the provision of information in connection with the shelf registration statement. A registration default will occur if, among other things, (1) we fail to consummate the Exchange Offer or have the shelf registration statement become effective on or before the date that is 365 days after the issue date or (2) the shelf registration statement becomes effective but thereafter ceases to be effective or usable in connection with the resale of Notes (subject to certain exceptions) during the periods specified in the registration rights agreement. If a registration default occurs with respect to the Notes, the annual interest rate of the Notes will be increased by 0.25% per annum and will increase again by 0.25% per annum 90 days thereafter until all registration defaults have been cured, up to a maximum amount of additional interest of 0.50% per annum. We will also use commercially reasonable efforts to cause to become effective a registration statement providing for the registration of certain secondary transactions in the Notes by Goldman, Sachs & Co. and its affiliates.

 

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As of September 30, 2016, we had cash and cash equivalents totaling $63.1 million and negative working capital of $380.0 million, which included the $21.0 million current portion of the first lien term loan facility and $14.7 million current portion of the incremental first lien term loan facility, as well as $33.5 million outstanding on our revolving credit facility. In addition, we had approximately $2,006.2 million of long term indebtedness outstanding under our first lien term loan facility, which matures on November 9, 2019, and incremental first lien term loan facility due on February 9, 2023 and 10.875% Senior Notes due 2024. We also had $448.6 million of short-term and long-term deferred revenue, which is not expected to be payable in cash.

Debt Covenants

Senior Credit Facilities

The Senior Credit Facilities require that we comply with a financial covenant to maintain a maximum ratio of consolidated senior secured indebtedness to Bank Adjusted EBITDA (as defined below).

The Senior Credit Facilities contain covenants that limit our ability to, among other things, incur additional debt or issue certain preferred shares; pay dividends on or make other distributions in respect of capital stock; make other restricted payments; make certain investments; sell or transfer certain assets; create liens on certain assets to secure debt; consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; and enter into certain transactions with affiliates. Additionally, the Senior Credit Facilities require us to comply with certain negative covenants and specify certain events of default that could result in amounts becoming payable, in whole or in part, prior to their maturity dates. We were in compliance with all covenants at September 30, 2016.

With the exception of certain equity interests and other excluded assets under the terms of the Senior Credit Facilities, substantially all of our assets are pledged as collateral for the obligations under the Senior Credit Facilities.

Notes

The indenture with respect to the Notes contains covenants that limit our ability to, among other things, incur additional debt or issue certain preferred shares; pay dividends on or make other distributions in respect of capital stock; make other restricted payments; make certain investments; sell or transfer certain assets; create liens on certain assets to secure debt; consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; and enter into certain transactions with affiliates. Upon a change of control as defined in the Indenture, we or EIG Investors must offer to repurchase the Notes at 101% of the aggregate principal amount thereof, plus accrued and unpaid interest, if any, up to, but not including, the repurchase date. These covenants are subject to a number of important limitations and exceptions.

The indenture also provides for events of default, which, if any of them occurs, may permit or, in certain circumstances, require the principal, premium, if any, interest and any other monetary obligations on all the then outstanding Notes to be due and payable immediately.

Net Leverage Ratio

The Senior Credit Facilities require that we comply with a financial covenant to maintain a maximum ratio of consolidated net senior secured indebtedness on the date of determination to an adjusted consolidated EBITDA measure, which we refer to as Bank Adjusted EBITDA, for the most recently completed four quarters (which we refer to as trailing twelve months, or TTM). This net leverage ratio may not exceed 6.50 to 1.00 through December 31, 2016, 6.25 to 1.00 from March 31, 2017 through December 31, 2017, and 6.00 to 1.00 from March 31, 2018 and thereafter. As of September 30, 2016, the Company was in compliance with this covenant.

Our credit agreement defines the net consolidated senior secured indebtedness as of any date of determination as the aggregate amount of indebtedness of the Company and its restricted subsidiaries, determined on a consolidated basis in accordance with GAAP, including indebtedness for borrowed money, unreimbursed obligations under letters of credit, obligations with respect to capital lease obligations and debt obligations evidenced by promissory notes and similar instruments, minus the aggregate amount of cash and permitted investments, excluding cash and permitted investments that are restricted.

Our credit agreement defines Bank Adjusted EBITDA as net income (loss) adjusted to exclude interest expense, income tax expense (benefit), depreciation and amortization. Bank Adjusted EBITDA also adjusts net income (loss) by excluding certain non-cash foreign exchange gains (losses), certain gains (losses) from sale of assets, stock-based compensation, unusual and non-recurring expenses (including acquisition related costs, gains or losses on early extinguishment of debt, and loss on impairment of tangible or intangible assets). It also adjusts net income (loss) for revenue on a billed basis, changes in deferred domain costs, share of loss (profit) of unconsolidated entities, and certain integration related costs. Finally, it adjusts net income (loss) for pro forma adjusted EBITDA on a twelve-month lookback period for acquisitions made in any given quarter.

 

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We use Bank Adjusted EBITDA to monitor our net leverage ratio and our ability to undertake key investing and financing functions such as making investments and incurring additional indebtedness, which may be prohibited by the covenants under our credit agreement unless we comply with certain financial ratios and tests.

Bank Adjusted EBITDA is a supplemental measure of our liquidity and is not presented in accordance with GAAP. Bank Adjusted EBITDA is not a measurement of our financial performance under GAAP and should not be considered an alternative to revenue, net income (loss), cash flow, or any other performance measure derived in accordance with GAAP. Our presentation of Bank Adjusted EBITDA may not be comparable with similarly titled measures of other companies.

As of September 30, 2016, our net leverage ratio on a TTM basis was 4.38 to 1.00 and was calculated as follows:

 

     For the three months ended,        
     December 31,
2015
    March 31,
2016
    June 30,
2016
    September 30,
2016
    TTM  
     (in thousands except ratios)  

Net income (loss)

   $ (9,232   $ 14,081      $ (33,430   $ (29,798   $ (58,379

Interest expense

     15,872        30,371        40,994        41,208        128,445   

Income tax expense (benefit)

     2,260        (99,902     (13,931     (7,387     (118,960

Depreciation

     9,361        13,172        16,760        17,010        56,303   

Amortization of other intangible assets

     23,866        29,874        37,823        37,982        129,545   

Stock-based compensation

     9,653        18,388        15,024        14,806        57,871   

Integration and restructuring costs

     4,749        15,037        9,627        7,652        37,065   

Transaction expenses and charges

     4,980        31,120        978        159        37,237   

(Gain) loss of unconsolidated entities

     5,524        (10,727     341        5,018        156   

Impairment of long-lived assets

     —          1,437        6,847        —          8,284   

(Gain) loss on assets, not ordinary course

     —          —          —          56        56   

Legal advisory expenses

     161        1,540        1,458        985        4,144   

Billed revenue to GAAP revenue adjustment

     4,524        42,573        12,317        3,724        63,138   

Domain registration cost cash to GAAP adjustment

     (1,354     (3,745     441        69        (4,589

Currency translation

     (42     156        206        209        529   

Adjustment for acquisitions on a pro forma basis*

     34,517        12,902        (162     (42     47,215   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
          
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Bank Adjusted EBITDA

   $ 104,839      $ 96,277      $ 95,293      $ 91,651      $ 388,060   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Current portion of notes payable

             69,200   

Current portion of capital lease obligations

             7,108   

Notes payable - long term

             1,961,512   

Capital lease obligations - long term

             2,082   

Certain deferred consideration amounts

             2,800   

Original issue discounts and deferred financing costs

             71,388   

Less:

          

Unsecured notes

             (350,000

Cash

             (63,148

Certain permitted restricted cash

             (611
          

 

 

 

Net senior secured indebtedness

           $ 1,700,331   
          

 

 

 

Net leverage ratio

             4.38   

Maximum net leverage ratio

             6.50   

 

* Consists of pro forma adjusted EBITDA for acquired entities on a TTM basis, as adjusted for projected cost savings arising from decisions undertaken by us on or before the acquisition date of the relevant acquisition. This adjustment is revised each fiscal quarter for new acquisitions.

 

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Cash and Cash Equivalents

As of September 30, 2016, our cash and cash equivalents were primarily held for working capital purposes and for required principal and interest payments under our indebtedness. A majority of our cash and cash equivalents was held in operating accounts. Our cash and cash equivalents increased by $30.1 million from $33.0 million at December 31, 2015 to $63.1 million at September 30, 2016. Of the $63.1 million cash and cash equivalents we had at September 30, 2016, $15.1 million was held in foreign countries, which, due to tax and accounting reasons, we do not plan to repatriate this cash in the near future. We used cash on hand at December 31, 2015, cash flows from operations and proceeds from our incremental first lien term loan facility and Notes to fund our acquisition and minority investment activity described under financing and investing activities below. Our future capital requirements will depend on many factors including, but not limited to acquisitions, our growth rate, expansion of sales and marketing activities, the introduction of new and enhanced products and services, market acceptance of our solutions and our gross profits and operating expenses. We believe that our current cash and cash equivalents and operating cash flows will be sufficient to meet our anticipated working capital and capital expenditure requirements, as well as our required principal and interest payments under our indebtedness, for at least the next 12 months.

The following table shows our purchases of property and equipment, principal payments on capital lease obligations, depreciation, amortization and cash flows from operating activities, investing activities and financing activities for the stated periods:

 

     Nine Months Ended September 30,  
     2015      2016  
     (dollars in thousands)  

Purchases of property and equipment

   $ (23,267    $ (29,317

Principal payments on capital lease obligations

   $ (2,827    $ (4,372

Depreciation

   $ 24,649       $ 46,942   

Amortization

   $ 67,741       $ 114,543   

Cash flows provided by operating activities

   $ 133,814       $ 101,804   

Cash flows used in investing activities

   $ (100,144    $ (925,074

Cash flows provided by (used in) financing activities

   $ (30,689    $ 851,545   

Capital Expenditures

Our capital expenditures on the purchase of property and equipment for the nine months ended September 30, 2015 and 2016 were $23.3 million and $29.3 million, respectively. The higher property and equipment expenditures in the nine months ended September 30, 2016 is mostly attributable to Constant Contact. The remaining balance payable on the capital leases is $9.2 million as of September 30, 2016. We expect our capital expenditures to increase over the next twelve months as we enhance our disaster recovery capabilities.

Depreciation

Our depreciation expense for the nine months ended September 30, 2015 and 2016 increased from $24.6 million to $46.9 million, respectively. This increase was primarily due to expansion in our business by on-boarding acquisitions as well as investments in data center infrastructure and leasehold improvements. The leasehold improvements were associated with operating leases as we expanded and revamped our presence in Massachusetts.

Amortization

Our amortization expense, which includes amortization of other intangible assets, amortization of deferred financing costs, amortization of net present value of deferred consideration and amortization of original issue discounts, increased by $46.8 million from $67.7 million for the nine months ended September 30, 2015 to $114.5 million for the nine months ended September 30, 2016. Of this increase in amortization expense, $49.4 million of amortization expense related to intangible assets of businesses that have been acquired since September 30, 2015, partially offset by $11.2 million of lower amortization expense related to acquisitions that occurred prior to September 30, 2015. In addition, $1.9 million of the increase is attributable to higher amortization expense of net present value of deferred consideration as a result of our Ace acquisition in September 2015, $4.3 million is attributable to increased deferred financing costs and $2.1 million is attributable to amortization of original issue discounts related to our incremental first lien term loan facility and Notes.

 

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Operating Activities

Cash provided by operating activities consists primarily of net income (loss) adjusted for certain non-cash items including depreciation, amortization, stock-based compensation expense and changes in deferred taxes, and the effect of changes in working capital, in particular in deferred revenue. As we add subscribers to our platform, we typically collect subscription fees at the time of initial billing and recognize revenue over the terms of the subscriptions. Accordingly, we generate operating cash flows as we collect cash from our subscribers in advance of delivering the related products and services, and we maintain a significant deferred revenue balance. As we add subscribers and sell additional products and services, our deferred revenue balance increases.

Net cash provided by operating activities was $101.8 million for the nine months ended September 30, 2016 compared with $133.8 million for the nine months ended September 30, 2015. Net cash provided by operating activities for the nine months ended September 30, 2016 consisted of net loss of $49.1 million, offset by non-cash charges of $87.9 million and a net change of $63.0 million in our operating assets and liabilities. The net change in our operating assets and liabilities included an increase in deferred revenue of $58.6 million, which was $29.4 million more than in the same period in 2015. Cash provided by operating activities for the nine months ended September 30, 2016 has been reduced by $38.3 million of transaction costs, incurred primarily to acquire Constant Contact.

Net cash provided by operating activities was $133.8 million for the nine months ended September 30, 2015, consisting of net loss of $16.5 million, non-cash charges of $122.9 million and a net change of $27.5 million in our operating assets and liabilities. The net change in our operating assets and liabilities included an increase in deferred revenue of $29.2 million.

Investing Activities

Cash flows used in investing activities consist primarily of purchase of property and equipment, acquisition consideration payments, and changes in restricted cash balances.

During the nine months ended September 30, 2016, net cash used in investing activities was $925.1 million. We used $889.6 million of cash, net of cash acquired, for the purchase consideration for our acquisitions of Constant Contact and AppMachine. We also used $29.1 million of cash to purchase property and equipment, net of proceeds from disposals of $0.2 million, and a net deposit of $0.8 million of restricted cash with a payment processor. In addition, we paid $0.6 million for a convertible promissory note from a business that provides web and mobile management solutions, with the potential for subsequent purchases of additional convertible notes, and $5.0 million for a minority interest investment in Fortifico Limited, a company providing a billing, customer support and CRM solution to small and mid-sized businesses.

During the nine months ended September 30, 2015, net cash used in investing activities was $100.1 million. We used $73.2 million of cash, net of cash acquired, for the purchase consideration of our acquisitions of Verio, World Wide Web Hosting, and Ace. In addition, we used $7.3 million to make an additional investment in WZ UK Ltd. We also used $23.2 million of cash to purchase property and equipment, net of proceeds from disposals of $0.1 million, and deposited $0.1 million of restricted cash with a payment processor. In addition, during the nine months ended September 30, 2015 we received a $3.5 million repayment on a note receivable related to our equity ownership in World Wide Web Hosting.

Financing Activities

Cash flow from financing activities consists primarily of the net change in our overall indebtedness, payment of associated financing costs, payment of deferred consideration for our acquisitions and the issuance or repurchase of equity.

During the nine months ended September 30, 2016, cash flows provided by financing activities was $851.5 million. We received $1.1 billion from the issuance of the incremental first lien term loan and Notes to finance the acquisition of Constant Contact. We also received $2.3 million of proceeds from the exercise of stock options, and $2.8 million as a capital investment from our minority partner. We borrowed in aggregate $49.5 million against our revolving credit facility and repaid in aggregate $83.0 million, including the $67.0 million that was paid with the proceeds from the new debt used to acquire Constant Contact related to our revolving credit facility. These items were offset by principal payments of $42.8 million related to our term loans, a $52.6 million payment of financing costs, $43.1 million of deferred consideration payments, $33.4 million for redemption in our controlling interest in WZ UK, and $4.4 million of principal payments related to capital lease obligations.

During the nine months ended September 30, 2015, cash flows used in financing activities was $30.7 million, which included a payment of $30.5 million under our agreement to increase our investment in JDI Backup Ltd. from 67% to 100%. We also paid $10.6 million of deferred consideration during the nine months ended September 30, 2015, $7.9 million of principal payments under our first lien term loan facility and $2.8 million of principal payments related to capital lease obligations. These items were partially offset by $1.1 million of proceeds we received from the exercise of stock options. During the nine months ended September 30, 2015, we borrowed in aggregate $109.0 million against our revolving credit facility and repaid in aggregate $89.0 million.

 

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Free Cash Flow

Free cash flow, or FCF, is a non-GAAP financial measure that we calculate as GAAP cash flow from operations less capital expenditures and capital lease obligations. We believe that FCF provides investors with an indicator of our ability to generate positive cash flows after meeting our obligations with regard to capital expenditures (including capital lease obligations).

The following table reflects the reconciliation of cash flow from operations to free cash flow (“FCF”) (all data in thousands):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2015      2016      2015      2016  

Cash flow from operations

   $ 37,582       $ 36,189       $ 133,814       $ 101,804   

Less:

           

Capital expenditures and capital lease obligations

   $ (9,710    $ (9,832    $ (26,094    $ (33,689
  

 

 

    

 

 

    

 

 

    

 

 

 

Free cash flow

   $ 27,872       $ 26,357       $ 107,720       $ 68,115   
  

 

 

    

 

 

    

 

 

    

 

 

 

Free cash flow decreased from $27.9 million for the three months ended September 30, 2015 to $26.4 million for the three months ended September 30, 2016, a decrease of $1.5 million. This decrease is primarily related to increased payments of interest expense incurred to finance the Constant Contact acquisition of $32.7 million and increased payments for restructuring costs, mostly for costs related to the Constant Contact restructuring plan of $4.5 million, partially offset by cash generated by Constant Contact.

Free cash flow declined from $107.7 million for the nine months ended September 30, 2015 to $68.1 million for the nine months ended September 30, 2016, a decrease of $39.6 million. This decrease is primarily related to transaction and restructuring related payments of $46.5 million primarily incurred in connection with the acquisition of Constant Contact.

Net Operating Loss Carry-Forwards

As of December 31, 2015, we had net operating loss, or NOL, carry-forwards available to offset future U.S. federal taxable income of approximately $97.8 million and future state taxable income of approximately $111.2 million. These NOL carry-forwards expire on various dates through 2034. Approximately $1.6 million of the U.S. federal NOL carry-forwards and $0.7 million of the state NOL carry-forwards are from excess stock-based compensation, for which the benefit will be recorded to additional-paid in capital when recognized. In addition, as of December 31, 2015, we had NOL carry-forwards in foreign jurisdictions available to offset future foreign taxable income by approximately $27.4 million. We have loss carry-forwards in India totaling $2.9 million that expire in 2021. We also have loss carry-forwards in the United Kingdom, Israel and Singapore of $23.4 million, $0.9 million and $0.2 million, respectively, which have an indefinite carry-forward period.

Utilization of the NOL carry-forwards can be subject to an annual limitation due to the ownership percentage change limitations under Section 382 of the Internal Revenue Code or Section 382 limitation. Ownership changes can limit the amount of net operating loss and other tax attributes that a company can use each year to offset future taxable income and taxes payable. In connection with a change in control in 2011 we were subject to Section 382 annual limitations of $77.1 million against the balance of NOL carry-forwards generated prior to the change in control in 2011. Through December 31, 2014 we accumulated the unused amount of Section 382 limitations in excess of the amount of NOL carry-forwards that were originally subject to limitation. Therefore, these unused NOL carry-forwards are available for future use to offset taxable income. We completed an analysis of changes in our ownership from 2011, through our IPO, to December 31, 2013 and concluded that there was not a Section 382 ownership change during this period and therefore any NOLs generated through December 31, 2013 will not be subject to any new Section 382 annual limitations on NOL carry-forwards. On November 20, 2014, we completed a follow-on offering of 13,000,000 shares of common stock. The underwriters also exercised their overallotment option to purchase an additional 1,950,000 shares of common stock from the selling stockholders. We performed an analysis of the impact of this offering and determined that no Section 382 change in ownership has occurred. As a result, all unused NOL carry-forwards at December 31, 2014 were available for future use to offset taxable income.

On March 11, 2015, we completed a follow-on offering of our common stock, in which selling stockholders sold 12,000,000 shares of common stock at a public offering price of $19.00 per share. The underwriter also exercised its overallotment option to

 

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purchase an additional 1,800,000 shares of common stock from the selling stockholders. We completed an analysis of our ownership changes in the first half of 2016, which resulted in no ownership-change for tax purposes within the meaning of the Internal Revenue Code Section 382(g).

 

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Contractual Obligations and Commitments

We closed our acquisition of Constant Contact on February 9, 2016. This acquisition was funded with an increase in our indebtedness of approximately $1.1 billion. Our outstanding indebtedness, including capital lease obligations, at September 30, 2016 was $2,084.6 million. In connection with the new indebtedness to finance the acquisition of Constant Contact, we paid off our existing revolving credit facility and entered into a new $165.0 million revolving credit facility. We also had $33.5 million outstanding under this new revolving credit facility as of September 30, 2016.

On July 13, 2016, WZ UK completed a restructuring pursuant to which we and the minority shareholders of Pseudio Limited and Resume Labs Limited sold our shares in these entities to WZ UK in exchange for shares in WZ UK. As a result of the restructuring, WZ UK became the 100% owner of Pseudio Limited and Resume Labs Limited and our ownership of WZ UK was diluted from 77.5% to 76.4%. Immediately subsequent to the restructuring, we acquired an additional 10% stake in WZ UK for $18.0 million, bringing our aggregate stake in WZ UK to 86.4%. In connection with this investment, we and the minority shareholders of WZ UK entered into a revised option agreement on September 22, 2016, pursuant to which we have a right and an obligation to purchase additional shares in WZ UK provided certain conditions are met.

Additionally, on July 27, 2016, we acquired the remaining 60% equity interest in AppMachine, increasing our stake to 100%. In connection with the acquisition, the parties terminated the prior investment agreement pursuant to which we were obligated to purchase the remaining shares in AppMachine in three tranches. The total consideration for the 60% equity interest was $22.5 million, of which $5.5 million was paid upon closing, and the remainder will be paid in annual installments over a period of four years, commencing with June 21, 2017. The purchase consideration of $22.5 million is subject to reduction in the event that we successfully bring certain indemnification claims against the sellers.

There have been no other significant changes in our contractual obligations from those disclosed in our Annual Report on Form 10-K filed with the SEC on February 29, 2016.

Recently Issued Accounting Pronouncements

For information on recent accounting pronouncements, see Recent Accounting Pronouncements in the notes to the consolidated financial statements appearing in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Off-Balance Sheet Arrangements

We do not have any special purpose entities or off-balance sheet arrangements.

 

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Quantitative and Qualitative Disclosure About Market Risk

We have operations both within the United States and internationally, and we are exposed to market risk in the ordinary course of our business. These risks include primarily foreign exchange risk, interest rate and inflation.

Foreign Currency Exchange Risk

A significant majority of our subscription agreements and our expenses are denominated in U.S. dollars. We do, however, have sales in a number of foreign currencies as well as business operations in Brazil and India and are subject to the impacts of currency fluctuations in those markets. The impact of these currency fluctuations is insignificant relative to the overall financial results of our company.

Interest Rate Sensitivity

We had cash and cash equivalents of $63.1 million at September 30, 2016, the majority of which was held in operating accounts for working capital purposes and other general corporate purposes which includes payment of principal and interest under our indebtedness. As of September 30, 2016, we had approximately $994.6 million of indebtedness outstanding under our first lien term loan facility, $724.0 million outstanding under our incremental first lien term loan, $350.0 million outstanding under The Notes and $33.5 million outstanding under a revolving credit facility of $165.0 million.

 

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The first lien term loan facility bears interest at a rate per annum equal to an applicable credit spread plus, at our option, (a) adjusted LIBOR or (b) an alternate base rate determined by reference to the greater of (i) the prime rate, (ii) the federal funds effective rate plus 0.50% and (iii) one-month adjusted LIBOR plus 1.00%. The term loan is subject to a floor of 1.00% per annum with an applicable credit spread for interest based on adjusted LIBOR of 4.00%. As a result of the “most-favored nation” pricing provision in our existing credit agreement, the interest rate on our existing first lien term loan facility increased to LIBOR plus 5.48% per annum on February 28, 2016, subject to a LIBOR floor of 1.0% per annum.

The incremental first lien term loan facility bears interest at a rate of LIBOR plus 5.0% per annum, subject to a LIBOR floor of 1.0% per annum, and has scheduled amortization of 0.50% per quarter.

Loans under the new $165.0 million revolving credit facility will bear interest at a rate of LIBOR plus 4.0% per annum (subject to a leverage-based step-down), without a LIBOR floor.

Loans under the first lien term loan facility and incremental first lien term loan facility and revolving credit facility are also subject to a base rate option, with interest rate spreads of 1.0% per annum less than those applicable to LIBOR-based loans.

We are also required to pay a commitment fee of 0.50% per annum to the lenders based on the average daily unused amount of the revolving commitments.

Based on our aggregate indebtedness outstanding under our first lien term loan facility and incremental first lien term loan facility of $1,718.6 million as of September 30, 2016, a 100 basis point increase in the adjusted LIBOR rate above the LIBOR floor would result in a $17.3 million increase in our aggregate interest payments over a 12-month period, and a 100 basis point decrease at the current LIBOR rate would not result in a decrease in our interest payments.

We entered into a three-year interest rate cap on December 9, 2015 as part of our risk management strategy. This interest rate cap limits our exposure to interest rate increases on $500.0 million of our first lien term loan. If the LIBOR interest rates for this loan increase more than 137 basis points above the rates at December 31, 2015, our interest rate cap would begin to protect us on interest charges for $500.0 million of outstanding debt.

Inflation Risk

We do not believe that inflation has a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability to do so could harm our business, financial condition and results of operations.

 

Item 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

As of September 30, 2016, our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based upon that evaluation of our disclosure controls and procedures as of September 30, 2016, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

During the nine months ended September 30, 2016, we acquired Constant Contact. Other than the addition of Constant Contact’s operations to our internal control over financial reporting and any related changes in control to integrate Constant Contact, there has not been any change in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

From time to time we are involved in legal proceedings or subject to claims arising in the ordinary course of our business. We are not presently involved in any such legal proceeding or subject to any such claim that, in the opinion of our management, would have a material adverse effect on our business, operating results or financial condition. However, the results of such legal proceedings or claims cannot be predicted with certainty, and regardless of the outcome, can have an adverse impact on us because of defense and settlement costs, diversion of management resources and other factors. Neither the ultimate outcome of the matters listed below nor an estimate of any probable losses or any reasonably possible losses can be assessed at this time.

Endurance

We received a subpoena dated December 10, 2015 from the Boston Regional Office of the SEC, requiring the production of certain documents, including, among other things, documents related to our financial reporting, including operating and non-GAAP metrics, refund, sales and marketing practices and transactions with related parties. We are fully cooperating with the SEC’s investigation. We can make no assurances as to the time or resources that will need to be devoted to this investigation or its final outcome, or the impact, if any, of this investigation or any related legal or regulatory proceedings on our business, financial condition, results of operations and cash flows.

On May 4, 2015, Christopher Machado, a purported holder of our common stock, filed a civil action in the United States District Court for the District of Massachusetts against us and our chief executive officer and our former chief financial officer, Machado v. Endurance International Group Holdings, Inc., et al., Civil Action No. 1:15-cv-11775-GAO. In a second amended complaint, filed on March 18, 2016, the plaintiff alleged claims for violations of Section 10(b) and 20(a) of the Exchange Act, on behalf of a purported class of purchasers of our securities between February 25, 2014 and February 29, 2016. Those claims challenged as false or misleading certain of our disclosures about our total number of subscribers, average revenue per subscriber, the number of customers paying over $500 per year for our products and services, the average number of products sold per subscriber, and our customer churn. The plaintiff seeks, on behalf of himself and the purported class, compensatory damages and his costs and expenses of litigation. We filed a motion to dismiss on May 16, 2016, which remains pending. In August 2016, the parties in the Machado action and another potential claimant, who asserts that he purchased common stock in our initial public offering, agreed to toll, as of July 1, 2016, the statutes of limitation and repose for all claims under the Securities Act of 1933 that the plaintiff and claimant might bring, individually or in a representative capacity, arising from alleged actions or omissions between September 9, 2013 and February 29, 2016. We and the individual defendants intend to deny any liability or wrongdoing and to vigorously defend all claims asserted. We cannot, however, make any assurances as to the outcome of the current proceeding or any additional claims if they are brought.

Constant Contact

On December 10, 2015, Constant Contact received a subpoena from the Boston Regional Office of the SEC, requiring the production of documents pertaining to Constant Contact’s sales, marketing, and customer retention practices, and periodic public disclosure of financial and operating metrics. We are fully cooperating with the SEC’s investigation. We can make no assurances as to the time or resources that will need to be devoted to this investigation or its final outcome, or the impact, if any, of this investigation or any related legal or regulatory proceedings on our business, financial condition, results of operations and cash flows.

On August 7, 2015, a purported class action lawsuit, William McGee v. Constant Contact, Inc., et al, was filed in the United States District Court for the District of Massachusetts against Constant Contact and two of its former officers. The lawsuit asserts claims under Sections 10(b) and 20(a) of the Exchange Act, and is premised on allegedly false and/or misleading statements, and non-disclosure of material facts, regarding Constant Contact’s business, operations, prospects and performance during the proposed class period of October 23, 2014 to July 23, 2015. This litigation remains in its early stages. We and the individual defendants intend to vigorously defend all claims asserted. We cannot, however, make any assurances as to the outcome of this proceeding.

In August 2012, RPost Holdings, Inc., RPost Communications Limited and RMail Limited, or collectively, RPost, filed a complaint in the United States District Court for the Eastern District of Texas that named Constant Contact as a defendant in a lawsuit. The complaint alleged that certain elements of Constant Contact’s email marketing technology infringe five patents held by RPost. RPost seeks an award for damages in an unspecified amount and injunctive relief. In February 2013, RPost amended its complaint to name five of Constant Contact’s marketing partners as defendants. Under Constant Contact’s contractual agreements with these marketing partners, it is obligated to indemnify them for claims related to patent infringement. Constant Contact filed a motion to sever and stay the claims against its partners and multiple motions to dismiss the claims against it. In January 2014, the case was

 

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stayed pending the resolution of certain state court and bankruptcy actions involving RPost, to which Constant Contact is not a party. The case continues to be stayed pending the state court and bankruptcy actions. Meanwhile, RPost asserted the same patents asserted against Constant Contact in litigation against Go Daddy. In June 2016, Go Daddy succeeded in invalidating all of those RPost patents. RPost has appealed, and the appellate court is expected to hear oral argument on the appeal in the Spring of 2017. The litigation against Constant Contact remains stayed, and is in its early stages. We believe we have meritorious defenses to any claim of infringement and intend to defend against the lawsuit vigorously.

Legal Proceedings Related to the Constant Contact Acquisition

On December 11, 2015, a putative class action lawsuit relating to the Constant Contact acquisition, captioned Irfan Chawdry, Individually and On Behalf of All Others Similarly Situated v. Gail Goodman, et al. Case No. 11797, or the Chawdry Complaint, and on December 21, 2015, a putative class action lawsuit relating to the acquisition captioned David V. Myers, Individually and On Behalf of All Others Similarly Situated v. Gail Goodman, et al. Case No. 11828, or the Myers Complaint (together with the Chawdry Complaint, the Complaints) were filed in the Court of Chancery of the State of Delaware naming Constant Contact, each of Constant Contact’s directors, Endurance and Paintbrush Acquisition Corporation as defendants. The Complaints generally allege, among other things, that in connection with the acquisition the directors of Constant Contact breached their fiduciary duties owed to the stockholders of Constant Contact by agreeing to sell Constant Contact for purportedly inadequate consideration, engaging in a flawed sales process, omitting material information necessary for stockholders to make an informed vote, and agreeing to a number of purportedly preclusive deal protection devices. The Complaints seek, among other things, to rescind the acquisition, as well as award of plaintiffs’ attorneys’ fees and costs in the action. The defendants have not yet answered or otherwise responded to either of these Complaints. The defendants believe the claims asserted in the Complaints are without merit and intend to defend against these lawsuits vigorously.

 

ITEM 1A. Risk Factors

Our business, financial condition, results of operations and future growth prospects could be materially and adversely affected by the following risks or uncertainties. The risks and uncertainties described below are those that we have identified as material, but they are not the only risks and uncertainties we face. Our business is also subject to general risks and uncertainties that affect many other companies, including overall economic and industry conditions, as well as other risks not currently known to us or that we currently consider immaterial. If any of such risks and uncertainties actually occurs, our business, financial condition, results of operations and growth prospects could differ materially from the plans, projections and other forward-looking statements included in the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Quarterly Report on Form 10-Q and in our other public filings.

Risks Related to Our Business and Our Industry

Our quarterly and annual operating results may be adversely affected due to a variety of factors, which could make our future results difficult to predict and could cause our operating results to fall below investor or analyst expectations.

Our quarterly and annual operating results may be adversely affected due to a variety of factors that could affect our revenue or our expenses in any particular period. You should not rely on quarter-to-quarter comparisons of our operating results as an indication of future performance. Factors that may adversely affect our quarterly and annual operating results may include:

 

    our ability to attract new subscribers, and retain existing subscribers;

 

    our ability to acquire subscribers in a cost-effective way;

 

    our ability to increase revenue from our existing subscribers;

 

    our ability to maintain a high level of subscriber satisfaction;

 

    our inability to raise the selling prices for our solutions or reductions in the selling prices for our solutions;

 

    competition in the market for our products and services, as well as competition for referral sources;

 

    rapid technological change, changing consumer preferences, frequent new product and service introductions, and evolving industry standards, including with respect to how our products and services are marketed to consumers, in how consumers find, purchase and use our products and services and in technology intended to block email marketing;

 

    difficulties in integrating technologies, products and employees from companies we have acquired or may acquire in the future or in migrating acquired subscribers from an acquired company’s platforms to our platform, which may result in subscriber dissatisfaction, an increase in subscriber churn, difficulties cross-selling products and services to subscribers, and our failure to realize the anticipated benefits from our acquisitions;

 

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    systems, data center and Internet failures and service interruptions;

 

    network security breaches or sabotage resulting in the unauthorized use or disclosure of, or access to, personally identifiable information or other confidential information;

 

    loss of key employees;

 

    the timing and results of our investments to support our growth strategy, including new product offerings, product marketing and other marketing efforts;

 

    economic conditions negatively affecting the SMB sector and changes in growth rate of SMBs;

 

    difficulties and costs arising from our international operations and continued international expansion;

 

    difficulties in distributing new products;

 

    shortcomings or errors in, or misinterpretations of, our metrics, forecasts and data, including those that cause us to fail to anticipate or identify trends in our market;

 

    terminations of, disputes with, or material changes to our relationships with third-party partners, including referral sources, product partners, data center providers, payment processors and landlords;

 

    a shift in subscriber demand to lower margin solutions, which could increase our cost of revenue;

 

    our ability to drive growth through mergers and acquisitions, joint ventures, or strategic investments;

 

    costs or liabilities associated with any past or future acquisitions, strategic investments or joint ventures that we may make or enter into;

 

    changes in legislation, including changes that affect our collection of sales and use taxes or changes to our business that subject us to taxation in additional jurisdictions;

 

    the amount and timing of capital expenditures, such as investments in our hardware and software systems, as well as extraordinary expenses, such as litigation or other dispute-related settlement payments;

 

    changes in regulation or to regulatory bodies, such as the Internet Corporation for Assigned Names and Numbers, or ICANN, and U.S. and international regulations governing email marketing and privacy, that could affect our business and our industry, or costs of or our failure to comply with such regulation; and

 

    litigation or governmental enforcement actions against us, including due to failures to comply with applicable law or regulation.

Our financial results for the second quarter of 2016 were below our expectations and the expectations of research analysts, due primarily to higher than expected subscriber acquisition costs and initial subscriber churn associated with new gateway products and relatively slow growth in our core hosting and web presence brands due to flat marketing expenditure levels during the first half of 2016, as well as to trends in the competitive landscape. In the third quarter of 2016, our total subscriber base also decreased from the prior quarter, which we believe was due to the allocation of our marketing spend, higher than expected churn in certain gateway products, the impact of less strategic brands, and competitive factors, including trends toward brand rather than generic search terms. It is possible that in one or more future quarters, due to any of the factors listed above, a combination of those factors or other reasons, our operating results may again be below our expectations and the expectations of research analysts and investors. In that event, our stock price could decline substantially.

We may not be able to add new subscribers, retain existing subscribers or increase sales to existing subscribers, which could adversely affect our operating results.

Our growth is dependent on our ability to continue to attract and acquire new subscribers while retaining existing subscribers and expanding the products and services we sell to them. Growth in the demand for our products and services may be inhibited, and we may be unable to grow our subscriber base, for a number of reasons, including, but not limited to:

 

    our failure to develop or offer new or additional products and services in a timely manner that keeps pace with new technologies and the evolving needs of our subscribers;

 

    our inability to market our solutions in a cost-effective manner to new subscribers or to our existing subscribers and to increase our sales to existing subscribers, including due to changes in regulation, or changes in the enforcement of existing regulation that would impair our marketing practices, require us to change our sign-up processes or require us to increase disclosure designed to provide greater transparency as to how we bill and deliver our services;

 

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    the relative maturity of our core hosting and web presence business and the hosting and web presence industry in general, which has and may continue to affect subscriber growth;

 

    our inability to acquire or retain new subscribers through mergers and acquisitions, joint ventures or strategic investments;

 

    our inability to offer solutions that are adequately integrated and customizable to meet the needs of our subscriber base, including due to our failure to successfully integrate acquired companies or to invest adequately in improving our technology platform;

 

    changes in search engine ranking algorithms or in search terms used by potential subscribers, either of which may have the effect of increasing our competitors’ search engine rankings or increasing our marketing costs to offset lower search engine rankings;

 

    changes in, or a failure to manage, technology intended to block email marketing;

 

    failure of our third-party development partners, which provide a significant portion of our offerings, to continue to support existing products and to develop and support new products;

 

    increased competition in the SMB market, including greater marketing efforts or investments by our competitors in advertising and promoting their brands, and the inability of our subscribers to differentiate our solutions from those of our competitors or our inability to effectively communicate such distinctions;

 

    our inability to maintain awareness of our brands, including due to fragmentation of our marketing efforts due to our historical approach of maintaining a portfolio of multiple brands rather than focusing our resources on a single brand or a few brands;

 

    our inability to maintain a consistent user experience and timely and consistent product upgrade schedule for all of our subscribers due to the fact that not all of our brands, products, or services operate from the same control panel or other systems;

 

    our inability to penetrate, or adapt to requirements of, international markets, including our inability to obtain or maintain the required licenses to operate in certain international markets;

 

    our inability to enter into automatically renewing contracts with our subscribers or increase subscription prices;

 

    the decisions by our subscribers to move the hosting of their Internet sites and web infrastructure to their own IT systems, into co-location facilities or to our competitors if we are unable to effectively market the scalability of our solutions;

 

    subscriber dissatisfaction causing our existing subscribers to cancel their subscriptions or stop referring prospective subscribers to us;

 

    increases in our subscriber churn rates; and

 

    perceived or actual security, integrity, reliability, quality or compatibility problems with our solutions, including related to unscheduled downtime, outages or network security breaches.

In the third quarter of 2016, our total subscriber base decreased by approximately 42,000 subscribers due to the factors discussed in “Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations”. We expect that our total subscribers will continue to decrease in the near term. If we are not successful in addressing the factors that have contributed to our decrease in total subscribers or in maintaining or improving our current levels of subscriber churn, we may not be able to return to or maintain positive subscriber or revenue growth in the future, which could have a material adverse effect on our business and financial results.

A substantial amount of our revenue growth historically has been derived from increased sales of products and services to existing subscribers and from introductory subscriptions renewing at regular rates. Our costs associated with increasing revenue from existing subscribers are generally lower than costs associated with generating revenue from new subscribers. Therefore, a reduction in the rate of revenue increase from our existing subscribers (including a reduction due to an increase in subscriber churn), even if offset by an increase in revenue from new subscribers, could reduce our operating margins. Any failure by us to increase our revenue from existing subscribers could have a material adverse effect on our business and financial results.

We must keep up with rapid and ongoing technological change, marketing trends and shifts in consumer demand to remain competitive in a rapidly evolving industry. We have made, and expect to continue to make, significant investments to support our growth strategy, which may not succeed.

The cloud-based technology and online marketing tool industries are characterized by rapid and ongoing technological change, frequent new product and service introductions and evolving industry standards. The manner in which we market to our subscribers

 

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and potential subscribers must keep pace with technological change, legal requirements, market trends, and shifts in how our solutions are found, purchased and used by subscribers. For example, application marketplaces, mobile platforms, advertising and marketing efforts by competitors, and new search engines and search methods are changing the way in which consumers find, purchase and use our solutions. Our future success will depend on our ability to adapt to rapidly changing technologies, to adapt our solutions and marketing practices to evolving industry standards and to anticipate subscriber needs and preferences. If we are not able to offer compelling and innovative solutions, take advantage of new technology, adapt our marketing practices or anticipate changing trends, we may be unable to continue to attract new subscribers or sell additional solutions to our existing subscribers and our competitive position will be impaired. In addition, if existing technologies or systems, such as the domain name system which directs traffic on the Internet, become obsolete, or if we fail to anticipate and manage technologies that prevent or harm our offerings, such as technology intended to block email marketing, our revenue and operating results may be adversely affected.

We have made significant investments to support our growth strategy and we may be required to incur additional technology, development, marketing and other expenses to develop new solutions or enhancements, which may not succeed. For example, during 2016 we have made substantial investments in new gateway product offerings, product marketing and other marketing efforts. The cost of attracting subscribers to these new product offerings has been higher than we expected, and the subscribers we have attracted have to date had higher churn rates than subscribers of our more established products. Even if such investments are ultimately successful, we must recognize the costs of the investments earlier than we may be able to recognize the anticipated benefits, which may continue to adversely affect our revenue and operating results. If there are any delays or defects with our new product offerings or if subscriber demand for these products is lower than expected or the cost to acquire subscribers remains higher than expected, or if subscribers do not remain on our platform for the anticipated period of time or increase their spending with us at the anticipated rate, we may not realize the expected return on our investments, which could continue to adversely affect our financial results.

We face significant competition for our solutions in the SMB market, which we expect will continue to intensify and which could require us to reduce our selling prices. As a result of such competitive pressures, we may not be able to maintain or improve our competitive position or market share.

The SMB market for cloud-based technologies and online marketing tools is highly competitive and constantly evolving. We expect competition to increase from existing competitors, who are also expanding the variety of solution-based services that they offer to SMBs, as well as potential new market entrants and competitors that may form strategic alliances with other competitors. Some of our competitors may have greater resources, more brand recognition and consumer awareness, more diversified product offerings, greater international scope or larger subscriber bases than we do, or may partner with large Internet companies that can offer these resources. As a result, we may not be able to compete successfully against them. If these companies decide to devote greater resources to the development, promotion and sale of their brands, products and services, if the brands, products and services offered by these companies are more attractive to or better meet the evolving needs of SMBs, or if these companies respond more quickly to changing technologies, greater numbers of SMBs may choose to use these competitors for creating an online presence and as a general platform for running online business operations. We believe that our business has been, and may continue to be, affected by changes in the behavior of consumers when searching for web presence and marketing solutions. In particular, consumers have increasingly been searching for these solutions using brand related search terms as opposed to unbranded search terms, such as hosting, website builders or email marketing. We believe this trend assists competitors who have invested more heavily in, and used a broader array of marketing channels in, building consumer awareness of their brand than we have. In addition, searches for specific products such as “cloud hosting”, “social media marketing”, and “ecommerce” are growing, which we believe assists competitors who market more heavily in these and other specific product areas.

There are also relatively few barriers to entry in this market, especially for providers of niche services, which often have low capital and operating expenses and the ability to quickly bring products to market that meet specific subscriber needs. Accordingly, as this market continues to develop, we expect the number of competitors to increase. The continued entry of competitors into the markets for cloud-based technologies and online marketing tools, and the rapid growth of some competitors that have already entered these markets, may make it difficult for us to maintain our market position.

In addition, in an attempt to gain market share, competitors may offer more aggressive price discounts or alternative pricing models, such as so-called “freemium” pricing in which a basic offering is provided for free with advanced features provided for a fee, on the services they offer, bundle several services at reduced prices, or increase commissions paid to their referral sources. These pricing pressures may require us to match these discounts and commissions in order to remain competitive, which would reduce our margins or cause us to fail to attract new subscribers that decide to purchase the discounted service offerings of our competitors. As a result of these factors, it is difficult to predict whether we will be able to maintain our average selling prices, pricing models and commissions paid to our referral sources. If we reduce our selling prices, alter our pricing models or increase commissions paid to our referral sources, it may become increasingly difficult for us to compete successfully, our profitability may be harmed and our operating results could be adversely affected.

 

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The rate of growth of the SMB market for our solutions could be significantly lower than our estimates. The success of our products depends on the expansion and reliability of the Internet infrastructure and the continued growth and acceptance of email as a communications tool. If demand for our products and services does not meet expectations, our ability to generate revenue and meet our financial targets could be adversely affected.

The rate of growth of the SMB market may not meet our expectations, or the market may not continue to grow at all, either of which would adversely affect our business. Our expectations for future revenue growth are based in part on assumptions reflecting our industry knowledge and experience serving SMBs, as well as our assumptions regarding demographic shifts, growth in the Internet infrastructure internationally and macroeconomic conditions. If any of these assumptions proves to be inaccurate, then our actual revenue growth could be significantly lower than our expected revenue growth.

Our ability to compete successfully depends on our ability to offer an integrated and comprehensive suite of products and services that enable our diverse base of subscribers to establish, manage and grow their businesses. Our web presence and commerce offerings are predicated on the assumption that an online presence is, and will continue to be, an important factor in our subscribers’ abilities to establish, expand, manage and monetize their businesses quickly, easily and affordably. If we are incorrect in this assumption, for example due to the introduction of a new technology or industry standard that supersedes the importance of an online presence or renders our existing or future solutions obsolete, then our ability to retain existing subscribers and attract new subscribers could be adversely affected, which could harm our ability to generate revenue and meet our financial targets.

The future success of our email marketing product depends on the continued and widespread adoption of email as a primary means of communication. Security problems such as “viruses,” “worms” and other malicious programs or reliability issues arising from outages and damage to the Internet infrastructure could create the perception that email is not a safe and reliable means of communication. Use of email by businesses and consumers also depends on the ability of internet service providers, or ISPs to prevent unsolicited bulk email, or “spam,” from overwhelming consumers’ inboxes. If security problems become widespread or frequent or if ISPs cannot effectively control spam, the use of email as a means of communication may decline as consumers find alternative ways to communicate. In addition, if alternative communications tools, such as social media or text messaging, gain widespread acceptance, the need for email may lessen. Any decrease in the use of email would reduce demand for our email marketing product and harm our business.

Our business and operations have experienced significant growth and organizational change over the past several years, which has placed, and will continue to place, significant demands on our management and infrastructure, especially our billing systems and operational infrastructure. If we fail to manage our change effectively, we may be unable to execute our business plan, provide high levels of service, produce accurate financial statements and other disclosures on a timely basis or address competitive challenges adequately.

As a result of acquisitions and internal growth, we increased our revenue from $520.3 million in the year ended December 31, 2013 to $629.8 million in the year ended December 31, 2014 to $741.3 million in the year ended December 31, 2015. The acquisition of Constant Contact, which prior to our acquisition generated $367.4 million in revenue in the year ended December 31, 2015, represents a significant expansion in the size and scope of our business.

Growth and organizational change has placed, and will continue to place, a significant strain on our managerial, engineering, network operations and security, sales and support, marketing, legal, compliance, finance and other resources. In particular, these factors have placed, and will continue to place, a significant strain on our ability to maintain effective internal financial and accounting controls and procedures. For example, as a result of our acquisitions, we have acquired multiple billing systems, some of which we are in the process of integrating, and we may acquire and integrate additional billing systems with future acquisitions. Any delays or other challenges associated with billing system build-outs or integrations could lead to inaccurate disclosure, which could prevent us from producing accurate financial statements on a timely basis and harm our operating results, our ability to operate our business and our investors’ view of us. In addition, we have identified in the past, and may in the future identify, errors in our systems, including the business intelligence system, which we use to generate certain operational and performance metrics. For example, in the third quarter of 2015, we identified errors in our business intelligence system that impacted three of our performance metrics, as described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K filed with the SEC on February 29, 2016. Our operational and performance metrics, which we voluntarily disclose, historically have not been subject to the same level of reporting controls as our financial statements and other financial information that we are required to disclose. We are working to improve our controls for these operational and performance metrics, but further errors with respect to these metrics could still occur. Errors of this type could result in inaccurate disclosures, negatively impact our business decisions and harm investors’ view of us.

The increase in the number of subscribers on our platform over the past several years has required us to invest in and improve the security, scale and flexibility of our infrastructure and information technology systems, and the increase in the number of payment transactions that we process for our subscribers has increased the amount of customer data that we store. Any loss of data or disruption in our ability to provide our product offerings due to disruptions to, or the inflexibility or lack of scale of, our infrastructure or information technology systems could harm our business or our reputation.

 

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Our U.S. and overseas operations and geographically dispersed workforce require substantial management effort, the allocation of significant management resources and significant investment in our infrastructure, including our information technology, operational, financial and administrative infrastructure and systems. We also need to ensure that our operational, financial, compliance, risk and management controls and our reporting procedures are in effect throughout our organization, and make improvements as necessary. As such, we may be unable to manage our expenses effectively in the future, which may adversely affect our gross margins or operating expenses in any particular quarter. If we fail to manage organizational change in an effective manner, the quality of our solutions may suffer or fail to keep up with changes in the industry or technological developments, which could adversely affect our brands and reputation and harm our ability to retain and attract subscribers.

The acquisition of Constant Contact and our other recent or potential future acquisitions, joint ventures and other strategic investments may not achieve the intended benefits or may disrupt our current plans and operations.

Acquisitions have been an important component of our growth strategy. In February 2016, we acquired Constant Contact and we have in the past acquired, and expect in the future to acquire, businesses and assets of other companies to increase our growth, add to our product portfolio, enhance our ability to compete in our core markets or allow us to enter new markets. We also regularly make strategic investments in, and enter into joint ventures with, third parties, typically with small companies focused on developing products that we believe may serve as effective new gateways to acquire new subscribers or that may appeal to our existing subscriber base. Our ability to execute these acquisitions, strategic investments and joint venture transactions depends on a number of factors, including the availability of target companies at prices and on terms acceptable to us, our ability to obtain the necessary equity, debt or other financing, and regulatory constraints. Our inability to complete anticipated acquisitions, strategic investments or joint ventures for these or other reasons may negatively impact our ability to achieve our long-term growth targets.

In addition, these transactions involve numerous risks, any of which could harm our business, including:

 

    difficulties or delays in integrating the technologies, products, operations, billing systems, personnel or operations of an acquired business and realizing the anticipated benefits of the combined businesses;

 

    reliance on third parties for transition services prior to subscriber migration or difficulties in supporting and migrating acquired subscribers, if any, to our platform, causing potential loss of such subscribers, unanticipated costs and damage to our reputation;

 

    disruption of our ongoing business and diversion of financial, management, operations and customer support resources from existing operations, including as result of completing acquisitions and evaluating potential acquisitions;

 

    difficulties in applying our controls and risk management and compliance policies and practices to acquired companies and joint ventures;

 

    integration and support of redundant solutions or solutions that are outside of our core capabilities;

 

    the incurrence of additional debt or the issuance of equity securities, resulting in dilution to existing stockholders, in order to fund an acquisition;

 

    assumption of debt or other actual or contingent liabilities of the acquired company, including litigation risk or risks associated with other unforeseen or undisclosed liabilities, or exposure to successor liability for any legal violations of the acquired company;

 

    differences in the standards, procedures, policies, corporate culture and compensation structure of our company and the acquired company, resulting in difficulty assimilating or integrating the acquired organization and its talent, which could lead to unanticipated costs or inefficiencies, morale issues, increased turnover and lower productivity than anticipated, and could also adversely affect the culture of our existing organization;

 

    the price we pay, or other resources that we devote, may exceed the value we realize, or the value we could have realized if we had allocated the purchase price or other resources to another opportunity, or unanticipated costs associated with pursuing acquisitions;

 

    potential loss of an acquired business’ strategic alliances and key employees, including those employees who depart prior to transferring to us, or without otherwise documenting, knowledge and information that are important to the efficient operation of the acquired business;

 

    potential deployment by an acquired company of its top talent to other of its business units prior to our acquisition if we do not acquire the entirety of an acquired company’s stock or assets;

 

    difficulties associated with governance, management and control matters in majority or minority investments or joint ventures, and risk of loss of all or a substantial portion of our investment;

 

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    disruption of our business due to sellers, former employees, contractors or third-party service providers of an acquired company or business misappropriating our intellectual property, violating non-competition agreements, or otherwise causing harm to our company;

 

    failure to properly conduct due diligence efforts, evaluate acquisitions or investments or identify liabilities or challenges associated with the companies, businesses or technologies we acquire;

 

    obligations to third parties that arise as a result of the change of control of the acquired company;

 

    adverse tax consequences, including exposure of our entire business to taxation in additional jurisdictions, exposure to substantial penalties, fees and costs if an acquired company failed to comply, or is alleged by regulatory authorities to have failed to comply, with relevant tax rules and regulations prior to our acquisition, or substantial depreciation or deferred compensation charges; and

 

    accounting effects, including potential impairment charges related to long-lived assets, goodwill and other intangible assets and requirements that we record deferred revenue at fair value.

Our acquisition of Constant Contact may be subject to additional difficulties and risks, including the loss of key employees, and the costs associated with our efforts to retain key employees, as well as the loss of existing and potential Constant Contact customers or partners, including as a result of the actual or perceived impact of the acquisition and integration on Constant Contact customers and partners or the aggressive targeting of existing and potential Constant Contact customers or partners by competitors seeking to capitalize on concerns about the acquisition. Any of the foregoing may impact our ability to successfully integrate our business with Constant Contact’s business and to realize the anticipated benefits and synergies of the Constant Contact acquisition, including the ability to cross-sell our products into Constant Contact’s customer base and vice versa and the ability to adapt Constant Contact’s products to different segments of the SMB market through our multi-brand strategy.

A key purpose of many of our smaller acquisitions, typically acquisitions of small hosting companies, has been to achieve subscriber growth, cost synergies and economies of scale by migrating customers of these companies to our platform. However, for several of our most recent acquisitions of this type, migrations to our platform have taken longer and been more disruptive to subscribers than we anticipated. If we are unable to improve upon our recent migration efforts and continue to experience unanticipated delays and subscriber disruption from migrations, we may not be able to achieve the expected benefits from these types of acquisitions.

We also rely heavily on the representations and warranties provided to us by the sellers in our acquisitions, including as they relate to creation, ownership and rights in intellectual property, existence of open source software and compliance with laws and contractual requirements. If any of these representations and warranties are inaccurate or breached, we may incur liability for which there may be no recourse, or inadequate recourse, against the sellers, in part due to contractual time limitations and limitations of liability, or we may need to pursue costly litigation against the sellers.

The international nature of our business and our continued international expansion expose us to business risks that could limit the effectiveness of our growth strategy and cause our operating results to suffer.

We currently maintain offices and conduct operations primarily in the United States, Brazil, India and the United Kingdom and have third-party support arrangements in India, the Philippines and China. In addition, we have localized versions of our Bluehost and HostGator sites targeted to customers in several countries, including Brazil, Russia, India, China, Turkey and Mexico. We have incurred significant expenses and allocated significant resources, including finance, operational, legal and compliance resources, related to the growth and continued expansion of our international operations and we intend to continue to expand internationally, including through mergers and acquisitions.

Any international expansion efforts that we undertake may not be successful. In addition, conducting operations in international markets or establishing international locations subjects us to new risks that we have not generally faced in the United States. These risks include:

 

    localization of the marketing and deployment of our solutions, including translation into foreign languages and adaptation for local practices and regulatory requirements;

 

    lack of familiarity with, burdens of, and increased expense relating to, complying with foreign laws, legal standards, regulatory requirements, tariffs and other barriers, some of which may favor local competitors, including laws related to employment or labor, laws regarding liability of online service providers for activities of subscribers, such as defamation, infringement or other illegal activities, and more stringent laws in foreign jurisdictions relating to the privacy and protection of personal data, as well as potential damage to our reputation as a result of our compliance or non-compliance with such requirements;

 

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    difficulties in identifying and managing local staff, systems integrators, technology partners, and other third-party vendors and service providers;

 

    diversion of our management’s attention and resources to explore, negotiate, or close acquisitions and to integrate, staff and manage geographically remote operations and employees;

 

    longer than expected lead times for, or the failure of, an SMB market for our solutions to develop in the countries and regions in which we are opening offices and conducting operations;

 

    our inability to effectively market our solutions to SMBs due to our failure to adapt to local cultural norms, technology standards, billing and collection standards or pricing models;

 

    differing technology practices and needs that we are not able to meet, including an increased demand from our international subscribers that our cloud-based solutions be easily accessible and operational on smartphones and tablets;

 

    difficulties in collecting payments from subscribers or in automatically renewing their contracts with us, especially due to the more limited availability and popularity of credit cards in certain countries;

 

    difficulties in attracting new subscribers, especially in developing countries and regions and those where the Internet infrastructure is still in its early stages;

 

    greater difficulty in enforcing contracts, including our terms of service and other agreements;

 

    management, communication and integration problems resulting from cultural or language differences and geographic dispersion;

 

    sufficiency of qualified labor pools and greater influence of organized labor in various international markets;

 

    competition from companies with international operations, including large international competitors and entrenched local companies;

 

    changes in global currency systems or fluctuations in exchange rates that may increase the volatility of or adversely affect our foreign-based revenue;

 

    compliance with the U.S. Foreign Corrupt Practices Act of 1977, as amended, or the FCPA, economic sanction laws and regulations, including those administered by the U.S. Treasury Department’s Office of Foreign Assets Control, or OFAC, export controls including the U.S. Commerce Department’s Export Administration Regulations and other U.S., non-U.S. and local laws and regulations regarding international and multi-national business operations;

 

    potentially adverse tax consequences, including the complexities of foreign value added tax (or sales, use or other tax) systems, our inadvertent failure to comply with all relevant foreign tax rules and regulations due to our lack of familiarity with the jurisdiction’s tax laws, and restrictions and withholdings on the repatriation of earnings;

 

    uncertain political and economic climates; and

 

    reduced or varied protection for intellectual property rights in some countries.

These factors have caused our international costs of doing business to exceed our comparable domestic costs and have caused the time and expense required to close our international acquisitions to exceed our comparable domestic costs. A negative impact from our international business efforts could adversely affect our business, operating results and financial condition as a whole.

In addition, our ability to expand internationally and attract and retain non-U.S. subscribers may be adversely affected by concerns about the extent to which U.S. governmental and law enforcement agencies may obtain data under the Foreign Intelligence Surveillance Act and Patriot Act and similar laws and regulations. Such non-U.S. subscribers may decide that the privacy risks of storing data with a U.S.-based company outweigh the benefits and opt to seek solutions from a company based outside of the United States. In addition, certain foreign governments may require local storage of their citizens’ data. If we become subject to such requirements, it may require us to increase the number of non-U.S. data centers or servers we maintain, increase our costs or adversely affect our ability to attract, retain or cost-effectively serve non-U.S. subscribers.

 

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We have experienced system, software, Internet, data center and customer support center failures and have not yet implemented a complete disaster recovery plan, and any interruptions, delays or failures in our services could harm our reputation, cause our subscribers to seek reimbursement for services paid for and not received, cause our subscribers to stop referring new subscribers to us, or cause our subscribers to seek to replace us as a provider of their cloud-based and online marketing solutions.

We must be able to operate our applications and systems without interruption. Since our ability to retain and attract subscribers depends on the performance, reliability and availability of our services, as well as in the delivery of our products and services to subscribers, even minor interruptions in our service or losses of data could harm our reputation. Our applications, network, systems, equipment, power supplies, customer support centers and data centers are subject to various points of failure, including:

 

    human error or accidents;

 

    power loss;

 

    equipment failure;

 

    Internet connectivity downtime;

 

    improper building maintenance by the landlords of the buildings in which our co-located data centers are located;

 

    physical or electronic security breaches (see also “—Security and privacy breaches may harm our business”);

 

    computer viruses;

 

    fire, hurricane, flood, earthquake, tornado and other natural disasters;

 

    water damage;

 

    terrorism;

 

    intentional bad acts, such as sabotage and vandalism;

 

    pandemics; and

 

    failure by us or our vendors to provide adequate service to our equipment.

We have experienced system failures, delays and periodic interruptions in service, or outages, due to factors including power and network equipment failures; storage system failures; power outages; and network configuration failures. In addition, because our cloud-based platform is complex, we have experienced outages when new versions, enhancements and updates to applications, software or systems are released by us or third parties.

We will likely experience future outages that disrupt the operation of our solutions and harm our business due to factors such as these or other factors, including the accidental or intentional actions of Internet users, current and former employees and others; cooling equipment failures; other computer failures; or other factors not currently known to us or that we consider immaterial. While we have experienced increases in subscriber cancellations and decreases in our Net Promoter Score, or NPS, a customer satisfaction metric developed by Bain & Company, following such outages in the past, we cannot be certain these outcomes are entirely attributable to the outages, and we do not believe that such outages have had a material effect on our business, financial condition or results of operations.

Our systems are not fully redundant, and we have not yet implemented a complete disaster recovery plan or business continuity plan. Although the redundancies we do have in place will permit us to respond, at least to some degree, to failures of applications and systems, our data centers are vulnerable in the event of failure. Most of our subscribers are hosted across six U.S.-based data centers, one of which is owned by us and the rest of which are co-located. Our owned data center hosts a significant portion of our subscribers. Accordingly, any failure or downtime in these data center facilities would affect a significant percentage of our subscribers. We do not yet have adequate structures or systems in place to recover from a data center’s severe impairment or total destruction, and recovery from the total destruction or severe impairment of any of these data centers would be extremely difficult and may not be possible at all. Closing any of these data centers without adequate notice could result in lengthy, if not permanent, interruptions in the availability of our solutions and loss of vast amounts of subscriber data.

Our data centers are also susceptible to impairment resulting from electrical power outages due to the amount of power and cooling they require to operate. Since we rely on third parties to provide our data centers with power sufficient to meet our needs, we cannot control whether our data centers will have an adequate amount of electrical resources necessary to meet our subscriber requirements. We attempt to limit exposure to system downtime due to power outages by using backup generators and power supplies. However, these protections may not limit our exposure to power shortages or outages entirely. We also rely on third parties to provide Internet connectivity to our data centers and any discontinuation or disruption to our connectivity could affect our ability to provide services to our subscribers.

 

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Our customer support centers are also vulnerable in the event of failure caused by total destruction or severe impairment. When calling our customer support services, most of our subscribers reach our customer support teams located in one of our six U.S.-based call centers. Our teams in each call center are trained to provide support services for a discrete subset of our brands, and they do not currently have complete capability to route calls from one call center to another call center. Accordingly, if any one of these call centers were to become non-operational due to severe impairment or total destruction, our ability to re-route calls to operational call centers or to provide customer support services to any subscribers of the brand or brands that the non-operational call center had formerly managed may be compromised. A significant portion of our email and chat-based customer support is provided by an India-based support team, which is employed by a third-party service provider. Although our email and chat-based customer support can be re-routed to our own centers, a disruption at our India customer support center could adversely affect our business.

Any of these events could materially increase our expenses or reduce our revenue, damage our reputation, cause our subscribers to seek reimbursement for services paid for and not received, cause our subscribers to stop referring new subscribers to us, and cause us to lose current and potential subscribers, which would have a material adverse effect on our operating results and financial condition. Moreover, the property and business interruption insurance we carry may not have coverage adequate to compensate us fully for losses that may occur.

If we are unable to maintain a high level of subscriber satisfaction, demand for our solutions could suffer.

We believe that our future revenue growth depends on our ability to provide subscribers with quality service that meets our stated commitments, meets or exceeds our subscribers’ evolving needs and expectations and is conducive to our ability to continue to sell new solutions to existing subscribers. We are not always able to provide our subscribers with this level of service, and our subscribers occasionally encounter interruptions in service and other technical challenges, including as a result of outages or human error.

If we are unable to provide subscribers with quality service, this may result in subscriber dissatisfaction, billing disputes and litigation, lower than expected renewal rates and impairments to our efforts to sell additional products and services to our subscribers, and we could face damage to our reputation, claims of loss, negative publicity or social media attention, decreased overall demand for our solutions and loss of revenue, any of which could have a negative effect on our business, financial condition and operating results.

In addition, we may from time to time fail to meet the needs of specific subscribers in order to best meet the service expectations of our overall subscriber base. For example, we may suspend a subscriber’s website when it breaches our terms of service, harms other subscribers’ websites or disrupts servers supporting those websites, such as when a cybercriminal installs malware on a subscriber’s website without that subscriber’s authorization or knowledge. Although such service interruptions are not uncommon in a cloud-based or online environment, we risk subscriber dissatisfaction by interrupting one subscriber’s service to prevent further attacks on or data breaches for other subscribers, and this could damage our reputation and have an adverse effect on our business.

 

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If the delivery of customers’ emails is limited or blocked or its customers’ emails are directed to an alternate or “tabbed” section of the recipient’s inbox, customers may cancel their accounts.

Internet Service Providers, or ISPs, can block emails from reaching the intended recipients. While we continually improve our technology and work closely with ISPs to maintain the deliverability rates of our email marketing product, the implementation of new or more restrictive policies by ISPs may make it more difficult to deliver our customers’ emails. In addition, some ISPs have started to categorize as “promotional” emails that originate from email service providers and, as a result, direct them to an alternate or “tabbed” section of the recipient’s inbox. If ISPs materially limit or halt the delivery of our customers’ emails, or if we fail to deliver our email marketing customers’ emails in a manner compatible with ISPs’ email handling or authentication technologies or other policies, or if the open rates of its customers’ emails are negatively impacted by the actions of ISPs to categorize emails, then our email marketing customers may question the effectiveness of our products and cancel their email marketing accounts. This, in turn, could harm our business and financial performance.

Security and privacy breaches may harm our business.

We store and transmit large amounts of sensitive, confidential, personal and proprietary information, including payment card information. Any physical or electronic security breach, virus, accident, employee error, criminal activity or malfeasance, fraudulent service plan order, impersonation scam perpetrated against us, security events impacting our third party service providers, intentional misconduct by cyber criminals or similar intrusion, breach or disruption could result in unauthorized access to, usage or disclosure of, or loss of, confidential information, damage to our platform, and interruptions, delays or cessation of service to our subscribers, each of which may cause damage to our reputation and result in increased security costs, litigation, regulatory investigations or other liabilities. The risk that these types of events could seriously harm our business is likely to increase as we expand the number of technology solutions and services that we offer and expand our operations in foreign countries. In addition, we frequently acquire other companies and businesses, which may increase our risk of security or privacy breaches, including if we encounter challenges in the subscriber migration or integration process, or if we do not successfully identify security and privacy vulnerabilities through the due diligence we conduct on acquisition targets.

In addition, many states and countries in which we have subscribers have enacted regulations requiring us to notify subscribers in the event that certain subscriber information is accessed, or believed to have been accessed, without authorization, and in some cases also develop proscriptive policies to protect against such unauthorized access. Such notifications can result in private causes of action being filed against us. Should we experience a loss of protected data, efforts to enhance controls, assure compliance and address penalties imposed by such regulatory regimes could increase our costs.

Organizations generally, and Internet-based organizations in particular, remain vulnerable to targeted attacks aimed at exploiting network and system applications or weaknesses. Techniques used to obtain unauthorized access to, or to sabotage, networks and systems often are not recognized until launched against a target. Cyber criminals are increasingly using powerful new tactics including evasive applications, proxies, tunneling, encryption techniques, vulnerability exploits, buffer overflows, distributed denial of service attacks, or DDoS attacks, botnets and port scans. For example, we are frequently the targets of DDoS attacks in which attackers attempt to block subscribers’ access to our websites. If we are unable to avert a DDoS or other attack for any significant period, we could sustain substantial revenue loss from lost sales and subscriber dissatisfaction. We may not have the resources or technical sophistication to anticipate or prevent rapidly evolving types of cyber-attacks. Moreover, we may not be able to immediately detect that such an attack has been launched, if, for example, unauthorized access to our systems was obtained without our knowledge in preparation for an attack contemplated to commence in the future. Cyber attacks may target us, our subscribers, our partners, banks, credit card processors, delivery services, e-commerce in general or the communication infrastructure on which we depend. We also rely on third parties to provide physical security for our data centers and other facilities. Any physical security breach to our data centers or other facilities could result in unauthorized access or damage to our systems.

Our employees, including our employee and contract support agents are often targeted by, and may be vulnerable to, e-mail scams, phishing, social media or similar attacks, as well as social engineering tactics used to perpetrate fraud. We have experienced and may in the future experience security attacks that cause our support agents to divulge confidential information about us or our subscribers, or to introduce viruses, worms or other malicious software programs onto their computers, allowing the perpetrators to, among other things, gain access to our systems or our subscribers’ accounts. Our subscribers may also use weak passwords, accidentally disclose their passwords or store them on a mobile device that is lost or stolen, or otherwise compromise the security of their data, creating the perception that our systems are not secure against third-party access when their accounts are compromised and used maliciously by third parties. In addition, if third parties with which we work, such as vendors, partners or developers, violate applicable laws or our policies, such violations may also put our information and our subscribers’ information at risk and could in turn have an adverse effect on our business and reputation.

If an actual or perceived security breach occurs, the market’s perception of our security measures could be harmed and we could lose sales and current and potential subscribers. We might also be required to expend significant capital and resources to investigate,

 

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protect against or address these problems. Any significant violations of data privacy could result in the loss of business, litigation and regulatory investigations and penalties that could damage our reputation and adversely affect our operating results and financial condition. Furthermore, if a high profile security breach occurs with respect to another provider of cloud-based technologies or online marketing tools, our subscribers and potential subscribers may lose trust in the security of these business models generally, which could harm our ability to retain existing subscribers or attract new ones. We cannot guarantee that our backup systems, regular data backups, security protocols, network protection mechanisms and other procedures currently in place, or that may be in place in the future, will be adequate to prevent network and service interruption, system failure, damage to one or more of our systems or data loss in the event of a security breach or attack on our network.

If we do not maintain a low rate of credit card chargebacks, protect against breach of the credit card information we store and comply with payment card industry standards, we will face the prospect of financial penalties and could lose our ability to accept credit card payments from subscribers, which would have a material adverse effect on our business, financial condition and operating results.

A majority of our revenue is processed through credit card transactions. Under current credit card industry practices, we are liable for fraudulent and disputed credit card transactions because we do not obtain the cardholder’s signature at the time of the transaction, even though the financial institution issuing the credit card may have authorized the transaction. Although we focus on keeping our rate of credit card refunds and chargebacks low, if our refunds or chargebacks increase, our credit card processors could require us to maintain or increase reserves, terminate their contracts with us or decline to serve as credit card processors for new joint ventures or brands, which would have an adverse effect on our financial condition.

We could also incur significant fines or lose our ability to process payments using credit cards if we fail to follow payment card industry data security standards, even if there is no compromise of subscriber information, if we are unable to accept credit card payments, our financial condition, results of operations and cash flows would be adversely affected.

Our failure to limit fraudulent transactions conducted on our websites, such as through the use of stolen credit card numbers, could also subject us to liability or require us to increase reserves with our credit card processors. Under credit card association rules, penalties may be imposed at the discretion of the association. Any such potential penalties would be imposed on our credit card processor by the association. Under our contracts with our card processors, we are required to reimburse the processor for such penalties. Our current level of fraud protection, based on our fraudulent and disputed credit card transaction history, is within the guidelines established by the credit card associations. However, we face the risk that we may fail to maintain an adequate level of fraud protection or that one or more credit card associations may, at any time, assess penalties against us or terminate our ability to accept credit card payments from subscribers, which would have a material adverse effect on our business, financial condition and operating results.

In addition, we could be liable if there is a breach of the credit card or other payment information we store. Online commerce and communications depend on the secure transmission of confidential information over public networks. We rely on encryption and authentication technology that we have developed internally, as well as technology that we license from third parties, to provide security and authentication for the transmission of confidential information, including subscriber credit card numbers. However, we cannot ensure that this technology can prevent breaches of the systems that we use to protect subscriber credit card data. Although we maintain network security insurance, we cannot be certain that our coverage will be adequate for liabilities actually incurred or that insurance will continue to be available to us on reasonable terms, or at all. In addition, some of our third-party partners also collect information from transactions with our customers, and we may be subject to litigation or our reputation may be harmed if our partners fail to protect our subscribers’ information or if they use it in a manner that is inconsistent with our practices.

Data breaches can also occur as a result of non-technical issues. Under our contracts with our card processors, if there is unauthorized access to, or disclosure of, credit card information that we store, we could be liable to the credit card issuing banks for their cost of issuing new cards and related expenses.

Our growing operations in India, use of an India-based service provider and India-based workforce may expose us to risks that could have an adverse effect on our costs of operations and harm our business.

We currently use India-based third-party service providers to provide certain outsourced services to support our U.S.-based operations, including email- and chat-based customer and technical support, billing support, network monitoring and engineering and development services. As our operations grow, we expect to increase our use of these and other India-based outsourced service providers. Although there are cost advantages to operating in India, significant growth in the technology sector in India has increased competition to attract and retain skilled employees and has led to a commensurate increase in compensation costs. In the future, we or our third-party service providers may not be able to hire and retain such personnel at compensation levels consistent with our existing compensation and salary structure in India. In addition, we employ our own India-based workforce. Our use of a workforce in India

 

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exposes us to disruptions in the business, political and economic environment in that region. Our operations in India require us to comply with local laws and regulatory requirements, which are complex and burdensome and of which we may not always be aware, and expose us to foreign currency exchange rate risk. Our Indian operations may also subject us to trade restrictions, reduced or inadequate protection for intellectual property rights, security breaches and other factors that may adversely affect our business. Negative developments in any of these areas could increase our costs of operations or otherwise harm our business.

We have a history of losses and may not be able to maintain profitability.

We have had a net loss in each year since inception through 2015. We had a net loss of $159.2 million for fiscal year 2013, a net loss of $42.8 million for fiscal year 2014 and a net loss of $25.8 million for fiscal year 2015 and we may incur losses in the future. In connection with our acquisitions, we have recorded long-lived assets at fair value. We record amortization expense in each reporting period related to the long-lived assets, which impacts the amount of net loss or income we record in each reporting period.

We have made and expect to continue to make significant expenditures to develop and expand our business. Increases in revenue and number of subscribers that we have experienced over the past several years may not be sustainable, and our revenue may be insufficient to maintain profitability. As further discussed in “Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations”, total subscribers decreased in the third quarter of 2016, and our core hosting and web presence business showed relatively slow revenue and subscriber growth during the first nine months of 2016. If we are not successful in addressing the factors that have contributed to these developments, we may not be able to either return to prior levels of subscriber and revenue growth or maintain current subscriber and revenue levels, which could result in a material adverse effect on our business and financial results. We may incur significant losses in the future for these or a number of other reasons, including interest expense related to our substantial indebtedness, and the other risks described in this report, and we may encounter unforeseen expenses, difficulties, complications and delays and other unknown events.

We may need additional equity, debt or other financing in the future, which we may not be able to obtain on acceptable terms, or at all, and any additional financing may result in restrictions on our operations or substantial dilution to our stockholders.

We may need to raise funds in the future, for example, to develop new technologies, expand our business, respond to competitive pressures, acquire businesses, or respond to unanticipated situations. We may try to raise additional funds through public or private financings, strategic relationships or other arrangements. Although our credit agreement limits our ability to incur additional indebtedness, these restrictions are subject to a number of qualifications and exceptions, and our credit agreement may be amended with the consent of our lenders.

Our ability to obtain debt or equity funding will depend on a number of factors, including market conditions, interest rates, our operating performance and investor interest. Additional funding may not be available to us on acceptable terms or at all. If adequate funds are not available, we may be required to reduce expenditures, including curtailing our growth strategies, foregoing acquisitions or reducing our product development efforts. If we succeed in raising additional funds through the issuance of equity or convertible securities, then the issuance could result in substantial dilution to existing stockholders. If we raise additional funds through the issuance of debt securities or preferred stock, these new securities would have rights, preferences and privileges senior to those of the holders of our common stock. In addition, any preferred equity issuance or debt financing that we may obtain in the future could have restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. To the extent any such new indebtedness is secured and is at higher interest rates than on our existing first lien term loan facility, the interest rates on our existing first lien term loan facility could increase as a result of the “most-favored nation” pricing provision in our existing credit agreement. Further, to the extent that we incur additional indebtedness or such other obligations, the risks associated with our substantial leverage described elsewhere in this report, including our possible inability to service our debt, would increase.

Our business depends on establishing and maintaining strong brands. If we are not able to effectively promote our brands, or if the reputation of our brands is damaged, our ability to expand our subscriber base will be impaired and our business and operating results will be harmed.

We market our solutions through various brands, including Bluehost, HostGator, iPage, Domain.com, A Small Orange, MOJO Marketplace, BigRock, ResellerClub, Constant Contact and SinglePlatform, among others.

We believe that establishing and maintaining our brands is critical to our efforts to expand our subscriber base. If we do not continue to build awareness of our brands, we could be placed at a competitive disadvantage to companies whose brands are, or become, more recognizable than ours. For instance, we believe that our business has been, and may continue to be, affected by the increasing tendency of consumers to search for web presence and marketing solutions using brand related search terms as opposed to unbranded search terms such as hosting, website builders or email marketing. We believe this trend assists competitors who have

 

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invested more heavily in, and used a broader array of marketing channels in, building consumer awareness of their brand than we have. To attract and retain subscribers and to promote and maintain our brands in response to competitive pressures, we may have to substantially increase our financial commitment to creating and maintaining distinct brand loyalty among subscribers or eliminate certain of our brands. We are currently evaluating different marketing strategies aimed at increasing brand awareness.

 

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If subscribers, as well as our third-party referral marketing, distribution and reseller partners, do not perceive our existing solutions to be reliable and of high quality, if we introduce new services or enter into new business ventures that are not favorably received by such parties, or if our brands become associated with any fraudulent or deceptive conduct on the part of our subscribers, the value of our brands could be diminished, thereby decreasing the attractiveness of our solutions to such parties. As a result, our operating results may be adversely affected by decreased brand recognition and harm to our reputation.

Our success depends in part on our strategic relationships and joint ventures or other alliances with third parties on whom we rely to acquire subscribers and to offer solutions to our subscribers and from which we license intellectual property to develop our own solutions.

In order to expand our business, we plan to continue to rely on third-party relationships and alliances, such as with referrers and promoters of our brands and solutions, as well as with our providers of solutions and services that we offer to subscribers. Identifying, negotiating, documenting and managing relationships with third parties in certain cases requires significant time and resources, and it is possible that we may not be able to devote the time and resources we expect to such relationships. Integrating and customizing third parties’ solutions with our platform also requires us to expend significant time and resources to ensure that each respective solution works with our platform, as well as with our other products and services. If any of the third parties on which we rely fails to perform as expected, breaches or terminates their agreement with us, or becomes engaged in a dispute with us, our reputation could be adversely affected and our business could be harmed.

We rely on third-party referral partners and other marketing partners to acquire subscribers. If these partners fail to promote our brands or to refer new subscribers to us, begin promoting competing brands in addition to ours, fail to comply with regulations, are forced to change their marketing efforts in response to new or existing regulations or cease to be viewed as credible sources of information by our potential subscribers, we may face decreased demand for our solutions, higher than expected subscriber acquisition costs, and loss of revenue. For instance, we believe that subscriber growth and subscriber acquisition costs at one of our brands have recently been negatively affected because an important referral source is now featuring several other web hosting options on their website, rather than just our brand. Some of our third-party partners purchase our solutions and resell them to their customer bases. These partners have the direct contractual relationships with our ultimate subscribers and, therefore, we risk the loss of both our third-party partners and their customers if our services fail to meet expectations or if our partners fail to perform their obligations or deliver the level of service to the ultimate subscriber that we expect.

Our ability to offer domain name services to our subscribers depends on certain third-party relationships. For example, certain of our subsidiaries are accredited by ICANN and various other registries as a domain name registrar. If we fail to comply with domain name registry requirements or if domain name registry requirements change, we could lose our accreditation, be required to increase our expenditures, comply with additional requirements or alter our service offerings, any of which could have a material adverse effect on our business, financial condition or results of operations.

We also have relationships with product partners whose solutions, including site builders, shopping carts and security tools, we offer to our subscribers. A majority of our offerings are provided by third parties. We may be unable to continue our relationship with any of these partners if, for example, they decline to continue to work with us or are acquired by third parties. In such an event, we may not be able to continue to offer these third-party tools to our subscribers or we may be forced to find an alternative that may be inferior to the solution that we had previously offered, which could harm our business and our operating results.

We also rely on software licensed from or hosted by third parties to offer our solutions to our subscribers. In addition, we may need to obtain future licenses from third parties to use intellectual property associated with the development of our solutions, which might not be available to us on acceptable terms, or at all. Any loss of the right to use any software or other intellectual property required for the development and maintenance of our solutions could result in delays in the provision of our solutions until equivalent technology is either developed by us, or, if available, is identified, obtained and integrated. Any errors or defects in third-party software could result in errors or a failure of our solutions which could harm our business and operating results. Further, we cannot be certain that the owners’ rights in their technologies will not be challenged, invalidated or circumvented.

Constant Contact relies on some of its partners to create integrations with third-party applications and platforms used by Constant Contact’s customers. If we fail to encourage these partners to create such integrations or if we do not adequately facilitate these integrations from a technology perspective, demand for Constant Contact products could decrease, which could harm our business and operating results.

 

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We rely on a limited number of data centers to deliver most of our services. If we are unable to renew our data center agreements on favorable terms, or at all, our operating margins and profitability could be adversely affected and our business could be harmed. In addition, our ownership of our largest data center subjects us to potential costs and risks associated with real property ownership.

We currently serve most of our subscribers from six data center facilities located in Massachusetts (three), Texas, Utah and California. We own one of our data centers and occupy the remaining data centers pursuant to co-location service agreements with third-party data center facilities which have built and maintain the co-located data centers for us and other parties. Although we own the servers in these six data centers and engineer and architect the systems upon which our platform runs, we do not control the operation of the facilities we do not own.

The terms of our existing co-located data center agreements vary in length and expire over a period ranging from 2016 through 2021. The owners of these or our other co-located data centers have no obligation to continue such arrangements beyond their current terms, nor are they obligated to renew their agreements with us on terms acceptable to us, or at all.

Our existing co-located data center agreements may not provide us with adequate time to transfer operations to a new facility in the event of early termination or if we were unable to negotiate a short-term transition arrangement or renew these agreements on terms acceptable to us. If we were required to move our equipment to a new facility without adequate time to plan and prepare for such migration, we would face significant challenges due to the technical complexity, risk and high costs of the relocation. Any such migration would result in significant costs for us and significant downtime for large numbers of our subscribers. This could damage our reputation and cause us to lose current and potential subscribers, which would harm our operating results and financial condition.

If we are able to renew the agreements on our existing co-located data center facilities, we expect that the lease rates will be higher than those we pay under our existing agreements. If we fail to increase our revenue by amounts sufficient to offset any increases in lease rates for these facilities, our operating results may be materially and adversely affected.

We currently intend to continue to contract with third-party data center operators, but we could be forced to re-evaluate those plans depending on the availability and cost of data center facilities, the ability to influence and control certain design aspects of the data center, and economic conditions affecting the data center operator’s ability to add additional facilities.

With respect to the data center facility that we own, we are subject to risks, and may incur significant costs, related to our ownership of the facility and the land on which it is located, including costs or risks related to building repairs or upgrades and compliance with various federal, state and local laws applicable to real property owners, including environmental laws.

If our solutions and software contain serious errors or defects, or if human error on our part results in damage to our subscribers’ businesses, then we may lose revenue and market acceptance and may incur costs to defend or settle claims.

Complex technology platforms, software applications and systems such as ours often contain errors or defects, such as errors in computer code or other systems errors, particularly when first introduced or when new versions, enhancements or updates are released. Because we also rely on third parties to develop many of our solutions, our products and services may contain additional errors or defects as a result of the integration of the third party’s product. Despite quality assurance measures, internal testing and beta testing by our subscribers, we cannot guarantee that our current and future solutions will not be free of serious defects, which could result in lost revenue or a delay in market acceptance.

Since our subscribers use our solutions to, among other things, maintain an online presence for their business, it is not uncommon for subscribers to allege that errors, defects, or other performance problems result in damage to their businesses. They could elect to cancel or not to renew their agreements, delay or withhold payments to us, or bring claims or file suit seeking significant compensation from us for the losses they or their businesses allege to have suffered. For instance, from time to time, our customer support personnel have inadvertently deleted subscriber data due to human error, technical problems or miscommunication with customers. These lost data cases have sometimes led to subscribers commencing litigation against us, settlement payments to subscribers, subscription cancellations, and negative social media attention. Although our subscriber agreements typically contain provisions designed to limit our exposure to specified claims, including data loss claims, existing or future laws or unfavorable judicial decisions could negate or diminish these limitations. Even if not successful, defending against claims brought against us can be time-consuming and costly and could seriously damage our reputation in the marketplace, making it harder for us to acquire and retain subscribers.

 

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Because we are required to recognize revenue for our subscription-based services over the term of the applicable subscriber agreement, changes in our sales may not be immediately reflected in our operating results. In addition, we may not have adequate reserves in the event that our historical levels of refunds increase, which could adversely affect our liquidity and profitability.

We recognize revenue from our subscribers ratably over the respective terms of their agreements with us in accordance with U.S. generally accepted accounting principles. These contracts are generally for service periods of up to 36 months. Accordingly, increases in sales during a particular period do not translate into corresponding increases in revenue during that same period, and a substantial portion of the revenue that we recognize during a quarter is derived from deferred revenue from our agreements with subscribers that we entered into during previous quarters. As a result, we may not generate net earnings despite substantial sales activity during a particular period, since we are not allowed under applicable accounting rules to recognize all of the revenue from these sales immediately, and because we are required to record a significant portion of our related operating expenses during that period. Conversely, the existence of substantial deferred revenue may prevent deteriorating sales activity from becoming immediately apparent in our reported operating results.

In connection with our domain registration services, as a registrar, we are required under our agreements with domain registries to prepay the domain registry for the term for which a domain is registered. We recognize this prepayment as an asset on our consolidated balance sheet and record domain revenue and the domain registration expense ratably over the term that a domain is registered. This cash payment to the domain registry may lead to fluctuations in our liquidity that is not immediately reflected in our operating results.

In addition, our standard terms of service permit our subscribers to seek refunds from us in certain instances, and we maintain reserves to provide such refunds. The amount of such reserves is based on the amount of refunds that we have provided in the past. If our actual level of refund claims exceeds our estimates and our refund reserves are not adequate to cover such claims, our liquidity or profitability could be adversely affected. Furthermore, if we experience an unexpected decline in our revenue, we may not be able to adjust spending in a timely manner to compensate for such shortfall, and any significant shortfall in revenue relative to planned expenditures could adversely affect our business and operating results.

We depend on the experience and expertise of our senior management team, and the loss of any member of our senior management team could have an adverse effect on our business, financial condition and operating results.

Our success and future performance depends in significant part upon the continued service of our senior management team, particularly Hari Ravichandran, our founder and chief executive officer. The members of our senior management team are not contractually obligated to remain employed by us. Accordingly, and in spite of our efforts to retain our senior management team with long-term equity incentives, any member of our senior management team could terminate his or her employment with us at any time and go to work for one of our competitors after the expiration of his or her non-compete period. The replacement of members of our senior management team likely would involve significant time and expense, and the loss of any member of our senior management team could significantly delay, prevent the achievement of or make it more difficult for us to pursue and execute on our business objectives, and could have an adverse effect on our business, financial condition and operating results.

Our growth will be adversely affected if we cannot continue to successfully retain, hire, train and manage our key employees.

Our ability to successfully pursue our growth strategy will depend on our ability to attract, retain and motivate key employees across our business. In particular, we are dependent on our platform and software engineers, those who manage our sales and service employees, and, as we grow internationally, those employees managing our operations outside of the United States. We face intense competition for these and other employees from numerous technology, software and manufacturing companies, and we cannot ensure that we will be able to attract, integrate or retain additional qualified employees in the future or at compensation levels consistent with our existing compensation and salary structure. In particular, candidates making employment decisions, particularly in high-technology industries, often consider the value of any equity they may receive in connection with their employment. As a result, any significant volatility in the market price of our common stock may adversely affect our ability to attract or retain highly skilled engineers and marketing personnel. In addition, we invest significant time and expense in training our employees, which increases their value to competitors who may seek to recruit them.

If we are unable to attract new employees and retain our current employees, we may not be able to develop and maintain our services at the same levels as our competitors, and we may therefore lose subscribers and market share. Our failure to attract and retain qualified individuals could have an adverse effect on our ability to execute on our business objectives and, as a result, our ability to compete could decrease, our operating results could suffer and our revenue could decrease.

 

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We are subject to governmental regulation and other legal obligations, particularly related to privacy, data protection and information security, and we are subject to consumer protection laws that regulate our marketing practices and prohibit unfair or deceptive acts and practices. Our actual or perceived failure to comply with such obligations could harm our business. Compliance with such laws could also impair our efforts to maintain and expand our subscriber base and provide certain of our product offerings, and thereby decrease our revenue.

The U.S. Federal Trade Commission, or FTC, and various state and local governments and agencies regularly use their authority under laws prohibiting unfair and deceptive marketing and trade practices to investigate and penalize companies for practices related to the collection, use, handling, disclosure, and security of personal data of U.S. consumers. In addition, in connection with the marketing and advertisement of our products and services by us or our affiliates, we could be the target of claims relating to false or deceptive advertising or marketing practices, including under the auspices of the FTC and state consumer protection statutes.

In the European Union, or EU, and in other jurisdictions outside of the United States, we could be the target of similar claims under consumer protection laws, regulation of cloud services, ecommerce and distance selling regulation, advertising regulation, unfair competition rules or similar legislation. Online digital services may be subject to increased scrutiny in the near future given their rapid growth in recent years. For example, on December 1, 2015, the UK Competition and Markets Authority, or the CMA, announced that it was conducting a review of compliance with UK consumer protection laws in the cloud storage sector. As part of that effort, the CMA contacted a number of cloud storage companies, including our UK subsidiary, JDI Backup Ltd, or JDI, requesting that information be provided on a voluntary basis. JDI provided the CMA with the requested information and committed to undertakings to make certain improvements to its terms and disclosures.

If we are found to have breached any consumer protection, ecommerce and distance selling, advertising, unfair competition laws or similar legislation in any country or any laws regulating cloud services, we may be subject to enforcement actions that require us to change our business practices in a manner which may negatively impact revenue, as well as litigation, fines, penalties and adverse publicity that could cause our subscribers to lose trust in us, which could have an adverse effect on our reputation and business in a manner that harms our financial position. We also rely on third parties to provide marketing and advertising of our products and services, and we could be liable for, or face reputational harm as a result of, their marketing practices if, for example, they fail to comply with applicable statutory and regulatory requirements.

We collect personally identifiable information and other data from our subscribers and prospective subscribers. We use this information to provide services to our subscribers, to support, expand and improve our business and, subject to each subscriber’s or prospective subscriber’s right to decline or opt out, we may use this information to market other products and services to them. We may also share subscribers’ personally identifiable information with certain third parties as authorized by the subscriber or as described in the applicable privacy policy.

The U.S. federal and various state and foreign governments have adopted or proposed guidelines or rules for the collection, distribution, use and storage of personal information of individuals, and the FTC and many state attorneys general are applying federal and state consumer protection laws to impose standards for the online collection, use and dissemination of data. However, these obligations may be interpreted and applied in a manner that is inconsistent from one jurisdiction to another and may conflict with other requirements or our practices. Any failure or perceived failure by us to comply with privacy or security laws, policies, legal obligations or industry standards or any security incident that results in the unauthorized release or transfer of personally identifiable information or other subscriber data may result in governmental enforcement actions, litigation, fines and penalties and/or adverse publicity and could cause our subscribers to lose trust in us, which could have an adverse effect on our reputation and business.

In addition, several foreign countries and governmental bodies, including the countries of the EU and Canada, have laws and regulations dealing with the collection and use of personal data obtained from their residents, which are often more restrictive than those in the United States. Laws and regulations in these jurisdictions apply broadly to the collection, use, storage, disclosure and security of personal information that identifies or may be used to identify an individual, such as names, contact information, and, in some jurisdictions, certain unique identifiers.

The data privacy regime in the EU includes certain directives which, among other things, require EU member states to regulate the processing and movement of personal data, marketing and the use of cookies. Each EU member state has transposed the requirements of these directives into its own national data privacy regime, and therefore the laws differ from jurisdiction to jurisdiction.

Future laws or regulations, or modifications to existing laws or regulations, could impair our ability to collect and/or use user information that we use to provide targeted advertising to our users, thereby impairing our ability to maintain and grow our subscriber base and increase revenue. Future restrictions on the collection, use, sharing or disclosure of our subscribers’ data or additional requirements for obtaining the consent of subscribers for the use and disclosure of such information could require us to modify our solutions and features, possibly in a material manner, and could limit our ability to develop new services and features.

For example, within the EU, legislators agreed upon the text of a new EU-wide General Data Protection Regulation, or GDPR, in December 2015 that is expected to come into effect in early 2018 and will replace the data protection laws of each EU member state. The GDPR will implement more stringent operational requirements for processors and controllers of personal data, including,

 

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for example, expanded disclosures about how personal information is to be used, limitations on retention of information, increased requirements to erase an individual’s information upon request, mandatory data breach notification requirements and higher standards for data controllers to demonstrate that they have obtained valid consent for certain data processing activities. It also significantly increases penalties for non-compliance. If our privacy or data security measures fail to comply with applicable current or future laws and regulations, we may be subject to litigation, regulatory investigations, enforcement notices requiring us to change the way we use personal data or our marketing practices, fines or other liabilities, as well as negative publicity and a potential loss of business. Moreover, if future laws and regulations limit our subscribers’ or prospective subscribers’ ability to use and share personal data or our ability to store, process and share personal data, demand for our solutions could decrease, our costs could increase, and our business, results of operations and financial condition could be harmed.

In recent years, U.S. and European lawmakers and regulators have expressed concern over the use of third-party cookies, web beacons and similar technology for online behavioral advertising. In the EU, informed consent is required for the placement of a cookie on a user’s device. Any failure by us to comply with applicable requirements may result in governmental enforcement actions, litigation, fines and penalties or adverse publicity which could have an adverse effect on our reputation and business. Regulation of cookies and web beacons may lead to broader restrictions on our research activities, including efforts to understand users’ Internet usage. Such regulations may have a chilling effect on businesses, such as ours, that collect and use online usage information in order to attract and retain customers and may increase the cost of maintaining a business that collects or uses online usage information, increase regulatory scrutiny and increase the potential for civil liability under consumer protection laws. In response to marketplace concerns about the usage of third-party cookies and web beacons to track user behaviors, providers of major browsers have included features that allow users to limit the collection of certain data in general or from specified websites, and some regulatory authorities have been advocating the development of browsers that block cookies by default. These developments could impair our ability to collect user information that helps us provide more targeted advertising to our users. If such technology is widely adopted, it could adversely affect our business, given our use of cookies and similar technologies to target our marketing.

Furthermore, the U.S. Controlling the Assault of Non Solicited Pornography and Marketing Act of 2003, or CAN SPAM Act, establishes certain requirements for commercial email messages and specifies penalties for the transmission of commercial email messages that are intended to deceive the recipient as to source or content. The CAN SPAM Act, among other things, obligates the sender of commercial emails to provide recipients with the ability to opt out of receiving future emails from the sender. In addition, some states have passed laws regulating commercial email practices that are significantly more punitive and difficult to comply with than the CAN SPAM Act, particularly Utah and Michigan, which have enacted do-not-email registries listing minors who do not wish to receive unsolicited commercial email that markets certain covered content, such as adult or other harmful products. Some portions of these state laws may not be pre-empted by the CAN SPAM Act. The ability of our subscribers’ customers to opt out of receiving commercial emails may minimize the effectiveness of our products, particularly Constant Contact’s email marketing product. Moreover, non-compliance with the CAN SPAM Act carries significant financial penalties. If we were found to be in violation of the CAN SPAM Act, applicable state laws not pre-empted by the CAN SPAM Act, or similar foreign laws regulating the distribution of commercial email, whether as a result of violations by our subscribers or if we were deemed to be directly subject to and in violation of these requirements, we could be required to pay penalties, which would adversely affect our financial performance and significantly harm our business, and our reputation would suffer. We also may be required to change one or more aspects of the way we operate our business, which could impair our ability to attract and retain subscribers or could increase our operating costs.

We rely on third parties to carry out a number of services for us, including processing personal data on our behalf, and while we enter into contractual arrangements to ensure that they only process such data according to our instructions and have sufficient security measures in place, any security breach or non-compliance with our contractual terms or breach of applicable law by such third parties could result in governmental enforcement actions, litigation, fines and penalties or adverse publicity and could cause our subscribers to lose trust in us, which could have an adverse impact on our reputation and business.

New laws, regulations or standards or new interpretations of existing laws, regulations or standards, including those in the areas of data security, data privacy, consumer protection and regulation of ISPs, could require us to incur additional costs and restrict our business operations. In addition, there is a risk that we could be held subject to legislation in countries where we reasonably thought the laws did not apply to us. Failure by us to comply with applicable requirements may result in governmental enforcement actions, litigation, fines and penalties or adverse publicity, which could have an adverse effect on our reputation and business.

Failure to adequately protect and enforce our intellectual property rights could substantially harm our business and operating results.

We have devoted substantial resources to the development of our intellectual property, proprietary technologies and related processes. In order to protect our intellectual property, proprietary technologies and processes, we rely upon a combination of trademark, patent and trade secret law, as well as confidentiality procedures and contractual restrictions. These afford only limited protection, may not prevent disclosure of confidential information, may not provide an adequate remedy in the event of

 

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misappropriation or unauthorized disclosure, and may not now or in the future provide us with a competitive advantage. Despite our efforts to protect our intellectual property rights, unauthorized parties, including employees, subscribers and third parties, may make unauthorized or infringing use of our products, services, software and other functionality, in whole or in part, or obtain and use information that we consider proprietary.

Policing our proprietary rights and protecting our brands and domain names is difficult and costly and may not always be effective. In addition, we may need to enforce our rights under the laws of countries that do not protect proprietary rights to as great an extent as do the laws of the United States and any changes in, or unexpected interpretations of, the intellectual property laws in any country in which we operate may compromise our ability to enforce our intellectual property rights. To the extent we expand our international activities, our exposure to unauthorized copying and use of our trademarks, products and proprietary information may increase.

We have registered, or applied to register, the trademarks associated with several of our leading brands in the United States and in certain other countries. Competitors may have adopted, and in the future may adopt, service or product names similar to ours, which could impede our ability to build our brands’ identities and possibly lead to confusion. In addition, there could be potential trade name or trademark infringement claims brought by owners of other registered trademarks or trademarks that incorporate variations of the terms or designs of one of our trademarks.

Litigation or proceedings before the U.S. Patent and Trademark Office or other governmental authorities and administrative bodies in the United States and abroad may be necessary to enforce our intellectual property rights or to defend against claims of infringement or invalidity. Such litigation or proceedings could be costly, time-consuming and distracting to our management, result in a diversion of resources, the impairment or loss of portions of our intellectual property, and have a material adverse effect on our business and operating results. There can be no assurance that our efforts to enforce or protect our proprietary rights will be adequate or that our competitors will not independently develop similar technology. In addition, the legal standards relating to the validity, enforceability and scope of protection of intellectual property rights on the Internet are uncertain and still evolving. Our failure to meaningfully establish and protect our intellectual property could result in substantial costs and diversion of resources and could substantially harm our business and operating results.

We could incur substantial costs as a result of any claim of infringement of another party’s intellectual property rights.

In recent years, there has been significant litigation in the United States and abroad involving patents and other intellectual property rights. Companies providing Internet-based products and services are increasingly bringing and becoming subject to suits alleging infringement of proprietary rights, particularly patent rights, and to the extent we face increasing competition and become increasingly visible as a publicly-traded company, or if we become more successful, the possibility of intellectual property infringement claims may increase. In addition, our exposure to risks associated with the use of intellectual property may increase as a result of acquisitions that we make or our use of software licensed from or hosted by third parties, as we have less visibility into the development process with respect to such technology or the care taken to safeguard against infringement risks. Third parties may make infringement and similar or related claims after we have acquired or licensed technology that had not been asserted prior to our acquisition or license.

Many companies are devoting significant resources to obtaining patents that could affect many aspects of our business. Since we do not have a significant patent portfolio, this may prevent us from deterring patent infringement claims, and our competitors and others may now and in the future have significantly larger and more mature patent portfolios than we have.

We have filed several patent applications in the United States and foreign counterpart filings for some of those applications. Although some of these applications have issued to registration, we cannot assure you that patents will issue from every patent application, or that we will prosecute every application to registration, that patents that issue from our applications will give us the protection that we seek, or that any such patents will not be challenged, invalidated or circumvented. Any patents that may issue in the future from our pending or future patent applications may not provide sufficiently broad protection and may not be enforceable in actions against alleged infringers.

The risk of patent litigation has been amplified by the increase in certain third parties, so-called “non-practicing entities,” whose sole business is to assert patent claims and against which our own intellectual property portfolio may provide little deterrent value. We could incur substantial costs in prosecuting or defending any intellectual property litigation and we have incurred such costs in the past. If we sue to enforce our rights or are sued by a third party that claims that our solutions infringe its rights, the litigation could be expensive and could divert our management’s time and attention. Even a threat of litigation could result in substantial expense and time.

Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential information could be compromised by disclosure. In addition, during the course of any such

 

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litigation, there could be public announcements of the results of hearings, motions or other interim proceedings or developments. If securities analysts or investors perceive these results to be negative, it could have a substantial adverse effect on the price of our common stock.

Any intellectual property litigation to which we might become a party, or for which we are required to provide indemnification, may require us to do one or more of the following:

 

    cease selling or using solutions that incorporate the intellectual property that our solutions allegedly infringe;

 

    make substantial payments for legal fees, settlement payments or other costs or damages;

 

    obtain a license or enter into a royalty agreement, which may not be available on reasonable terms or at all, to sell or use the relevant technology; or

 

    redesign the allegedly infringing solutions to avoid infringement, which could be costly, time-consuming or impossible.

If we are required to make substantial payments or undertake any of the other actions noted above as a result of any intellectual property infringement claims against us, our business or operating results could be harmed.

In addition, some of our agreements with partners and others require us to indemnify those parties for third-party intellectual property infringement claims, which would increase the cost to us resulting from an adverse ruling on any such claim.

Our use of “open source” software could adversely affect our ability to sell our services and subject us to possible litigation.

We use open source software, such as MySQL and Apache, in providing a substantial portion of our solutions, and we may incorporate additional open source software in the future. Such open source software is generally licensed by its authors or other third parties under open source licenses. If we fail to comply with these licenses, we may be subject to certain conditions, including requirements that we offer our solutions that incorporate the open source software for no cost; that we make available source code for modifications or derivative works we create based upon, incorporating or using the open source software; and/or that we license such modifications or derivative works under the terms of the particular open source license. In addition, if a third-party software provider has incorporated open source software into software that we license from such provider, we could be required to disclose any of our source code that incorporates or is a modification of such licensed software. If an author or other third party that distributes such open source software were to allege that we had not complied with the conditions of one or more of these licenses, we could be required to incur significant legal expenses defending such allegations and could be subject to significant damages, enjoined from the sale of our solutions that contained the open source software, and required to comply with the foregoing conditions, which could disrupt the distribution and sale of some of our solutions. In addition, there have been claims challenging the ownership of open source software against companies that incorporate open source software into their products. As a result, we could be subject to suits by parties claiming ownership of what we believe to be open source software. Such litigation could be costly for us to defend, have a negative effect on our operating results and financial condition or require us to devote additional research and development resources to change our products.

We could face liability, or our reputation might be harmed, as a result of the activities of our subscribers, the content of their websites, the data they store on our servers or the emails that they send.

Our role as a provider of cloud-based solutions, including website hosting services, domain registration services and email marketing, may subject us to potential liability for the activities of our subscribers on or in connection with their websites or domain names or for the data they store on or send using our servers. Although our subscriber terms of use prohibit illegal use of our services by our subscribers and permit us to take down websites or take other appropriate actions for illegal use, subscribers may nonetheless engage in prohibited activities or upload or store content with us in violation of applicable law or the subscriber’s own policies, which could subject us to liability.

Several U.S. federal statutes may apply to us with respect to various subscriber activities:

 

    The Digital Millennium Copyright Act of 1998, or DMCA, provides recourse for owners of copyrighted material who believe that their rights under U.S. copyright law have been infringed on the Internet. Under the DMCA, based on our current business activity as an online service provider that does not monitor, own or control website content posted by our subscribers, we generally are not liable for infringing content posted by our subscribers or other third parties, provided that we follow the procedures for handling copyright infringement claims set forth in the DMCA. Generally, if we receive a proper notice from, or on behalf of, a copyright owner alleging infringement of copyrighted material located on websites we host, and we fail to expeditiously remove or disable access to the allegedly infringing material or otherwise fail to meet the requirements of the safe harbor provided by the DMCA, the copyright owner may seek to impose liability on us. Technical mistakes in complying with the detailed DMCA take-down procedures could subject us to liability for copyright infringement.

 

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    The Communications Decency Act of 1996, or CDA, generally protects interactive computer service providers such as us, from liability for certain online activities of their customers, such as the publication of defamatory or other objectionable content. As an interactive computer services provider, we do not monitor hosted websites or prescreen the content placed by our subscribers on their sites. Accordingly, under the CDA, we are generally not responsible for the subscriber-created content hosted on our servers. However, the CDA does not apply in foreign jurisdictions and we may nonetheless be brought into disputes between our subscribers and third parties which would require us to devote management time and resources to resolve such matters and any publicity from such matters could also have an adverse effect on our reputation and therefore our business.

 

    In addition to the CDA, the Securing the Protection of our Enduring and Established Constitutional Heritage Act, or the SPEECH Act, provides a statutory exception to the enforcement by a U.S. court of a foreign judgment that is less protective of free speech than the United States. Generally, the exception applies if the law applied in the foreign court did not provide at least as much protection for freedom of speech and press as would be provided by the First Amendment of the U.S. Constitution or by the constitution and law of the state in which the U.S. court is located, or if no finding of a violation would be supported under the First Amendment of the U.S. Constitution or under the constitution and law of the state in which the U.S. court is located. Although the SPEECH Act may protect us from the enforcement of foreign judgments in the United States, it does not affect the enforceability of the judgment in the foreign country that issued the judgment. Given our international presence, we may therefore, nonetheless, have to defend against or comply with any foreign judgments made against us, which could take up substantial management time and resources and damage our reputation.

Although these statutes and case law in the United States have generally shielded us from liability for subscriber activities to date, court rulings in pending or future litigation, or future legislative or regulatory actions, may narrow the scope of protection afforded us under these laws. Several court decisions arguably have already narrowed the scope of the immunity provided to interactive computer services in the United States under the CDA. In addition, laws governing these activities are unsettled in many international jurisdictions, or may prove difficult or impossible for us to comply with in some international jurisdictions. Also, notwithstanding the exculpatory language of these bodies of law, we may be embroiled in complaints and lawsuits which, even if ultimately resolved in our favor, add cost to our doing business and may divert management’s time and attention. Finally, other existing bodies of law, including the criminal laws of various states, may be deemed to apply or new statutes or regulations may be adopted in the future, any of which could expose us to further liability and increase our costs of doing business.

In addition, our email marketing subscribers could also use our email marketing products or website to transmit negative messages or website links to harmful applications, reproduce and distribute copyrighted material or the trademarks of others without permission, or report inaccurate or fraudulent data or information. Any such use of our email marketing products could damage our reputation and we could face claims for damages, copyright or trademark infringement, defamation, negligence or fraud. Moreover, our email marketing customers’ promotion of their products and services through our email marketing products may not comply with federal, state and foreign laws.

We cannot predict whether our role in facilitating these activities would expose us to liability under these laws. Even if claims asserted against us do not result in liability, we may incur substantial costs in investigating and defending such claims. If we are found liable for our customers’ activities, we could be required to pay fines or penalties, redesign business methods or otherwise expend resources to remedy any damages caused by such actions and to avoid future liability.

We may face liability for, or become involved in, disputes in connection with ownership or control of subscriber accounts, domain names or email contact lists or in connection with domain names we own.

As a provider of cloud-based solutions, including as a registrar of domain names and related services, we from time to time become aware of disputes over ownership or control of subscriber accounts, websites or domain names. For example, disputes may arise as a result of a subscriber engaging a webmaster or other third party to help set up a web hosting account, register or renew a domain name, build a website, upload content, or set up email or other services.

We could face potential claims of tort law liability for our failure to renew a subscriber’s domain, and we have faced such liability in the past. We could also face potential tort law liability for our role in the wrongful transfer of control or ownership of accounts, websites or domain names. The safeguards and procedures we have adopted may not be successful in insulating us against liability from such claims in the future. In addition, we face potential liability for other forms of account, website or domain name “hijacking,” including misappropriation by third parties of subscriber accounts, websites or domain names and attempts by third parties to operate accounts, websites or domain names or to extort the subscriber whose accounts, websites or domain names were

 

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misappropriated. Furthermore, our risk of incurring liability for a security breach on or in connection with a subscriber account, website or domain name would increase if the security breach were to occur following our sale to a subscriber of an SSL certificate that proved ineffectual in preventing it. Finally, we are exposed to potential liability as a result of our domain privacy service, wherein the identity and contact details for the domain name registrant are masked. Although our terms of service reserve the right to provide the underlying WHOIS information and/or to cancel privacy services on domain names giving rise to domain name disputes, including when we receive reasonable evidence of an actionable harm, the safeguards we have in place may not be sufficient to avoid liability, which could increase our costs of doing business.

Occasionally a subscriber may register a domain name that is identical or similar to another party’s trademark or the name of a living person. Disputes involving registration or control of domain names are often resolved through the Uniform Domain Name Dispute Resolution Policy, or UDRP, ICANN’s administrative process for domain name dispute resolution, or through litigation under the Anticybersquatting Consumer Protection Act, or ACPA, or under general theories of trademark infringement or dilution. The UDRP generally does not impose liability on registrars, and the ACPA provides that registrars may not be held liable for registering or maintaining a domain name absent a showing of bad faith, intent to profit or reckless disregard of a court order by the registrar. However, we may face liability if we fail to comply in a timely manner with procedural requirements under these rules. In addition, these processes typically require at least limited involvement by us and, therefore, increase our costs of doing business. Moreover, as the owner of domain name portfolios containing domains that we are providing for resale, we may face liability if one or more domain names in our portfolios is alleged to violate another party’s trademark. While we screen the domains we acquire to mitigate the risk of third-party claims of trademark infringement, we may nonetheless inadvertently register or acquire domains that infringe or allegedly infringe third-party rights. Moreover, advertisements displayed on websites associated with domains registered by us may contain allegedly infringing content placed by third parties. As a result, our involvement in domain name disputes may increase in the future.

We are subject to export controls and economic sanctions laws that could impair our ability to compete in international markets and subject us to liability if we are not in full compliance with applicable laws.

Our business activities are subject to various restrictions under U.S. export controls and trade and economic sanctions laws, including the U.S. Commerce Department’s Export Administration Regulations and economic and trade sanctions regulations maintained by OFAC. Failure to comply with these laws and regulations could subject us to civil or criminal penalties, government investigations, and reputational harm. In addition, if our third-party resellers fail to comply with these laws and regulations in their dealings, we could face potential liability or penalties for violations. Furthermore, U.S. export control laws and economic sanctions laws prohibit certain transactions with U.S. embargoed or sanctioned countries, governments, persons and entities.

Although we take precautions and have implemented, and continue to seek to enhance, compliance measures to prevent transactions with U.S. sanction targets, from time to time we have identified, and we expect to continue to identify, instances of non-compliance with these laws, rules and regulations and transactions which we are required to block and report to OFAC. In addition, as a result of our acquisition activities, we have acquired, and it is likely that we will continue to acquire, companies for which we could face potential liability or penalties for violations if they have not implemented sufficient compliance measures to prevent transactions with U.S. sanction targets. Until we are able to fully integrate our compliance processes into the operations of such acquired companies, we are at an increased risk of transacting business with U.S. sanction targets. Our failure to comply with these laws, rules and regulations could result in negative consequences to us, including government investigations, penalties and reputational harm.

Changes in our solutions or changes in export and import regulations may create delays in the introduction and sale of our solutions in international markets, prevent our subscribers with international operations from deploying our solutions or, in some cases, prevent the export or import of our solutions to certain countries, governments or persons altogether. Any change in export or import regulations, shift in the enforcement or scope of existing regulations, or change in the countries, governments, persons or technologies targeted by such regulations, could result in decreased use of our solutions or decreased ability to export or sell our solutions to existing or potential subscribers with international operations. Any decreased use of our solutions or limitation on our ability to export or sell our solutions could adversely affect our business, financial condition and operating results.

Due to the global nature of our business, we could be adversely affected by violations of anti-bribery laws.

The global nature of our business requires us to comply with laws and regulations that prohibit bribery and corruption anywhere in the world. The FCPA, the U.K. Bribery Act 2010, or the Bribery Act, and similar anti-bribery laws in other jurisdictions where we do business generally prohibit companies and their intermediaries from making improper payments to government officials and other persons for the purpose of obtaining or retaining business or an improper business advantage. In addition, the FCPA requires public companies to maintain records that accurately and fairly represent their transactions and have an adequate system of internal accounting controls. We currently operate, and plan to expand our operations, in areas of the world that have a reputation for heightened risks of corruption and, in certain circumstances, compliance with anti-bribery laws may conflict with local customs and practices. We operate in several countries and sell our products to subscribers around the world, which requires our employees and

 

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business partners acting on our behalf to comply with all laws, including anti-corruption laws. In addition, changes in laws could result in increased regulatory requirements and compliance costs which could adversely affect our business, financial condition and results of operations. We cannot assure that our employees, business partners or other agents will not engage in prohibited conduct and expose us to the risk of liability under the FCPA, the Bribery Act, or other anti-bribery laws. If we are found to be in violation of the FCPA, the Bribery Act or other anti-bribery laws, we could suffer criminal and civil penalties, other sanctions, and reputational damage, which could have a material adverse effect on our business.

Adverse economic conditions in the United States and international economies could harm our operating results.

Unfavorable general economic conditions, such as a recession or economic slowdown in the United States or in one or more of our other major markets, could adversely affect the affordability of, and demand for, our solutions. The national and global economic downturn in recent years affected many sectors of the economy and resulted in, among other things, declines in overall economic growth, consumer and corporate confidence and spending; increases in unemployment rates; and uncertainty about economic stability. Changing macroeconomic conditions may affect our business in a number of ways, making it difficult to accurately forecast and plan our future business activities. In particular, SMB spending patterns are difficult to predict and are sensitive to the general economic climate, the economic outlook specific to the SMB industry, the SMB’s level of profitability and debt and o