10-Q 1 now-2016331x10q.htm 10-Q 10-Q


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

FORM 10-Q
x
Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended March 31, 2016
OR
 ¨
Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Commission File Number: 001-35580

SERVICENOW, INC.
(Exact name of registrant as specified in its charter) 
Delaware
 
20-2056195
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification Number)


ServiceNow, Inc.
2225 Lawson Lane
Santa Clara, California 95054
(408) 501-8550
(Registrant's telephone number, including area code) 


Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes x No  ¨
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes x 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 x
Accelerated filer ¨
Non-accelerated filer ¨ (Do not check if a smaller reporting company)
Smaller reporting company  ¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes  ¨ No x
As of March 31, 2016, there were approximately 162.8 million shares of the Registrant’s Common Stock outstanding.




TABLE OF CONTENTS

 
 
 
Page
 
 
Item 1.
 
Condensed Consolidated Balance Sheets as of March 31, 2016 (Unaudited) and December 31, 2015
 
Condensed Consolidated Statements of Comprehensive Loss for the Three Months Ended March 31, 2016 and 2015 (Unaudited)
 
Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2016 and 2015 (Unaudited)
 
Item 2.
Item 3.
Item 4.
 
 
 
 
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
 
 
 
 
   
 
 

i



PART I

ITEM 1.     FINANCIAL STATEMENTS

SERVICENOW, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
 
March 31,
 
December 31,
 
2016
 
2015
 
(Unaudited)
 
 
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
453,450

 
$
412,305

Short-term investments
447,423

 
388,945

Accounts receivable, net
190,263

 
203,333

Current portion of deferred commissions
55,588

 
51,976

Prepaid expenses and other current assets
46,534

 
29,076

Total current assets
1,193,258

 
1,085,635

Deferred commissions, less current portion
36,417

 
33,016

Long-term investments
361,831

 
422,667

Property and equipment, net
154,244

 
144,714

Intangible assets, net
46,246

 
43,005

Goodwill
57,364

 
55,669

Other assets
24,683

 
22,346

Total assets
$
1,874,043

 
$
1,807,052

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
39,621

 
$
37,369

Accrued expenses and other current liabilities
336,613

 
101,264

Current portion of deferred revenue
672,049

 
593,003

Total current liabilities
1,048,283

 
731,636

Deferred revenue, less current portion
10,468

 
10,751

Convertible senior notes, net
482,643

 
474,534

Other long-term liabilities
30,293

 
23,317

Total liabilities
1,571,687

 
1,240,238

Stockholders’ equity:
 
 
 
Common stock
162

 
160

Additional paid-in capital
1,207,104

 
1,140,545

Accumulated other comprehensive loss
(14,569
)
 
(16,882
)
Accumulated deficit
(890,341
)
 
(557,009
)
Total stockholders’ equity
302,356

 
566,814

Total liabilities and stockholders’ equity
$
1,874,043

 
$
1,807,052

 
See accompanying notes to condensed consolidated financial statements

1



SERVICENOW, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(Unaudited)
(in thousands, except share and per share data)
 
 
Three Months Ended March 31,
 
2016
 
2015
Revenues:
 
 
 
Subscription
$
267,422

 
$
179,907

Professional services and other
38,457

 
32,057

Total revenues
305,879

 
211,964

Cost of revenues(1):
 
 
 
Subscription
52,781

 
42,444

Professional services and other
41,479

 
34,455

Total cost of revenues
94,260

 
76,899

Gross profit
211,619

 
135,065

Operating expenses(1):
 
 
 
Sales and marketing
158,610

 
110,057

Research and development
65,924

 
49,848

General and administrative
41,237

 
29,392

Legal settlement
270,000

 

Total operating expenses
535,771

 
189,297

Loss from operations
(324,152
)
 
(54,232
)
Interest expense
(8,109
)
 
(7,578
)
Interest and other income (expense), net
702

 
4,704

Loss before provision for income taxes
(331,559
)
 
(57,106
)
Provision for income taxes
1,773

 
987

Net loss
$
(333,332
)
 
$
(58,093
)
Net loss per share - basic and diluted
$
(2.06
)
 
$
(0.38
)
Weighted-average shares used to compute net loss per share - basic and diluted
162,067,108

 
151,601,880

Other comprehensive gain (loss):
 
 
 
Foreign currency translation adjustments
$
680

 
$
(4,059
)
Unrealized gain on investments, net of tax
1,633

 
494

Other comprehensive gain (loss), net of tax
2,313

 
(3,565
)
Comprehensive loss
$
(331,019
)
 
$
(61,658
)
 
(1)
Includes stock-based compensation as follows:
 
Three Months Ended March 31,
 
2016
 
2015
Cost of revenues:
 
 
 
Subscription
$
6,607

 
$
5,165

Professional services and other
6,759

 
5,213

Sales and marketing
30,998

 
22,574

Research and development
20,533

 
15,638

General and administrative
10,411

 
9,484

 See accompanying notes to condensed consolidated financial statements

2


SERVICENOW, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)

 
Three Months Ended March 31,
 
2016
 
2015
Cash flows from operating activities:
 
 
 
Net loss
$
(333,332
)
 
$
(58,093
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization
17,452

 
13,824

Amortization of premiums on investments
1,490

 
1,830

Amortization of deferred commissions
18,033

 
15,597

Amortization of debt discount and issuance costs
8,109

 
7,578

Stock-based compensation
75,308

 
58,074

Other
(330
)
 
(1,943
)
Changes in operating assets and liabilities, net of effect of acquisitions:
 
 
 
Accounts receivable
15,811

 
10,436

Deferred commissions
(23,971
)
 
(15,400
)
Prepaid expenses and other assets
(19,808
)
 
(18,887
)
Accounts payable
3,387

 
6

Deferred revenue
70,803

 
55,861

Accrued expenses and other liabilities
245,735

 
(1,517
)
Net cash provided by operating activities
78,687

 
67,366

Cash flows from investing activities:
 
 
 
Purchases of property and equipment
(29,077
)
 
(26,699
)
Business combination, net of cash acquired
(500
)
 
(1,100
)
Purchase of other intangibles
(5,750
)
 

Purchases of investments
(180,365
)
 
(132,364
)
Sales of investments
92,885

 
49,412

Maturities of investments
91,858

 
76,386

Restricted cash
(457
)
 
31

Net cash used in investing activities
(31,406
)
 
(34,334
)
Cash flows from financing activities:
 
 
 
Proceeds from employee stock plans
19,873

 
30,474

Taxes paid related to net share settlement of equity awards
(28,453
)
 
(735
)
Payments on financing obligation
(110
)
 

Net cash (used in) provided by financing activities
(8,690
)
 
29,739

Foreign currency effect on cash and cash equivalents
2,554

 
(7,245
)
Net increase in cash and cash equivalents
41,145

 
55,526

Cash and cash equivalents at beginning of period
412,305

 
252,455

Cash and cash equivalents at end of period
$
453,450

 
$
307,981

Supplemental disclosures of non-cash investing activities:
 
 
 
Property and equipment included in accounts payable and accrued expenses
$
8,393

 
$
8,475



See accompanying notes to condensed consolidated financial statements

3



SERVICENOW, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Unless the context requires otherwise, references in this report to “ServiceNow,” the "Company", “we,” “us,” and “our” refer to ServiceNow, Inc. and its consolidated subsidiaries.

(1)    Description of the Business
 
ServiceNow is a leading provider of enterprise cloud computing solutions that define, structure, manage and automate services across the global enterprise. Our mission is to help the modern enterprise operate faster and be more scalable by applying a service-oriented lens to the activities, tasks and processes that comprise day-to-day work life.

 
(2)    Summary of Significant Accounting Policies
 
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements and condensed footnotes have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring items) considered necessary for fair statement of results for the interim periods presented have been included. The results of operations for the three months ended March 31, 2016 are not necessarily indicative of the results to be expected for the year ended December 31, 2016 or for other interim periods or for future years. The condensed consolidated balance sheet as of December 31, 2015 is derived from audited financial statements as of that date, however, it does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s Form 10-K for the year ended December 31, 2015, which was filed with the Securities and Exchange Commission on February 25, 2016.
 
Principles of Consolidation
 
The condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles, or GAAP, and include our accounts and the accounts of our wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated upon consolidation.

Prior Period Reclassification
 
Certain reclassifications of prior period amounts have been made to conform to the current period presentation.
 
Use of Estimates
 
The preparation of condensed consolidated financial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements, as well as reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
  
Warranties and Indemnification 

Our cloud computing solutions are typically warranted to perform in material conformance with its specifications.
 
We include service level commitments to our customers that permit those customers to receive credits in the event we fail to meet those service levels. We establish an accrual based on an evaluation of the known service disruptions. Service level credit accrual charges are recorded against revenue and were not material for all periods presented.


4



We have also agreed to indemnify our directors and executive officers for costs associated with any fees, expenses, judgments, fines and settlement amounts incurred by any of these persons in any action or proceeding to which any of those persons is, or is threatened to be, made a party by reason of the person’s service as a director or officer, including any action by us, arising out of that person’s services as a director or officer of our company or that person’s services provided to any other company or enterprise at our request. We maintain director and officer insurance coverage that may enable us to recover a portion of any future amounts paid. The fair values of these obligations are not material as of each balance sheet date.

Our agreements include provisions indemnifying customers against intellectual property and other third-party claims. We have not incurred any costs as a result of such indemnification obligations and have not recorded any liabilities related to such obligations in the condensed consolidated financial statements.

Recent Accounting Pronouncements

In March 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2016-09, "Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting," which includes multiple provisions intended to simplify accounting for share-based payments. This new standard is effective for our interim and annual periods beginning January 1, 2017 and early adoption is permitted. We are currently evaluating the impact of this standard on our condensed consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)," which requires lessees to generally recognize on the balance sheet operating and financing lease liabilities and corresponding right-of-use assets, and to recognize on the income statement the expenses in a manner similar to current practice. This new standard is effective for our interim and annual periods beginning January 1, 2019 and early adoption is permitted. While we are currently evaluating the impact of this standard on our condensed consolidated financial statements, we anticipate this standard will have a material impact on our condensed consolidated financial statements given the significant amount of operating leases we have.

In January 2016, the FASB issued ASU 2016-01, "Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities," which addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. This new standard is effective for our interim and annual periods beginning January 1, 2018 and early adoption is not permitted. We are currently evaluating the impact of this standard on our condensed consolidated financial statements.

In April 2015, the FASB issued ASU 2015-05, "Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement." ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes software. If a cloud computing arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. We adopted this standard during the three months ended March 31, 2016 on a prospective basis and the adoption had no material impact on our condensed consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers (Topic 606)," which will supersede virtually all existing revenue guidance. Under this standard, an entity is required to recognize revenue upon transfer of promised goods or services to customers in an amount that reflects the expected consideration received in exchange for those goods or services. As such, an entity will need to use more judgment and make more estimates than under the current guidance. This standard should be applied retrospectively either to each prior reporting period presented in the financial statements, or only to the most current reporting period presented in the financial statements with a cumulative effect adjustment recorded in the retained earnings. In March 2016, the FASB issued ASU 2016-08, "Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)," which clarifies the principal versus agent guidance in the new revenue recognition standard. In April 2016, the FASB issued ASU 2016-10, "Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing," which clarifies the guidance on accounting for licenses of intellectual property (IP) and identifying performance obligations in the new revenue recognition standard. These new standards are effective for our interim and annual periods beginning January 1, 2018 and early adoption is permitted. We are currently evaluating the impact of these standards on our condensed consolidated financial statements.


5



(3)    Investments
 
Marketable securities

The following is a summary of our available-for-sale investment securities, excluding those securities classified within cash and cash equivalents on the consolidated balance sheets (in thousands):
 
 
March 31, 2016
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
Available-for-sale securities:
 
 
 
 
 
 
 
Commercial paper
$
38,433

 
$
1

 
$

 
$
38,434

Corporate notes and bonds
655,617

 
617

 
(468
)
 
655,766

Certificates of deposit
14,467

 

 

 
14,467

U.S. government agency securities
100,589

 
28

 
(30
)
 
100,587

Total available-for-sale securities
$
809,106

 
$
646

 
$
(498
)
 
$
809,254

 
 
December 31, 2015
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
Available-for-sale securities:
 
 
 
 
 
 
 
Commercial paper
$
32,430

 
$
2

 
$
(38
)
 
$
32,394

Corporate notes and bonds
617,054

 
7

 
(2,027
)
 
615,034

Certificates of deposit
29,610

 
2

 
(17
)
 
29,595

U.S. government agency securities
134,962

 
1

 
(374
)
 
134,589

Total available-for-sale securities
$
814,056

 
$
12

 
$
(2,456
)
 
$
811,612


As of March 31, 2016, the contractual maturities of our investments did not exceed 24 months. The fair values of available-for-sale investments, by remaining contractual maturity, are as follows (in thousands):
 
March 31, 2016
Due in 1 year or less
$
447,423

Due in 1 year through 2 years
361,831

Total
$
809,254

    
We had certain available-for-sale securities in a gross unrealized loss position, substantially all of which had been in such position for less than 12 months. There were no impairments considered "other-than-temporary" as it is more likely than not we will hold the securities until maturity or a recovery of the cost basis. The following table shows the fair values and the gross unrealized losses of these securities, classified by the length of time that the securities have been in a continuous unrealized loss position, and aggregated by investment types (in thousands):
 
 
March 31, 2016
 
Less than 12 Months
 
12 Months or Greater
 
Total
 
Fair Value
 
Gross
Unrealized
Losses
 
Fair Value
 
Gross
Unrealized
Losses
 
Fair Value
 
Gross
Unrealized
Losses
Corporate notes and bonds
$
338,073

 
$
(468
)
 
$

 
$

 
$
338,073

 
$
(468
)
U.S. government agency securities
66,202

 
(30
)
 

 

 
66,202

 
(30
)
Total
$
404,275

 
$
(498
)
 
$

 
$

 
$
404,275

 
$
(498
)

6




 
December 31, 2015
 
Less than 12 Months
 
12 Months or Greater
 
Total
 
Fair Value
 
Gross
Unrealized
Losses
 
Fair Value
 
Gross
Unrealized
Losses
 
Fair Value
 
Gross
Unrealized
Losses
Commercial paper
$
24,913

 
$
(38
)
 
$

 
$

 
$
24,913

 
$
(38
)
Corporate notes and bonds
539,586

 
(1,897
)
 
60,099

 
(130
)
 
599,685

 
(2,027
)
Certificates of deposit
19,750

 
(17
)
 

 

 
19,750

 
(17
)
U.S. government agency securities
132,581

 
(374
)
 

 

 
132,581

 
(374
)
Total
$
716,830

 
$
(2,326
)
 
$
60,099

 
$
(130
)
 
$
776,929

 
$
(2,456
)

Strategic investments

We account for our investments in non-marketable equity securities of certain privately-held companies under the cost method, as we have less than a 20% ownership interest and we do not have the ability to exercise significant influence over the operations of these companies.  The carrying value of these investments was $10.5 million as of March 31, 2016 and December 31, 2015, which is included in "Other assets" on the condensed consolidated balance sheets.
 
(4)    Fair Value Measurements
 
The following table presents our fair value hierarchy for our assets measured at fair value on a recurring basis at March 31, 2016 (in thousands): 
 
Level 1
 
Level 2
 
Total
Cash equivalents:
 
 
 
 
 
Money market funds
$
88,990

 
$

 
$
88,990

Short-term investments:
 
 
 
 
 
Commercial paper

 
38,434

 
38,434

Corporate notes and bonds

 
350,828

 
350,828

Certificates of deposit

 
6,962

 
6,962

U.S. government agency securities

 
51,199

 
51,199

Long-term investments:
 
 
 
 
 
Corporate notes and bonds

 
304,938

 
304,938

Certificates of deposit

 
7,505

 
7,505

U.S. government agency securities

 
49,388

 
49,388

Total
$
88,990

 
$
809,254

 
$
898,244

 

7



The following table presents our fair value hierarchy for our assets measured at fair value on a recurring basis at December 31, 2015 (in thousands): 
 
Level 1
 
Level 2
 
Total
Cash equivalents:
 
 
 
 
 
Money market funds
$
263,515

 
$

 
$
263,515

Commercial paper

 
2,000

 
2,000

Corporate notes and bonds

 
1,119

 
1,119

Short-term investments:
 
 
 
 
 
Commercial paper

 
32,394

 
32,394

Corporate notes and bonds

 
303,567

 
303,567

Certificates of deposit

 
23,736

 
23,736

U.S. government agency securities

 
29,248

 
29,248

Long-term investments:
 
 
 
 
 
Corporate notes and bonds

 
311,467

 
311,467

Certificates of deposit

 
5,859

 
5,859

U.S. government agency securities

 
105,341

 
105,341

Total
$
263,515

 
$
814,731

 
$
1,078,246


We determine the fair value of our security holdings based on pricing from our service provider and market prices from industry-standard independent data providers. Such market prices may be quoted prices in active markets for identical assets (Level 1 inputs) or pricing determined using inputs other than quoted prices that are observable either directly or indirectly (Level 2 inputs), such as yield curve, volatility factors, credit spreads, default rates, loss severity, current market and contractual prices for the underlying instruments or debt, broker and dealer quotes, as well as other relevant economic measures.

See Note 8 for the fair value measurement of our convertible senior notes.

(5) Goodwill and Intangible Assets
Goodwill balances are presented below (in thousands):
 
Carrying Amount
Balance as of December 31, 2015
$
55,669

Foreign currency translation adjustments
1,695

Balance as of March 31, 2016
$
57,364


Intangible assets consist of the following (in thousands):
 
March 31, 2016
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
Developed technology
$
58,715

 
$
(20,398
)
 
$
38,317

Other
8,575

 
(646
)
 
7,929

Total intangible assets
$
67,290

 
$
(21,044
)
 
$
46,246

 
December 31, 2015
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
Developed technology
$
58,144

 
$
(17,463
)
 
$
40,681

Other
3,695

 
(1,371
)
 
2,324

Total intangible assets
$
61,839

 
$
(18,834
)
 
$
43,005

Amortization expense for intangible assets for the three months ended March 31, 2016 and 2015 was approximately $2.9 million and $3.0 million, respectively.

8




(6)    Property and Equipment
 
Property and equipment, net consists of the following (in thousands):
 
 
March 31,
 
December 31,
 
2016
 
2015
Computer equipment and software
$
197,253

 
$
180,197

Leasehold improvements
33,126

 
31,659

Furniture and fixtures
27,527

 
26,017

Building
6,513

 
6,318

Construction in progress
3,200

 
1,886

 
267,619

 
246,077

Less: Accumulated depreciation
(113,375
)
 
(101,363
)
Total property and equipment, net
$
154,244

 
$
144,714

 
Construction in progress consists primarily of leasehold improvements and in-process software development costs. Depreciation expense for the three months ended March 31, 2016 and 2015 was $14.6 million and $10.8 million, respectively.

(7)    Accrued Expenses and Other Current Liabilities
 
Accrued expenses and other current liabilities consist of the following (in thousands):
 
 
March 31,
 
December 31,
 
2016
 
2015
Taxes payable
$
8,129

 
$
9,080

Bonuses and commissions
36,097

 
33,124

Accrued compensation
18,211

 
17,089

Other employee expenses
14,136

 
21,529

Accrued legal settlement expenses (1)
250,000

 

Other
10,040

 
20,442

Total accrued expenses and other current liabilities
$
336,613

 
$
101,264


(1)
Refer to Note 14 for further details.
 
(8)    Convertible Senior Notes
In November 2013, we issued 0% convertible senior notes due November 1, 2018 with an aggregate principal amount of $575 million, or the Notes. The Notes will not bear interest. The Notes mature on November 1, 2018 unless converted or repurchased in accordance with their terms prior to such date. We cannot redeem the Notes prior to maturity.
The Notes are unsecured obligations and do not contain any financial covenants or restrictions on the payments of dividends, the incurrence of indebtedness or the issuance or repurchase of securities by us or any of our subsidiaries.
Upon conversion, we may choose to pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock. We intend to settle the principal amount of the Notes with cash.
The Notes are convertible up to 7.8 million shares of our common stock at an initial conversion rate of approximately 13.54 shares of common stock per $1,000 principal amount, which is equal to an initial conversion price of approximately $73.88 per share of common stock, subject to adjustment. Holders of the Notes may convert their Notes at their option at any time prior to the close of business on the business day immediately preceding July 1, 2018, only under the following circumstances:

during any calendar quarter commencing after the calendar quarter ending on March 31, 2014 (and only during such calendar quarter), if the last reported sale price of the common stock for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;

9




during the five business day period after any five consecutive trading day period, or the measurement period, in which the trading price per $1,000 principal amount of the Notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such trading day; or

upon the occurrence of specified corporate events.

On or after July 1, 2018, a holder may convert all or any portion of its notes at any time prior to the close of business on the second scheduled trading day immediately preceding the maturity date regardless of the foregoing conditions. Upon conversion, we will pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock, at our election.

The conversion price will be subject to adjustment in some events. Holders of the Notes who convert their notes in connection with certain corporate events that constitute a “make-whole fundamental change” are, under certain circumstances, entitled to an increase in the conversion rate. Additionally, in the event of a corporate event that constitutes a “fundamental change,” holders of the Notes may require us to purchase with cash all or a portion of the Notes upon the occurrence of a fundamental change, at a purchase price equal to 100% of the principal amount of the Notes plus any accrued and unpaid interest.

In accounting for the issuance of the Notes, we separated the Notes into liability and equity components. The carrying cost of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the par value of the Notes. The difference between the principal amount of the Notes and the proceeds allocated to the liability component, or the debt discount, is amortized to interest expense using the effective interest method over the term of the Note. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.

In accounting for the transaction costs related to the issuance of the Notes, we allocated the total amount incurred to the liability and equity components based on their relative fair values. Transaction costs attributable to the liability component are being amortized to interest expense over the term of the Notes, and transaction costs attributable to the equity component were netted with the equity component of the Notes in stockholders’ equity. The Notes consisted of the following (in thousands):
 
March 31, 2016
 
December 31, 2015
Liability:
 
 
 
Principal
$
575,000

 
$
575,000

Less: debt issuance cost and debt discount, net of amortization
(92,357
)
 
(100,466
)
Net carrying amount
$
482,643

 
$
474,534


We consider the fair value of the Notes at March 31, 2016 and December 31, 2015 to be a Level 2 measurement. The estimated fair values of the Notes were $610.4 million and $741.8 million at March 31, 2016 and December 31, 2015, respectively (based on the closing trading price per $100 of the Notes on March 31, 2016 and December 31, 2015, respectively). The Notes were not convertible as of March 31, 2016 and December 31, 2015.

As of March 31, 2016, the remaining life of the Notes is 31 months. The following table sets forth total interest expense recognized related to the Notes (in thousands):
 
Three Months Ended March 31,
 
2016
 
2015
Amortization of debt issuance cost
$
435

 
$
406

Amortization of debt discount
7,674

 
7,172

Total
$
8,109

 
$
7,578

Effective interest rate of the liability component
6.5%

Note Hedge


10



To minimize the impact of potential economic dilution upon conversion of the Notes, we entered into convertible note hedge transactions, or the Note Hedge, with respect to our common stock concurrent with the issuance of the Notes. The Note Hedge covers approximately 7.8 million shares of our common stock at a strike price per share that corresponds to the initial conversion price of the Notes, subject to adjustment, and is exercisable upon conversion of the Notes. We paid an aggregate amount of $135.8 million for the Note Hedge. The Note Hedge will expire upon maturity of the Notes. The Note Hedge is intended to reduce the potential economic dilution upon conversion of the Notes in the event that the fair value per share of our common stock at the time of exercise is greater than the conversion price of the Notes. The Note Hedge is a separate transaction and is not part of the terms of the Notes. The Note Hedge does not impact earnings per share, as it was entered into to offset any dilution from the Notes.

Warrants

Separately, we entered into warrant transactions, or the Warrants, whereby we sold warrants to acquire up to 7.8 million shares of our common stock, at a strike price of $107.46 per share, subject to adjustment. We received aggregate proceeds of $84.5 million from the sale of the Warrants. If the average market value per share of our common stock for the reporting period, as measured under the Warrants, exceeds the strike price of the Warrants, the Warrants will have a dilutive effect on our earnings per share. The Warrants are separate transactions and are not remeasured through earnings each reporting period. The Warrants are not part of the Notes or the Note Hedge, and have been accounted for as part of additional paid-in capital.

(9)    Accumulated Other Comprehensive Loss

The components of accumulated other comprehensive loss, net of tax, consist of the following (in thousands):

 
March 31,
 
December 31,
 
2016
 
2015
Foreign currency translation adjustment
$
(13,758
)
 
$
(14,438
)
Net unrealized loss on investments, net of tax
(811
)
 
(2,444
)
        Accumulated other comprehensive loss
$
(14,569
)
 
$
(16,882
)

Reclassification adjustments out of accumulated other comprehensive loss into net loss were immaterial for all periods presented.

(10)    Stockholders' Equity
 
Common Stock

We were authorized to issue 600,000,000 shares of common stock as of March 31, 2016. Holders of our common stock are not entitled to receive dividends unless declared by our board of directors. As of March 31, 2016, we had 162,848,163 shares of common stock outstanding and had reserved shares of common stock for future issuance as follows: 
 
March 31, 2016
Stock option plans:
 
Options outstanding
7,718,715

RSUs
14,161,913

Stock awards available for future grants:
 
2012 Equity Incentive Plan(1)
21,360,061

2012 Employee Stock Purchase Plan(1)
8,850,836

Total reserved shares of common stock for future issuance
52,091,525

 
(1)
Refer to Note 11 for a description of these plans.

During the three months ended March 31, 2016 and 2015, we issued a total of 2,062,399 shares and 3,681,747 shares, respectively, from stock option exercises, vesting of restricted stock units, or RSUs, and purchases from the employee stock purchase plan, or ESPP.

(11)    Stock Awards
 

11


We have a 2005 Stock Option Plan, or 2005 Plan, which provides for grants of stock awards, including options to purchase shares of common stock, stock purchase rights and RSUs to certain employees, officers, directors and consultants.
 
Our 2012 Equity Incentive Plan, or 2012 Plan, provides for the grant of incentive stock options, nonqualified stock options, stock appreciation rights, RSUs, performance-based stock awards and other forms of equity compensation, or collectively, stock awards. In addition, the 2012 Plan provides for the grant of performance cash awards. Incentive stock options may be granted only to employees. All other awards may be granted to employees, including officers, as well as directors and consultants. The share reserve may increase to the extent outstanding stock options under the 2005 Plan expire or terminate unexercised. The share reserve also automatically increases on January 1 of each year until January 1, 2022, by up to 5% of the total number of shares of common stock outstanding on December 31 of the preceding year as determined by the board of directors. On January 1, 2016, 8,039,288 shares of common stock were automatically added to the 2012 Plan pursuant to the provision described in the preceding sentence.

Our 2012 Employee Stock Purchase Plan, or 2012 ESPP, authorizes the issuance of shares of common stock pursuant to purchase rights granted to our employees. The price at which common stock is purchased under the 2012 ESPP is equal to 85% of the fair market value of the common stock on the first or last day of the offering period, whichever is lower. Offering periods are six months long and begin on February 1 and August 1 of each year. The number of shares of common stock reserved for issuance automatically increases on January 1 of each year until January 1, 2022, by up to 1% of the total number of shares of common stock outstanding on December 31 of the preceding year as determined by the board of directors. On January 1, 2016, 1,607,858 shares of common stock were automatically added to the 2012 ESPP pursuant to the provision described in the preceding sentence.

Stock Options
 
A summary of the stock option activity for the three months ended March 31, 2016 is as follows:
 
 
Number of
Shares
 
Weighted-
Average
Exercise
Price
 
Weighted-
Average
Remaining
Contractual
Term (Years)
 
Aggregate
Intrinsic Value
(in thousands)
Outstanding at December 31, 2015
8,255,554

 
$
16.65

 
 
 
 
Granted
169,400

 
65.92

 
 
 
 
Exercised
(579,504
)
 
5.28

 
 
 
$
35,876

Canceled
(126,735
)
 
58.05

 
 
 
 
Outstanding at March 31, 2016
7,718,715

 
$
17.90

 
5.86
 
$
340,109

Vested and expected to vest as of March 31, 2016
7,612,105

 
$
17.27

 
5.81
 
$
339,664

Vested and exercisable as of March 31, 2016
6,420,996

 
$
10.62

 
5.39
 
$
325,305

 
Aggregate intrinsic value represents the difference between the estimated fair value of our common stock and the exercise price of outstanding, in-the-money options. The weighted-average grant date fair value per share of options granted was $26.81 for the three months ended March 31, 2016. The total fair value of shares vested was $4.9 million for the three months ended March 31, 2016.
 
As of March 31, 2016, total unrecognized compensation cost, adjusted for estimated forfeitures, related to unvested stock options was approximately $26.2 million. The weighted-average remaining vesting period of unvested stock options at March 31, 2016 was 2.35 years.
 

12


 RSUs

A summary of RSU activity for the three months ended March 31, 2016 is as follows:
 
Number of
Shares
 
Weighted Average Grant Date Fair Value
(Per Share)
 
Aggregate
Fair Value
(in thousands)
Non-vested and outstanding at December 31, 2015
12,417,805

 
$
63.38

 
 
Granted
3,822,832

 
51.11

 
 
Vested
(1,708,179
)
 
58.42

 
$
89,516

Forfeited
(370,545
)
 
64.43

 
 
Non-vested and outstanding at March 31, 2016
14,161,913

 
$
60.64

 
$
866,426

Expected to vest as of March 31, 2016
11,593,513

 
 
 
$
709,291


RSUs granted under the 2005 Plan and the 2012 Plan to employees generally vest over a four-year period. As of March 31, 2016, total unrecognized compensation cost, adjusted for estimated forfeitures, related to unvested RSUs was approximately $639.0 million and the weighted-average remaining vesting period was 2.99 years.

(12)    Net Loss Per Share
 
The following table presents the calculation of basic and diluted net loss per share (in thousands, except share and per share data): 

 
Three Months Ended March 31,
 
2016
 
2015
Numerator:
 
 
 
Net loss
$
(333,332
)
 
$
(58,093
)
Denominator:
 
 
 
Weighted-average shares outstanding—basic and diluted
162,067,108

 
151,601,880

Net loss per share—basic and diluted:
$
(2.06
)
 
$
(0.38
)
 
Potentially dilutive securities that are not included in the calculation of diluted net loss per share because doing so would be antidilutive are as follows:
 
 
March 31,
 
2016
 
2015
Common stock options
7,718,715

 
13,506,834

Restricted stock units
14,161,913

 
13,539,235

Common stock subject to repurchase

 
3,794

ESPP obligations
292,689

 
209,013

Convertible senior notes
7,783,023

 
7,783,023

Warrants related to the issuance of convertible senior notes
7,783,023

 
7,783,023

Total potentially dilutive securities
37,739,363

 
42,824,922

 
(13)    Income Taxes

We compute our provision for income taxes by applying the estimated annual effective tax rate to year-to-date income (loss) from recurring operations and adjust the provision for discrete tax items recorded in the period.


13



Our effective tax rate was (1)% and (2)% for the three months ended March 31, 2016 and 2015, respectively, which was lower than the U.S. federal statutory tax rate of 34%.  The lower tax rate was primarily attributable to our loss from operations, the foreign tax rate differential, and non-deductible expenses arising from stock-based compensation.

We are subject to taxation in the United States and foreign jurisdictions.  As of March 31, 2016, our tax years 2005 to 2015 remain subject to examination in most jurisdictions.

There are differing interpretations of tax laws and regulations, and as a result, disputes may arise with tax authorities involving issues of the timing and amount of deductions and allocations of income among various tax jurisdictions. We periodically evaluate our exposures associated with our tax filing positions. We believe that adequate amounts have been reserved for any adjustments that may ultimately result from these examinations, and we do not anticipate a significant impact to our gross unrecognized tax benefits within the next 12 months related to these years. Although the timing of the resolution, settlement, and closure of any audit is highly uncertain, it is reasonably possible that the balance of gross unrecognized tax benefits could significantly change in the next 12 months. However, given the number of years that remain subject to examination, we are unable to estimate the full range of possible adjustments to the balance of gross unrecognized tax benefits.

(14)    Commitments and Contingencies
 
Leases
 
We lease facilities for data center capacity and office space under non-cancelable operating lease agreements with various expiration dates. There have been no material changes in our commitments under contractual obligations, as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015.
 
Legal Proceedings
 
From time to time, we are party to litigation and other legal proceedings in the ordinary course of business. While the results of any litigation or other legal proceedings are uncertain, management does not believe the ultimate resolution of any pending legal matters is likely to have a material adverse effect on our financial position, results of operations or cash flows, except as discussed below and for those matters for which we have recorded a loss contingency. We accrue for loss contingencies when it is both probable that we will incur the loss and when we can reasonably estimate the amount of the loss or range of loss.

Generally, our subscription agreements require us to defend our customers for third-party intellectual property infringement and other claims. Any adverse determination related to intellectual property claims or other litigation could prevent us from offering our services and adversely affect our financial condition and results of operations.

On February 6, 2014, Hewlett-Packard Company (Hewlett-Packard) filed a lawsuit against us in the U.S. District Court for the Northern District of California. The lawsuit alleged patent infringement and sought damages and an injunction. On or about November 1, 2015, Hewlett Packard Enterprise Company (HPE) separated from Hewlett-Packard as an independent company, and Hewlett-Packard assigned to HPE all right, title, and interest in the eight Hewlett-Packard patents in the lawsuit and HPE was substituted as plaintiff in the litigation. On March 4, 2016, we entered into a confidential settlement agreement resolving the lawsuit with HPE (HPE Settlement). As a result, on March 9, 2016, the lawsuit was dismissed.

BMC Software, Inc. (BMC) filed lawsuits against us in the U.S. District Court for the Eastern District of Texas on September 23, 2014 and February 12, 2016, and in the Dusseldorf (Germany) Regional Court, Patent Division, on March 2, 2016. Each of the lawsuits alleged patent infringement and sought damages and an injunction. On April 8, 2016, we entered into a confidential settlement agreement resolving all the lawsuits with BMC (BMC Settlement). As a result, the second Texas lawsuit was dismissed on April 14, 2016, and each of the initial Texas lawsuit and the German lawsuit was dismissed on April 25, 2016.

These settlements are considered multiple element arrangements for accounting purposes.  We evaluated the accounting treatment of these settlements by identifying each element of the arrangements, which included amongst other elements, a release of past infringement claims and a covenant not to sue for a specified term of years. The primary benefit we received from the arrangements was the settlement and termination of all existing litigation, the avoidance of future litigation expenses and the avoidance of future management and customer disruptions. We determined that none of the elements of the settlement agreements have identifiable future benefits. Accordingly, we recorded an aggregate legal settlement charge of $270.0 million in our condensed consolidated statement of comprehensive loss for the three months ended March 31, 2016, of which $250.0 million was accrued in the "Accrued expenses and other current liabilities" on our condensed consolidated balance sheet as of March 31, 2016. The charge covers the fulfillment by us of all financial obligations under both the BMC Settlement and HPE Settlement with no remaining financial obligations under either settlement.


14



(15)   Information about Geographic Areas and Products
 
Revenues by geographic area, based on the location of our users, were as follows for the periods presented (in thousands):
 
Three Months Ended March 31,
 
2016
 
2015
North America (1)
$
210,517

 
$
148,646

EMEA (2)
74,281

 
48,530

Asia Pacific and other
21,081

 
14,788

Total revenues
$
305,879

 
$
211,964

 
Long-lived assets by geographic area were as follows (in thousands):
 
March 31,
 
December 31,
 
2016
 
2015
North America(3)
$
110,011

 
$
104,085

EMEA(2)
32,174

 
32,027

Asia Pacific and other
12,059

 
8,602

Total long-lived assets
$
154,244

 
$
144,714


(1)
Revenues attributed to the United States were approximately 95% and 94% of North America revenues for the three months ended March 31, 2016 and 2015, respectively.
(2)
Europe, the Middle East and Africa
(3)
Long-lived assets attributed to the United States were approximately 98% of North America long-lived assets as of March 31, 2016 and December 31, 2015.
 
Subscription revenues consist of the following (in thousands):

 
Three Months Ended March 31,
 
2016
 
2015
Enterprise Service Management solutions
$
245,862

 
$
167,204

IT Operations Management solutions
21,560

 
12,703

Total subscription revenues
$
267,422

 
$
179,907


Our Enterprise Service Management solutions include Service Management, Business Management and ServiceNow Platform, which have similar features and functions, and are generally priced on a per user basis. Our IT Operations Management solutions, which improve visibility, availability and agility of enterprise services, are generally priced on a per node basis.


(16)    Subsequent Events
 
On April 8, 2016, we acquired ITapp in an all-cash transaction for approximately $15.0 million to expand our cloud management solution offering. Our accounting and analysis of this transaction is pending completion.

On April 8, 2016, we entered into a confidential settlement agreement with BMC to resolve all patent-related litigation between the Company and BMC. Refer to Note 14 for further details of the settlement.



15



ITEM 2.     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion and analysis of our financial condition, results of operations and cash flows should be read in conjunction with the (1) unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q, and (2) the audited consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2015 included in the Form 10-K dated as of, and filed with the Securities and Exchange Commission, or the SEC, on February 25, 2016 (File No. 001-35580). This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. These statements are often identified by the use of words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “estimate,” or “continue,” and similar expressions or variations. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified herein, and those discussed in the section titled “Risk Factors,” set forth in Part II, Item 1A of this Quarterly Report on Form 10-Q and in our other SEC filings. We disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.
 
Certain measures in the section entitled “—Key Factors Affecting Our Performance—Billings,” and “—Comparison of the Three Months Ended March 31, 2016 and 2015" are presented on a constant currency basis. These measures, as well as our free cash flow measure included in the section entitled "—Key Factors Affecting Our Performance—Free Cash Flow," are not in accordance with U.S. Generally Accepted Accounting Principles, or GAAP. These non-GAAP financial measures are not intended to be considered in isolation or as a substitute for, or superior to, financial information prepared and presented in accordance with GAAP. These measures may be different from non-GAAP financial measures used by other companies, limiting their usefulness for comparison purposes. We believe investors should consider these non-GAAP financial measures in evaluating our results as they are indicative of our ongoing performance and reflect how management evaluates our operational results and trends. 

Overview
 
ServiceNow is a leading provider of enterprise cloud computing solutions that define, structure, manage and automate services across the global enterprise. Our mission is to help the modern enterprise operate faster and be more scalable by applying a service-oriented lens to the activities, tasks and processes that comprise day-to-day work life. We offer our services on an annual subscription fee basis which includes access to the ordered subscription service and related support including updates to the subscribed service during the subscription term. We provide a scaled pricing model based on the duration of the subscription term and we frequently extend discounts to our customers based on the number of users. We generate sales through our direct sales team and indirectly through channel partners and third-party referrals. We also generate revenues from professional services for implementation and training of customer personnel. We generally bill our customers annually in advance for subscription services and monthly in arrears for our professional services as the work is performed.
 
A majority of our revenues come from large global enterprise customers. We continue to invest in the development of our services, infrastructure and sales and marketing to drive long-term growth. We increased our overall employee headcount to 3,991 as of March 31, 2016 from 3,047 as of March 31, 2015.

Key Factors Affecting Our Performance
 
Renewal rate. We calculate our renewal rate by subtracting our attrition rate from 100%. Our attrition rate for a period is equal to the annualized contract value, or ACV, from lost customers, divided by the total ACV from all customers that renewed during the period, excluding changes in price or users, and total ACV from all lost customers. A lost customer is a customer that did not renew a contract expiring and that, in our judgment, will not be renewed. Typically a customer that reduces its subscription upon renewal is not considered a lost customer. However, in instances where the subscription decrease represents the majority of the customer's ACV, we may deem the renewal as a lost customer. Our renewal rate was 97% for the three months ended March 31, 2016 and 2015.

Total customers. We believe our total customer count is a key indicator of our market penetration, growth and future revenues. We have aggressively invested in, and intend to continue to invest in, our direct sales force and additional partnerships with our indirect sales channel in order to grow our customer base. Our total enterprise customer count was approximately 3,000 and 2,500, as of March 31, 2016 and 2015, respectively. In addition, we had approximately 500 and 100 customers that have purchased our Express product offering (Express customers), which is our entry-level IT service management solution, as of March 31, 2016 and 2015, respectively.

16




Number of customers with ACV greater than $1 million. We count the total number of customers with ACV greater than $1 million as of the end of the period. We had 249 and 168 customers with ACV greater than $1 million as of March 31, 2016 and 2015, respectively.

The number of deals with net new ACV greater than $1 million entered into during the three months ended March 31, 2016 and 2015 were 13 and eight, respectively. We define net new ACV as ACV from new customers and upsells to existing customers, net of losses to those customers. Our upsells are primarily derived from an increase in the number of user seats purchased by our existing customers and are also derived from the addition of other subscription services. 

G2K customer count. The Global 2000, or G2K, customer count is defined as the total number of G2K companies in our customer base as of the end of the period. The Forbes Global 2000 is an annual ranking of the top 2000 public companies in the world by Forbes magazine. The ranking is based on a mix of four metrics: sales, profit, assets, and market value. The Forbes Global 2000 is updated annually in the second quarter of the calendar year. Current and prior period G2K customer counts are based on the most recent list for comparability purposes. We adjust the G2K count for acquisitions, spin-offs and other market activity to ensure the G2K customer count is accurately captured. For example, we add a G2K customer when a G2K company that is not our customer acquires a company in our existing customer base that is not a G2K company. When we enter into a contract with a G2K parent company, or any of its related subsidiaries, or any combination of entities within a G2K company, we count only one G2K customer. We do not count further penetration into entities within the G2K as a new customer in the G2K customer count. Our G2K customer count also excludes Express customers.

Our G2K customer count based on the most recent Forbes Global 2000 list and adjusted for acquisitions, spin-offs and other market activity was 653 and 556 as of March 31, 2016 and 2015, respectively.

Average ACV per G2K customer. We calculate average ACV for our G2K customers by taking cumulative ACV from G2K customers as of the end of the period divided by cumulative count of G2K customers as of the end of the period. Our average ACV per G2K customer was approximately $906,000 and $748,000 for the three months ended March 31, 2016 and 2015, respectively.

Billings. We define billings as revenue recognized plus the change in total deferred revenue as presented on the condensed consolidated statements of cash flows. The change in total deferred revenue as presented on the condensed consolidated statements of cash flows represent the change in deferred revenues in local currencies translated into U.S. dollars using an average foreign currency exchange rate, and aligns actual billings with the exchange rates in effect at the time of the billings. We believe billings offers investors useful supplemental information regarding the performance of our business and will help investors better understand the sales volume and performance of our business.

A calculation of billings is provided below:
 
Three Months Ended March 31,
 
% Change
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Billings:
 
 
 
 
 
Total revenues
$
305,879

 
$
211,964

 
44
%
Change in deferred revenue from the condensed consolidated statements of cash flows
70,803

 
55,861

 
27
%
Total billings
$
376,682

 
$
267,825

 
41
%

While our international operations provide a significant portion of our total billings and revenues, foreign exchange rate fluctuations did not significantly impact our actual year-over-year billings growth.

Average contract term. We calculate the average contract term for new customers, upsells and renewals based on the term of those contracts entered into during the period weighted by their ACV. The average new customer contract term was 32 months and 30 months for the three months ended March 31, 2016 and 2015, respectively. The average upsell contract term was 23 months for the three months ended March 31, 2016 and 2015. The average renewal contract term was 26 months for the three months ended March 31, 2016 and 2015.


17



Free cash flow. We define free cash flow, a non-GAAP financial measure, as GAAP net cash provided by operating activities reduced by purchases of property and equipment. We believe information regarding free cash flow provides investors with an important perspective on the cash available to invest in our business and fund ongoing operations. However, our calculation of free cash flow may not be comparable to similar measures used by other companies. A calculation of free cash flow is provided below:
 
Three Months Ended March 31,
 
% Change
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Free cash flow:
 
 
 
 
 
Net cash provided by operating activities
$
78,687

 
$
67,366

 
17
%
Purchases of property and equipment
(29,077
)
 
(26,699
)
 
9
%
Free cash flow (1)
$
49,610

 
$
40,667

 
22
%
 
(1) Free cash flow includes the effect of a $17.5 million payment for legal settlement. Refer to Note 14 in the notes to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for further details.

Components of Results of Operations
 
Revenues
 
Subscription revenues. Subscription revenues are primarily comprised of fees that give customers access to the ordered subscription service, related support and upgrades, if any, to the subscribed service during the subscription term. Pricing includes multiple instances, hosting and support services, data backup and disaster recovery services, as well as future upgrades, when and if available, offered during the subscription term. We typically invoice our customers for subscription fees in annual increments upon execution of the initial contract or subsequent renewal. Our contracts are generally non-cancelable during the subscription term, though a customer can terminate for breach if we materially fail to perform.

Professional services and other revenues. Professional services revenues consist of fees associated with the implementation and configuration of our subscription service. Our arrangements for professional services are primarily on a time-and-materials basis. We generally invoice our professional services monthly in arrears based on actual hours and expenses incurred. Other revenues primarily include fees from customer training delivered on-site or publicly available classes, attendance and sponsorship fees for our annual Knowledge user conference and other customer forums. Typical payment terms require our customers to pay us within 30 days of invoice.

We generate sales directly through our sales team and, to a lesser extent, through our channel partners. Revenues from our direct sales organization represented 88% of our total revenues for the three months ended March 31, 2016 and 2015. We make sales to our channel partners at a discount and record those revenues at the discounted price when all revenue recognition criteria are met. From time to time, our channel partners also provide us referrals for which we pay a referral fee. We pay referral fees to channel partners and other third parties, which are between 10% and 15% of the customer's ACV, depending on the level of activity the partner performs in the sales process. We include these fees in sales and marketing expense.
 
Allocation of Overhead Costs
 
Overhead costs associated with office facilities, IT and certain depreciation related to infrastructure that is not dedicated for customer or research and development use are allocated to cost of revenues and operating expenses based on headcount. 

Cost of Revenues
 
Cost of subscription revenues. Cost of subscription revenues consists primarily of expenses related to hosting our services and providing support to our customers. These expenses are comprised of data center capacity costs, which includes facility costs associated with our data center, depreciation related to our cloud-based infrastructure hardware equipment dedicated for customer use, amortization of acquired developed technology intangibles, personnel related costs directly associated with our cloud-based infrastructure and customer support, including salaries, benefits, bonuses and stock-based compensation and allocated overhead.

Cost of professional services and other revenues. Cost of professional services and other revenues consists primarily of personnel related costs directly associated with our professional services and training departments, including salaries, benefits, bonuses and stock-based compensation, the costs of contracted third-party partners and allocated overhead.


18



Professional services associated with the implementation and configuration of our subscription services are performed directly by our services team, as well as by contracted third-party partners. Fees paid to third-party partners are primarily recognized as cost of revenues as the professional services are delivered. Cost of revenues associated with our professional services engagements contracted with third-party partners as a percentage of professional services and other revenues was 21% and 20% in the three months ended March 31, 2016 and 2015, respectively.

Sales and Marketing Expenses
 
Sales and marketing expenses consist primarily of personnel related expenses directly associated with our sales and marketing staff, including salaries, benefits, bonuses, commissions and stock-based compensation. Sales and marketing expenses also include third-party referral fees, marketing and promotional events, including our annual Knowledge user conference, online marketing, product marketing and allocated overhead.
 
Research and Development Expenses
 
Research and development expenses consist primarily of personnel related expenses directly associated with our research and development staff, including salaries, benefits, bonuses and stock-based compensation and allocated overhead. Research and development expenses also include data center capacity costs and depreciation of cloud-based infrastructure hardware equipment that are used solely for research and development purposes.
 
General and Administrative Expenses
 
General and administrative expenses consist primarily of personnel related expenses for our executive, finance, legal, human resources, facility and administrative personnel, including salaries, benefits, bonuses and stock-based compensation, external legal, accounting and other professional services fees, other corporate expenses and allocated overhead.

Legal Settlement Expenses
 
Legal settlement expenses consist of charges related to the settlement agreements with Hewlett Packard Enterprise Company and BMC Software, Inc. Refer to Note 14 in the notes to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for further details of these matters.

Provision for Income Taxes
 
Provision for income taxes consists of federal, state and foreign income taxes. Due to cumulative losses, we maintain a valuation allowance against our U.S. deferred tax assets as of March 31, 2016 and December 31, 2015. We consider all available evidence, both positive and negative, including but not limited to earnings history, projected future outcomes, industry and market trends and the nature of each of the deferred tax assets in assessing the extent to which a valuation allowance should be applied against our U.S. deferred tax assets.

Recent Accounting Pronouncements

In March 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2016-09, "Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting," which includes multiple provisions intended to simplify accounting for share-based payments. This new standard is effective for our interim and annual periods beginning January 1, 2017 and early adoption is permitted. We are currently evaluating the impact of this standard on our condensed consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)," which requires lessees to generally recognize on the balance sheet operating and financing leases liabilities and corresponding right-of-use assets, and to recognize on the income statement the expenses in a manner similar to current practice. This new standard is effective for our interim and annual periods beginning January 1, 2019 and early adoption is permitted. While we are currently evaluating the impact of this standard on our condensed consolidated financial statements, we anticipate this standard will have a material impact on our condensed consolidated balance sheets given that we have operating lease commitments in excess of $300 million as of March 31, 2016. However, we do not anticipate this standard will have a material impact on our condensed consolidated statements of comprehensive loss since the expense recognition under this new standard will be similar to current practice.


19



In January 2016, the FASB issued ASU 2016-01, "Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities," which addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. This new standard is effective for our interim and annual periods beginning January 1, 2018 and early adoption is not permitted. We are currently evaluating the impact of this standard on our condensed consolidated financial statements.

In April 2015, the FASB issued ASU 2015-05, "Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement." ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes software. If a cloud computing arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. We adopted this standard during the three months ended March 31, 2016 on a prospective basis and the adoption had no material impact on our condensed consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers (Topic 606)," which will supersede virtually all existing revenue guidance. Under this standard, an entity is required to recognize revenue upon transfer of promised goods or services to customers in an amount that reflects the expected consideration received in exchange for those goods or services. As such, an entity will need to use more judgment and make more estimates than under the current guidance. This standard should be applied retrospectively either to each prior reporting period presented in the financial statements, or only to the most current reporting period presented in the financial statements with a cumulative effect adjustment recorded in the retained earnings. In March 2016, the FASB issued ASU 2016-08, "Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)," which clarifies the principal versus agent guidance in the new revenue recognition standard. In April 2016, the FASB issued ASU 2016-10, "Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing," which clarifies the guidance on accounting for licenses of intellectual property (IP) and identifying performance obligations in the new revenue recognition standard. These new standards are effective for our interim and annual periods beginning January 1, 2018 and early adoption is permitted. We are currently evaluating the impact of these standards on our condensed consolidated financial statements.

Results of Operations
 
To enhance comparability, the following table sets 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 March 31,
 
2016
 
2015
 
(in thousands)
Revenues:



Subscription
$
267,422

 
$
179,907

Professional services and other
38,457

 
32,057

Total revenues
305,879

 
211,964

Cost of revenues(1):
 
 
 
Subscription
52,781

 
42,444

Professional services and other
41,479

 
34,455

Total cost of revenues
94,260

 
76,899

Gross profit
211,619

 
135,065

Operating expenses(1):
 
 
 
Sales and marketing
158,610

 
110,057

Research and development
65,924

 
49,848

General and administrative
41,237

 
29,392

Legal settlement
270,000

 

Total operating expenses
535,771

 
189,297

Loss from operations
(324,152
)
 
(54,232
)
Interest expense
(8,109
)
 
(7,578
)
Interest income and other income (expense), net
702

 
4,704

Loss before provision for income taxes
(331,559
)
 
(57,106
)
Provision for income taxes
1,773

 
987

Net loss
$
(333,332
)
 
$
(58,093
)
 
(1)
Stock-based compensation included in the statements of operations above was as follows:
 
Three Months Ended March 31,
 
2016
 
2015
 
(in thousands)
Cost of revenues:
 
 
 
Subscription
$
6,607

 
$
5,165

Professional services and other
6,759

 
5,213

Sales and marketing
30,998

 
22,574

Research and development
20,533

 
15,638

General and administrative
10,411

 
9,484



20



 
Three Months Ended March 31,
 
2016
 
2015
Revenues:
 
 
 
Subscription
87
 %
 
85
 %
Professional services and other
13

 
15

Total revenues
100

 
100

Cost of revenues:

 

Subscription
17

 
20

Professional services and other
14

 
16

Total cost of revenues
31

 
36

Gross profit
69

 
64

Operating expenses:

 

Sales and marketing
52

 
52

Research and development
22

 
24

General and administrative
13

 
14

Legal settlement
88

 

Total operating expenses
175

 
90

Loss from operations
(106
)
 
(26
)
Interest expense
(3
)
 
(3
)
Interest income and other income (expense), net

 
2

Loss before provision for income taxes
(109
)
 
(27
)
Provision for income taxes
1

 

Net loss
(110
)%
 
(27
)%
 
 
Three Months Ended March 31,
 
2016
 
2015
 
(in thousands)
Revenues by geography
 
 
 
North America
$
210,517

 
$
148,646

EMEA (1)
74,281

 
48,530

Asia Pacific and other
21,081

 
14,788

Total revenues
$
305,879

 
$
211,964

 
(1) Europe, the Middle East and Africa


21




Comparison of the Three Months Ended March 31, 2016 and 2015
 
Revenues 

 
Three Months Ended March 31,
 
% Change    
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Revenues:
 
 
 
 
 
Subscription
$
267,422

 
$
179,907

 
49
%
Professional services and other
38,457

 
32,057

 
20
%
Total revenues
$
305,879

 
$
211,964

 
44
%
Percentage of revenues:
 
 
 
 
 
Subscription
87
%
 
85
%
 
 
Professional services and other
13
%
 
15
%
 
 
Total
100
%
 
100
%
 
 
 
Subscription revenues increased $87.5 million during the three months ended March 31, 2016, compared to the same period in the prior year, driven by our upsells and an increase in our customer count.

Subscription revenues consist of the following:
 
Three Months Ended March 31,
 
% Change    
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Enterprise Service Management solutions
$
245,862

 
$
167,204

 
47
%
IT Operations Management solutions
21,560

 
12,703

 
70
%
Total subscription revenues
$
267,422

 
$
179,907

 
49
%

Our Enterprise Service Management solutions include Service Management, Business Management and ServiceNow Platform, which have similar features and functions and are generally priced on a per user basis. Our IT Operations Management solutions, which improve visibility, availability and agility of enterprise services, are generally priced on a per node basis. We expect subscription revenues for our IT Operations Management solutions to grow in absolute dollars and as a percentage of revenues for the remainder of the year.

Professional services and other revenues increased $6.4 million during the three months ended March 31, 2016, compared to the same period in the prior year, due to an increase in the services provided to our growing customer base. We expect professional services and other revenues to increase at a slower rate compared to subscription revenues as we are increasingly focused on deploying our internal professional services organization as a strategic resource and relying on our partner ecosystem to contract directly with customers for service delivery.

Our international operations have provided and will continue to provide a significant portion of our total revenues, and we have, in the past, experienced material fluctuations in our non-U.S. revenues and billings as a result of significant movements in certain major foreign exchange rates. However, during the three months ended March 31, 2016, foreign exchange rate fluctuations did not significantly impact our actual year-over-year revenue growth.


22




Cost of Revenues and Gross Profit Percentage
 
 
Three Months Ended March 31,
 
% Change    
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Cost of revenues:
 
 
 
 
 
Subscription
$
52,781

 
$
42,444

 
24
%
Professional services and other
41,479

 
34,455

 
20
%
Total cost of revenues
$
94,260

 
$
76,899

 
23
%
Gross profit percentage:
 
 
 
 
 
Subscription
80
 %
 
76
 %
 
 
Professional services and other
(8
)%
 
(7
)%
 
 
Total gross profit percentage
69
 %
 
64
 %
 
 
Gross Profit
$
211,619

 
$
135,065

 
 
Headcount (at period end)
 
 
 
 
 
Subscription
607


491

 
24
%
Professional services and other
498


445

 
12
%
Total headcount
1,105

 
936

 
18
%
 
Cost of subscription revenues increased $10.3 million during the three months ended March 31, 2016, compared to the same period in the prior year, primarily due to increased headcount resulting in an increase of $3.3 million in personnel related costs excluding stock-based compensation and an increase of $1.4 million in stock-based compensation. In addition, there was an increase of $1.6 million in overhead expenses, an increase of $1.5 million in data center capacity costs due to the expansion of our data centers, and an increase of $1.5 million in depreciation expense primarily due to purchases of cloud-based infrastructure hardware equipment for our data centers.

Our subscription gross profit percentage increased to 80% for the three months ended March 31, 2016, from 76% for the three months ended March 31, 2015, due to data center density and improved economies of scale. We expect our cost of subscription revenues to increase in absolute dollar terms as we provide subscription services to more customers and increase the number of users within our customer instances. We expect our subscription gross profit percentage for the remainder of the year to remain relatively flat. To the extent future acquisitions are consummated, our cost of subscription revenues may increase due to additional non-cash charges associated with the amortization of intangible assets acquired. Our forecast for revenues, cost of revenues, and operating expenses was based on foreign exchange rates as of March 31, 2016.

Cost of professional services and other revenues increased $7.0 million during the three months ended March 31, 2016 as compared to the same period in the prior year, primarily due to increased headcount resulting in an increase of $2.1 million in personnel related costs excluding stock-based compensation, an increase of $2.0 million in contracted third-party partner costs, an increase of $1.5 million in stock-based compensation, and an increase of $1.1 million in overhead expenses.

Our professional services and other gross profit percentage decreased to (8)% for the three months ended March 31, 2016, from (7)% for the three months ended March 31, 2015, due to higher growth rate in our stock-based compensation of 30% compared to the growth rate in our professional services and other revenues of 20%.

Foreign exchange rate fluctuations from the first quarter of 2015 to the first quarter of 2016 did not significantly impact our cost of revenues.



23



Sales and Marketing
 
 
Three Months Ended March 31,
 
% Change    
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Sales and marketing
$
158,610

 
$
110,057

 
44
%
Percentage of revenues
52
%
 
52
%
 
 
Headcount (at period end)
1,571

 
1,105

 
42
%
 
Sales and marketing expenses increased $48.6 million during the three months ended March 31, 2016 compared to the same period in the prior year, primarily due to increased headcount that resulted in an increase of $25.1 million in personnel related costs excluding stock-based compensation, an increase of $8.4 million in stock-based compensation, an increase of $5.9 million in overhead expenses and an increase of $2.9 million in commissions expense. Commissions and referral fees amounted to 8% and 10% of subscription revenues for three months ended March 31, 2016 and 2015, respectively. Marketing program expenses, which include events, advertising and market data, increased $5.5 million during the three months ended March 31, 2016 compared to the same period in the prior year. Foreign exchange rate fluctuations from the first quarter of 2015 to the first quarter of 2016 did not significantly impact our sales and marketing expenses.

In the second quarter of 2016, we expect to incur sales and marketing expenses of approximately $26.0 million related to Knowledge. Excluding the charges related to Knowledge, we expect sales and marketing expenses to increase for the remainder of the year in absolute dollar terms, as we continue to expand our direct sales force, increase our marketing activities, grow our international operations, build brand awareness and sponsor additional marketing events, but decrease as a percentage of total revenues as we gain efficiencies in our sales and marketing efforts.

Research and Development
 
 
Three Months Ended March 31,
 
% Change    
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Research and development
$
65,924

 
$
49,848

 
32
%
Percentage of revenues
22
%
 
24
%
 
 
Headcount (at period end)
821

 
649

 
27
%
 
Research and development expenses increased $16.1 million during the three months ended March 31, 2016 compared to the same period in the prior year, primarily due to increased headcount, which resulted in an increase of $7.9 million in personnel related costs excluding stock-based compensation, an increase of $4.9 million in stock-based compensation and an increase of $2.4 million in overhead expenses. Foreign exchange rate fluctuations from the first quarter of 2015 to the first quarter of 2016 did not significantly impact our research and development expenses.
 
We expect research and development expenses to increase for the remainder of the year in absolute dollar terms, but remain relatively flat as a percentage of total revenues as we continue to improve the existing functionality of our services, develop new applications to fill market needs and continue to enhance our platform.


24



General and Administrative

 
Three Months Ended March 31,
 
% Change    
 
2016
 
2015
 
 
(dollars in thousands)
 
 
General and administrative
$
41,237

 
$
29,392

 
40
%
Percentage of revenues
13
%
 
14
%
 
 
Headcount (at period end)
494

 
357

 
38
%
 
General and administrative expenses increased $11.8 million during the three months ended March 31, 2016, compared to the same period in the prior year, primarily due an increase of $5.8 million in outside services driven by an increase in attorney fees associated with our litigations and an increase in contractors to support our administrative functions. In addition, personnel related costs excluding stock-based compensation increased $3.3 million, and stock-based compensation increased $0.9 million, primarily driven by increased headcount. Foreign exchange rate fluctuations from the first quarter of 2015 to the first quarter of 2016 did not significantly impact our general and administrative expenses.

We expect general and administrative expenses to decrease for the remainder of the year in absolute dollar terms and as a percentage of total revenues due to decreased attorney fees associated with our litigations as a result of the settlements. Refer to Note 14 in the notes to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for further details of these matters.

Legal Settlement

 
Three Months Ended March 31,
 
% Change    
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Legal settlement
$
270,000

 
$

 
NM
Percentage of revenues
88
%
 
%
 
 

Legal settlement expenses increased $270.0 million during the three months ended March 31, 2016 compared to the same period in the prior year, related to the settlement agreements with HPE and BMC. Refer to Note 14 in the notes to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for further details of these matters.

Stock-based Compensation
 
 
Three Months Ended March 31,
 
% Change    
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Cost of revenues:
 
 
 
 
 
Subscription
$
6,607

 
$
5,165

 
28
%
Professional services and other
6,759

 
5,213

 
30
%
Sales and marketing
30,998

 
22,574

 
37
%
Research and development
20,533

 
15,638

 
31
%
General and administrative
10,411

 
9,484

 
10
%
Total stock-based compensation
$
75,308

 
$
58,074

 
30
%
Percentage of revenues
25
%
 
27
%
 
 

Stock-based compensation increased $17.2 million during the three months ended March 31, 2016, compared to the same period in the prior year, primarily due to equity grants to new employees and additional grants to current employees, an increase in the weighted-average grant date fair value of stock awards issued in the past four years and additional performance RSUs granted to our executives in the current year. The new equity incentive awards granted after the same period in prior year, including the performance RSUs, resulted in an increase of $16.9 million in stock-based compensation.

25




Stock-based compensation is inherently difficult to forecast due to fluctuations in our stock price and the uncertainty around the achievement of performance criteria associated with our performance RSUs. We expect stock-based compensation to continue to increase for the remainder of the year in absolute dollar terms, but remain relatively flat as a percentage of total revenues. 
 
Interest Expense
 
 
Three Months Ended March 31,
 
% Change    
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Interest expense
$
(8,109
)
 
$
(7,578
)
 
7
%
Percentage of revenues
(3
)%
 
(3
)%
 
 

Interest expense increased $0.5 million during the three months ended March 31, 2016 compared to the same period in the prior year, due to the increase in amortization expense of debt discount and issuance costs related to our convertible senior notes, or the "Notes" issued in November 2013. For the remainder of the year, we expect to incur approximately $25.2 million in amortization expense of debt discount and issuance costs related to the Notes.

Interest Income and Other Income (Expense), net
 
 
Three Months Ended March 31,
 
% Change    
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Interest income
$
1,825

 
$
948

 
93
 %
Foreign currency exchange gain/(loss)
(1,333
)
 
3,826

 
(135
)%
Other
210

 
(70
)
 
NM

Interest and other expense, net
$
702

 
$
4,704

 
(85
)%
Percentage of revenues
%
 
2
%
 
 

Interest income and other income (expense), net, decreased $4.0 million during the three months ended March 31, 2016 compared to the same period in the prior year, primarily due to a loss from foreign currency transactions. We had a foreign currency transaction loss of $1.3 million for the three months ended March 31, 2016 compared to a gain of $3.8 million for the three months ended March 31, 2015 that resulted from the movement of the U.S. Dollar against other major currencies.

Our expanding international operations will continue to increase our exposure to currency risks, though we cannot presently predict the impact of this exposure on our condensed consolidated financial statements. While we have not engaged in the hedging of our foreign currency transactions to date, we are conducting an ongoing evaluation of the costs and benefits of initiating such a program and in the future may hedge selected significant transactions denominated in currencies other than the U.S. Dollar.

Provision for Income Taxes
 
 
Three Months Ended March 31,
 
% Change    
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Loss before income taxes
$
(331,559
)
 
$
(57,106
)
 
481
%
Provision for income taxes
1,773

 
987

 
80
%
Effective tax rate
(1
)%
 
(2
)%
 
 
 
Our effective tax rate changed to (1)% for the three months ended March 31, 2016 compared to (2)% for the three months ended March 31, 2015 primarily due to our loss from operations, the foreign tax rate differential, and non-deductible expenses arising from stock-based compensation.


26



We continue to maintain a full valuation allowance on our federal and state deferred tax assets, and the significant components of the tax expense recorded are current cash taxes in various jurisdictions. The cash tax expenses are impacted by each jurisdiction’s individual tax rates, laws on timing of recognition of income and deductions, and availability of net operating losses and tax credits. Given the full valuation allowance, sensitivity of current cash taxes to local rules and our foreign restructuring, we expect that our effective tax rate could fluctuate significantly on a quarterly basis and could be adversely affected to the extent earnings are lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates. We consider the earnings of our foreign subsidiaries to be indefinitely reinvested outside of the United States.

Net Loss

 
Three Months Ended March 31,
 
% Change    
 
2016
 
2015
 
 
(dollars in thousands)
 
 
Net loss
$
(333,332
)
 
$
(58,093
)
 
474
%
Percentage of revenues
(110
)%
 
(27
)%
 
 

Net loss increased $275.2 million during the three months ended March 31, 2016 compared to the same period in the prior year due primarily to the legal settlement expenses related to the settlement agreements with HPE and BMC. We expect to continue to incur a GAAP loss for the remainder of the year due to increased costs and expenses including non-cash charges associated with equity awards, amortization of purchased intangibles from business combinations and other expenses.



Liquidity and Capital Resources
 
 
Three Months Ended March 31,
 
2016
 
2015
 
(dollars in thousands)
Net cash provided by operating activities
$
78,687


$
67,366

Net cash used in investing activities
(31,406
)

(34,334
)
Net cash (used in) provided by financing activities
(8,690
)

29,739

Net increase in cash and cash equivalents, net of foreign currency effect on cash and cash equivalents
41,145


55,526


Our principal sources of liquidity are our cash and cash equivalents, investments, and cash generated from operations. As of March 31, 2016, we had $900.9 million in cash and cash equivalents and short-term investments, of which $104.6 million represented cash owned by foreign subsidiaries. In addition, we had $361.8 million in long-term investments that provide additional capital resources.

We anticipate our current cash and cash equivalents balance and cash generated from operations will be sufficient to meet our liquidity needs including the payment for legal settlement, expansion of data centers, lease obligations, expenditures related to the growth of our headcount, and the acquisition of fixed assets and investments in office facilities to accommodate our growth, for at least the next 12 months. Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our growth, operating results, cash utilized for acquisitions, if any are consummated, and the capital expenditures required to meet possible increased demand for our services. If we require additional capital resources to grow our business at any time in the future, we may seek to finance our operations from the current funds available or seek additional equity or debt financing.
 
Operating Activities
 
Cash provided by operating activities mainly consists of our net loss adjusted for certain non-cash items, including depreciation and amortization, amortization of premiums on investments, amortization of deferred commissions, amortization of issuance cost and debt discount, stock-based compensation and changes in operating assets and liabilities during the year.


27



Net cash provided by operating activities was $78.7 million for the three months ended March 31, 2016 compared to $67.4 million for the three months ended March 31, 2015. The increase in operating cash flow was primarily due to an increase in non-cash adjustments to reconcile net loss to net cash provided by operations and the favorable impact on operating cash flow from changes in operating assets and liabilities. Net cash flow from the aggregate of changes in accounts receivable, deferred commissions and deferred revenue increased by $11.7 million due to increased sales for the three months ended March 31, 2016. We expect cash provided by operating activities to decrease in the second quarter of 2016 due to payment of accrued legal settlement expenses. Refer to Note 14 in the notes to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for further details.

 Investing Activities
 
Net cash used in investing activities for the three months ended March 31, 2016 was $31.4 million compared to $34.3 million for the three months ended March 31, 2015. The decrease in cash used in investing activities was mainly due to the $10.9 million decrease in the net purchases of investments, offset by the $5.8 million increase in purchase of other intangibles related to patents and the $2.4 million increase in capital expenditures related to the purchase of cloud-based infrastructure hardware equipment to support the expansion of our data centers as well as investments in leasehold improvements, furniture and equipment to support our headcount growth. We expect cash used in investing activities to increase in the second quarter of 2016 due to the acquisition of ITapp. Refer to Note 16 in the notes to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for further details.

Financing Activities
 
Net cash used in financing activities for the three months ended March 31, 2016 was $8.7 million compared to $29.7 million of net cash provided by financing activities for the three months ended March 31, 2015. The change was primarily due to the $27.7 million increase in taxes paid related to net share settlement of equity awards and the $10.6 million decrease in proceeds from employee stock plans.

Contractual Obligations and Commitments
 
Contractual obligations represent future cash commitments and liabilities under agreements with third parties, and exclude orders for goods and services entered into in the normal course of business that are not enforceable or legally binding. Apart from the $250.0 million of legal settlement expenses payable in the second quarter of fiscal 2016 (refer to Note 14 in the notes to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for further details), there have been no material changes in our commitments under contractual obligations, as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015, which was filed with the SEC on February 25, 2016.

Off-Balance Sheet Arrangements
 
During all periods presented, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in those types of relationships.
 
Critical Accounting Policies and Significant Judgments and Estimates
 
Our management’s discussion and analysis of financial condition and results of operations is based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements, as well as the reported revenues and expenses during the reporting periods. These items are monitored and analyzed by us for changes in facts and circumstances, and material changes in these estimates could occur in the future. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Changes in estimates are reflected in reported results for the period in which they become known. Actual results may differ from these estimates under different assumptions or conditions and such differences could be material.
 
There have been no significant changes to our critical accounting policies and estimates as described in our Annual Report on Form 10-K for the year ended December 31, 2015, which was filed with the SEC on February 25, 2016.


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ITEM 3.     QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no material changes in our market risk as compared to the disclosures in Part II, Item 7A in our Annual Report on Form 10-K for the year ended December 31, 2015, which was filed on February 25, 2016.

ITEM 4.     CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Regulations under the Exchange Act require public companies, including our company, to maintain “disclosure controls and procedures,” which are defined in Rule 13a-15(e) and Rule 15d-15(e) to mean a company’s controls and other procedures that are designed to ensure that information required to be disclosed 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 in our reports filed under the Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required or necessary disclosures. In designing and evaluating our disclosure controls and procedures, management recognizes that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. Our Chief Executive Officer and Chief Financial Officer have concluded, based on the evaluation of the effectiveness of the disclosure controls and procedures by our management as of the end of the quarter covered by this Quarterly Report, that our disclosure controls and procedures were effective at the reasonable assurance level for this purpose.

Changes in Internal Control Over Financial Reporting

Regulations under the Exchange Act require public companies, including our company, to evaluate any change in our “internal control over financial reporting” as such term is defined in Rule 13a-15(f) and Rule 15d-15(f) of the Exchange Act. In connection with their evaluation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report, our Chief Executive Officer and Chief Financial Officer did not identify any change in our internal control over financial reporting during the quarter covered by this Quarterly Report that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.


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PART II
ITEM 1.     LEGAL PROCEEDINGS

On February 6, 2014, Hewlett-Packard Company (Hewlett-Packard) filed a lawsuit against us in the U.S. District Court for the Northern District of California. The lawsuit alleged patent infringement and sought damages and an injunction. On or about November 1, 2015, Hewlett Packard Enterprise Company (HPE) separated from Hewlett-Packard as an independent company, and Hewlett-Packard assigned to HPE all right, title, and interest in the eight Hewlett-Packard patents in the lawsuit and HPE was substituted as plaintiff in the litigation. On March 4, 2016, we entered into a confidential settlement agreement resolving the lawsuit with HPE (HPE Settlement). As a result, on March 9, 2016, the lawsuit was dismissed.

BMC Software, Inc. (BMC) filed lawsuits against us in the U.S. District Court for the Eastern District of Texas on September 23, 2014 and February 12, 2016, and in the Dusseldorf (Germany) Regional Court, Patent Division, on March 2, 2016. Each of the lawsuits alleged patent infringement and sought damages and an injunction. On April 8, 2016, we entered into a confidential settlement agreement resolving all the lawsuits with BMC (BMC Settlement). As a result, the second Texas lawsuit was dismissed on April 14, 2016, and each of the initial Texas lawsuit and the German lawsuit was dismissed on April 25, 2016.

We recorded an aggregate legal settlement charge of $270.0 million in our condensed consolidated statement of comprehensive loss for the three months ended March 31, 2016. The charge covers the fulfillment by us of all financial obligations under both the BMC Settlement and HPE Settlement with no remaining financial obligations under either settlement. Refer to Note 14 in the notes to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q for further details of these matters.

ITEM 1A.    RISK FACTORS
 
Investing in our securities involves a high degree of risk. You should consider carefully the risks and uncertainties described below, together with all of the other information in this report, including our condensed consolidated financial statements and related notes report, before making an investment decision. We have identified the following risks and uncertainties that may have a material adverse effect on our business, financial condition, results of operations and future prospects. Our business could be harmed by any of these risks. The trading price of our common stock could decline due to any of these risks, and you may lose all or part of your investment.
 
Risks Related to Our Business and Industry

We expect our revenue growth rate to continue to decline, and we expect to continue to incur losses in accordance with U.S. Generally Accepted Accounting Principles, or GAAP.
 
We have experienced significant revenue growth in prior periods; however, our revenue growth rate is declining and we expect that it will continue to decline into the foreseeable future. We also expect our costs to increase in future periods as we continue to invest in our capacity to support anticipated growth. These investments may not result in increased revenues or growth in our business. Even if our revenues continue to increase, we expect to continue to incur a loss in accordance with GAAP during future periods due to increased costs such as non-cash charges associated with equity awards, business combinations and other expenses. Additionally, we may encounter unforeseen operating expenses, difficulties, complications, delays and other unforeseen or unpredictable factors that may result in increased costs. Furthermore, it is difficult to predict the size and growth rate of our market, customer demand for our products, customer adoption and renewal rates, and the entry of competitive products or the success of existing competitive products. As a result, we may not achieve or maintain profitability in the future, our gross margins may be negatively impacted, and our ability to generate cash flow from operations may be negatively impacted. If we fail to grow our revenues sufficiently to keep pace with our growing investments and other expenses, our business, operating results and growth prospects will be adversely affected.


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We have recently introduced products in new markets that are important to our growth prospects and for which we do not have an operating history. If we are unsuccessful in competing in these new markets, our revenue growth rate, business and operating results will be adversely affected.

We have recently introduced products in the markets for IT operations management, customer service, security incident management and use of our platform for service management outside of enterprise IT. Our successful entry into these and other new markets is important to our revenue growth prospects. We do not have a substantial operating history with these products, which limits our ability to forecast operating results, and the success of our efforts to address these markets depends on many factors, including: the degree of differentiation of our products and services from those offered by more established competitors in these markets; whether our product and services offer compelling benefits and value to customers; the time-frame and quality of our research and development efforts; the rigor and effectiveness of our quality testing and controls; and our ability to successfully market and sell into new markets with which our marketing and sales personnel are less experienced. We may not have the necessary resources, including employees with the required product management, engineering, marketing and sales expertise, to compete effectively in these markets. Any new service that we develop may not be introduced in a timely or cost-effective manner, may not be priced appropriately, may not offer compelling customer benefits compared to competing products and services, and may not achieve the broad market acceptance necessary to generate significant revenues. If we are not able to successfully develop, market and sell these and other newly introduced products and services to our existing customers and prospective new customers our revenue growth rate, business and operating results will be adversely affected.

If we are unsuccessful in increasing our rate of growth in new geographic markets, our revenue growth rate, business and operating results will be adversely affected.

Sales outside of North America represented approximately 31% of our total revenues for the three months ended March 31, 2016. Our business and future prospects depend on increasing our international sales as a percentage of our total revenues, and the failure to grow internationally will harm our business. Additionally, operating in international markets requires significant investment and management attention and will subject us to regulatory and economic risks that are different from those in the United States. We have made, and will continue to make, substantial investments in data centers and cloud computing infrastructure, sales, marketing, personnel and facilities as we enter and expand in new geographic markets, such as Brazil and various countries within Asia. When we make these investments it is typically unclear whether, and when, sales in the new market will justify our investments, and we may significantly underestimate the level of investment and time required to be successful, or whether we will be successful. For example, our rate of acquisition of new Global 2000 customers, a key factor effecting our growth, has generally been greater in North America, Australia and in areas within Europe than it has been in Africa, Asia, Eastern Europe, South America and other markets in which we are less established. Accordingly, if we continue to further penetrate the Global 2000 at a higher rate in our established markets than in our emerging markets, over time an increasing percentage of the overall Global 2000 enterprises that are not yet our customers are in markets in which we have generally had a lower rate of customer acquisition or in which we are not yet competing. Additionally, currency fluctuations in certain countries and regions may negatively impact actual prices that partners and customers are willing to pay in those countries and regions, or the effective prices we realize in our reporting currency. We have experienced, and may continue to experience, difficulties in some of our investments in geographic expansion, including in hiring qualified sales management personnel. If we are unsuccessful in making these investments, or if our required investments are greater than anticipated, our revenue growth rate, business and operating results will be adversely affected.

We expect competition to cause the sales prices of our products to decline, which may harm our financial results.

The sales prices for our products, subscriptions and services may decline for a variety of reasons, including competitive pricing pressures, discounts, a change in our mix of products and subscriptions, anticipation of the introduction of new products or subscriptions, or promotional programs. Competition continues to increase in the market segments in which we participate, and we expect competition to further increase in the future, thereby leading to increased pricing pressures. Larger competitors with more diverse product and service offerings may reduce the price of products or subscriptions that compete with ours or may bundle them with other products and subscriptions. In addition, we expect that smaller competitors and new entrants may accelerate the decline of prices in the IT service management market, which is our more mature offering from which we derive the substantial majority of our revenues and will continue to do so for the foreseeable future. Furthermore, we anticipate that the sales prices and gross profits for our products will decrease over product life cycles. We may not be successful in developing and introducing new offerings on a timely basis, and any new product and subscription offerings, if introduced, may not enable us to maintain our prices and gross profits at levels that will allow us to maintain positive gross margins.


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If we fail to meet the financial performance expectations of investors or securities analysts, the price of our common stock could decline substantially.

For any quarterly or annual period there is a risk that our financial performance will not meet the financial guidance we have previously given for that period, or that we may otherwise fail to meet the financial performance expectations of the securities analysts who issue reports on our company and our common stock price, or of investors in our common stock. There is also a risk that we may issue forward-looking financial guidance for a quarterly or annual period that fails to meet the expectations of such securities analysts or investors. If any of the foregoing occurs, for any reason either within or outside of our control, the price of our common stock could decline substantially and investors in our common stock could incur substantial losses. Some of the important factors that may cause our revenues, operating results and cash flows, or our forward-looking financial guidance, to fall below the expectations of such securities analysts or investors include:

our ability to retain and increase sales to existing customers, attract new customers and satisfy our customers’ requirements;
changes in foreign currency exchange rates;
the rate of expansion and productivity of our sales force;
the number of new employees added;
the cost, timing and management effort for our development of new services;
general economic conditions that may adversely affect either our customers’ ability or willingness to purchase additional subscriptions, delay a prospective customer’s purchasing decision, reduce the value of new subscription contracts or affect renewal rates;
the amount and timing of operating costs and capital expenditures related to the operation and expansion of our business;
seasonality in terms of when we enter into customer agreements for our services;
the length of the sales cycle for our services;
changes in our pricing policies, whether initiated by us or as a result of competition;
significant security breaches, technical difficulties or interruptions of our services;
new solutions, products or changes in pricing policies introduced by our competitors;
changes in effective tax rates;
changes in the average duration of our customer agreements and changes in billing cycle;
changes in our renewal and upsell rates;
the timing of customer payments and payment defaults by customers;
extraordinary expenses such as litigation costs or damages, including settlement payments;
the impact of new accounting pronouncements;
changes in laws or regulations impacting the delivery of our services;
the amount and timing of stock awards and the related financial statement expenses; and
our ability to accurately estimate the total addressable market for our products and services.

Lawsuits against us by third-parties that allege we infringe their intellectual property rights could harm our business and operating results.

There is considerable patent and other intellectual property development activity in our industry. Our success depends in part on not infringing upon the intellectual property rights of others. We may be unaware of the intellectual property rights of others that may cover some or all of our technology or services. From time to time, our competitors or other third parties, including patent holding companies seeking to monetize patents they have purchased or otherwise obtained, may claim that we are infringing upon their intellectual property rights. For example, we recently settled two patent-related litigation matters and recorded a one-time aggregate legal settlement charge of $270.0 million.

In any intellectual property litigation, regardless of the scope or merits of the claims at issue, we may incur substantial attorney’s fees and other litigation expenses and, if the claims are successfully asserted against us and we are found to be infringing upon the intellectual property rights of others, we could be required to: pay substantial damages and make substantial ongoing royalty payments; cease offering our products and services; modify our products and services; comply with other unfavorable terms, including settlement terms; and indemnify our customers and business partners and obtain costly licenses on their behalf and refund fees or other payments previously paid to us. Moreover, the mere existence of any lawsuit, or any interim or final outcomes, and the course of its conduct and the public statements related to it (or absence of such statements) by the courts, press, analysts and litigants, could be unsettling to our customers and prospective customers and could cause an adverse impact to our customer satisfaction and related renewal rates and cause us to lose potential sales, and could also be unsettling to investors or prospective investors in our common stock and could cause a substantial decline in the price of our common stock. Accordingly, any claim or litigation against us could be costly, time-consuming and divert the attention of our management and key personnel from our business operations and harm our financial condition and operating results.

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If we suffer a cyber-security event we may lose customers, lose future sales, experience business interruption and injury to our competitive position, and incur significant liabilities, any of which would harm our business and operating results.

Our operations involve the storage, transmission and processing of our customers’ confidential, proprietary and sensitive information, including in some cases personally identifiable information, protected health information, proprietary information and credit card and other sensitive financial information. While we have security measures in place designed to protect customer information and prevent data loss, they may be breached as a result of third-party action, including intentional misconduct by computer hackers, employee error, malfeasance or otherwise, and result in someone obtaining unauthorized access to our customers’ data or our data, including our intellectual property and other confidential business information. A security breach or unauthorized access could result in the loss or exposure of this data, litigation, indemnity and other contractual obligations, government fines and penalties, mitigation expenses and other liabilities. Additionally, the cost and operational consequences of responding to breaches and implementing remediation measures could be significant.

Computer malware, viruses and hacking and phishing attacks by third parties have become more prevalent in our industry, have occurred on our systems in the past and may occur on our systems in the future. Because techniques used to obtain unauthorized access to or sabotage systems change frequently and generally are not recognized until successfully launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. As cyber-security threats develop and grow, it may be necessary to make significant further investments to protect data and infrastructure. If an actual or perceived breach of our security occurs, we could suffer severe reputational damage adversely affecting customer or investor confidence, the market perception of the effectiveness of our security measures could be harmed, we could lose potential sales and existing customers, our ability to deliver our services or operate our business may be impaired, we may be subject to litigation or regulatory investigations or orders, and we may incur significant liabilities. We do not have insurance sufficient to compensate us for the potentially significant losses that may result from security breaches.

Disruptions in our services could damage our customers’ businesses, subject us to substantial liability and harm our reputation and financial results.

Our customers use our services to manage important aspects of their businesses, and any disruptions in our services could damage our customers' businesses, subject us to substantial liability, and harm our reputation and financial results. From time to time, we experience defects in our services, and new defects may be detected in the future. We provide regular updates to our services, which frequently contain undetected defects when first introduced or released. Defects may also be introduced by our use of third-party software, including open source software. Disruptions may also result from errors we make in delivering, configuring, or hosting our services, or designing, installing, expanding or maintaining our cloud infrastructure. Disruptions in service can also result from incidents that are outside of our control. We currently serve our customers primarily using equipment managed by us and co-located in third-party data center facilities operated by several different providers located around the world. These centers are vulnerable to damage or interruption from earthquakes, floods, fires, power loss and similar events. They may also be subject to break-ins, sabotage, intentional acts of vandalism and similar misconduct, equipment failure and adverse events caused by operator error. We cannot rapidly switch to new data centers or move customers from one data center to another in the event of any such adverse event. Despite precautions taken at these facilities, problems at these facilities could result in lengthy interruptions in our services and the loss of customer data. In addition, our customers may use our services in ways that cause disruptions in service for other customers. Our reputation and business will be adversely affected if our customers and potential customers believe our services are unreliable. Disruptions in our services may reduce our revenues, cause us to issue credits or pay penalties, subject us to claims and litigation, cause our customers to delay payment or terminate or fail to renew their subscriptions, and adversely affect our ability to attract new customers. The occurrence of payment delays, or service credit, warranty, termination for material breach or other claims against us, could result in an increase in our bad debt expense, an increase in collection cycles for accounts receivable, an increase to our warranty provisions or service level credit accruals or other increased expenses or risks of litigation. We do not have insurance sufficient to compensate us for the potentially significant losses that may result from claims arising from disruptions in our services.


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If we are unable to continuously enhance our products and services to deliver consumer product-like experiences, mobility, messaging and ease of use, they could become less competitive or obsolete and our business and operating results will be adversely affected.

We believe that enterprises are increasingly focused on delivering a consumer-like technology experience to users within the enterprise, such as employees, and to individuals interacting with the enterprise, such as customers, partners and suppliers. Accordingly, our ability to attract new customers and to renew and increase revenues from existing customers depends on our ability to continuously enhance our products and services and provide them in ways that are broadly accepted. In particular, we need to continuously modify and improve our products and services to keep pace with changes in user expectations, including intuitive and attractive user interfaces, use and mobility features, messaging, social networking, and communication, database, hardware and security technologies. If we are unable to consistently and timely meet these requirements, our products and services may become less marketable and less competitive or obsolete, and our business and operating results will be adversely affected.

The markets in which we participate are intensely competitive, and if we do not compete effectively our business and operating results will be adversely affected.

The markets in which we compete to manage services across the enterprise are fragmented, rapidly evolving and highly competitive, with relatively low barriers to entry. As the market for service management matures, we expect competition to intensify. We face competition from in-house solutions, large integrated systems vendors, and established and emerging cloud and software vendors. Our competitors vary in size and in the breadth and scope of the products and services offered. Many of our competitors and potential competitors are larger, have greater name recognition, longer operating histories, more established customer relationships, larger marketing budgets and greater resources than we do. Furthermore, third parties with greater available resources and the ability to initiate or withstand substantial price competition may acquire our current or potential competitors. Our primary competitors include BMC Software, Inc., CA, Inc., Hewlett Packard Enterprise Company, International Business Machines Corporation and Salesforce.com. Further, other potential competitors not currently offering competitive products may expand their services to compete with our services. As we expand the breadth of our services to include offerings in the markets for IT operations management, customer service, security incident management and use of our platform for service management outside of enterprise IT, we expect increasing competition from platform vendors and from application development vendors focused on these other markets. Our competitors may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards and customer requirements. An existing competitor or new entrant could introduce new technology that reduces demand for our services. In addition to product and technology competition, we face pricing competition. Some of our competitors offer their products or services at a lower price, which has resulted in pricing pressures. Some of our larger competitors have the operating flexibility to bundle competing products and services with other software offerings, including offering them at a lower price as part of a larger sale. For all of these reasons, we may not be able to compete successfully and competition could result in reduced sales, reduced margins, losses or the failure of our services to achieve or maintain market acceptance, any of which could harm our business.

If we lose key employees or are unable to attract and retain the employees we need, our business and operating results will be adversely affected.

Our success depends largely upon the continued services of our management team and many key individual contributors. From time to time, there may be changes in our management team resulting from the hiring or departure of employees, which could disrupt our business. Our employees are generally employed on an at-will basis, which means that our employees could terminate their employment with us at any time. The loss of one or more members of our management team or other key employees could have a serious impact on our business. In the technology industry, there is substantial and continuous competition for engineers with high levels of experience in designing, developing and managing software and Internet-related solutions, as well as competition for sales executives and operations personnel. We may not be successful in attracting and retaining qualified personnel. We have from time to time experienced, and we may continue to experience, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. In particular, competition for experienced software and cloud computing infrastructure engineers in the San Francisco Bay area, San Diego, Seattle, London and Amsterdam, our primary operating locations, is intense. If we fail to attract new personnel or fail to retain and motivate our current personnel, our business and future growth prospects could be adversely affected.

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Our revenue growth rate, business and operating results will be adversely affected if we fail to effectively expand our sales and marketing capabilities.

Increasing our customer base and achieving broader market acceptance of our services will depend, to a significant extent, on our ability to effectively expand our sales and marketing operations and activities. We are substantially dependent on our direct sales force to obtain new customers. From March 31, 2015 to March 31, 2016, our sales and marketing organization increased from 1,105 to 1,571 employees. We plan to continue to expand our direct sales force both domestically and internationally. There is significant competition for direct sales personnel with the sales skills and technical knowledge that we require. Our ability to achieve significant revenue growth in the future will depend, in large part, on our success in recruiting, training and retaining a sufficient number of direct sales personnel and we may be unable to hire or retain sufficient numbers of qualified individuals. Newly hired employees require significant training and time before they achieve full productivity, particularly in new sales territories, and our recent hires and planned hires may not become as productive as quickly as we plan, or at all. Further, in our less established markets such as in Brazil and various countries within Asia, we do not have significant experience as an organization developing and implementing sales and marketing campaigns, and such campaigns may be expensive and difficult to implement, and we may be unable to attract and retain qualified personnel to conduct such campaigns. Our business will be adversely affected if our sales and marketing expansion efforts do not generate a significant increase in revenues.

Our business depends substantially on our existing customers purchasing additional subscriptions from us and renewing their subscriptions upon expiration of their subscription term. Any decline in customer additional purchases or renewals would harm our business and operating results.

In order for us to maintain or improve our operating results, it is important that our existing customers expand their use of our services by adding new users and applying our products and services in new ways across the enterprise, and renew their subscriptions upon expiration of the subscription contract term. Our customers have no obligation to renew their subscriptions, and our customers may not renew subscriptions with a similar contract period or with the same or a greater number of users. Although our renewal rates have historically been high, some of our customers have elected not to renew their agreements with us and we cannot accurately predict renewal rates. Moreover, in some cases, some of our customers have the right to cancel their agreements prior to the expiration of the term. Our renewal rates may decline or fluctuate as a result of a number of factors, including: our customers' satisfaction with our products and services and customer support; our prices and pricing policies and the prices of competing products and services; mergers and acquisitions affecting our customer base; customer personnel changes; global economic conditions; or reductions in our customers’ spending levels. Our renewal rates may also decline based on our customers’ satisfaction with the implementation and other professional services of our partners, or the quality of implementations by our customers, all of which are generally outside of our control. If our customers do not renew their subscriptions, renew on less favorable terms, fail to add more authorized users, fail to purchase additional professional services, decline to act as enthusiastic reference accounts for our customer prospects, or disparage our products and services, our revenue growth rate, business and operating results will be adversely affected.

Our revenue growth depends in part on the success of our strategic relationships with third parties and their continued performance.

We depend on our channel partners, including our implementation partners, systems integrators, managed services providers and sales partners in order to grow our business. Our sales efforts have focused on large enterprise customers and there are a limited number of partners with the capacity to provide these customers an effective level of services. In order to continue our revenue growth, we need to recruit these partners and these partners need to devote substantial resources to our solutions. Accordingly, we need to build services, implement partner programs, and provide training and other resources to recruit, retain and enable these partners. Our agreements with partners are typically non-exclusive and do not prohibit them from working with our competitors or from offering competing solutions. Our competitors may be effective in providing incentives to our partners to favor their solutions or otherwise disrupt the relationships we have with our partners. In addition, global economic conditions could harm the businesses of our partners, and it is possible that they may not be able to devote the additional resources we expect to the relationship. If we are unsuccessful in establishing or maintaining our relationships with our channel partners, our ability to compete in the marketplace or to grow our revenues could be impaired and our operating results would suffer. To compete in the markets for our newly introduced products in the markets for IT operations management, customer service, security incident management and use of our platform for service management outside of enterprise IT, we may need to establish relationships with additional sales and implementation partners. Further, reliance on third parties exposes us to risk of poor performance and failed customer expectations. If our channel partners do not effectively provide services or support to the satisfaction of our end-customers, we may incur additional costs to address the situation, the profitability of that work might be impaired, and the customer’s dissatisfaction could damage our reputation or ability to obtain additional revenues from that customer or prospective customers.


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Privacy laws and concerns, evolving regulation of cloud computing, and the changes in laws, regulations and standards related to the Internet may cause our business to suffer.

Federal, state or foreign government bodies or agencies have in the past adopted, and may in the future adopt, laws and regulations affecting data privacy, the use of the Internet as a commercial medium, and data sovereignty requirements concerning the location of data centers that store and process data. Industry organizations also regularly adopt and advocate for new standards in these areas. Changing laws, regulations and standards applying to the solicitation, collection, transfer, processing, storage or use of personal or consumer information could affect our customers’ ability to use and share data, potentially restricting our ability to store, process and share data with our customers in connection with providing our services, and in some cases could impact our ability to offer our services in certain locations or our customers’ ability to deploy our services globally. For example, the European Court of Justice in October 2015 issued a ruling immediately invalidating the U.S.-EU Safe Harbor framework that had been in place since 2000, which facilitated the transfer of personal data from the European Economic Area to the United States in compliance with applicable European data protection laws. While other adequate legal mechanisms for lawfully transferring European personal data to the United States remain, there is regulatory uncertainty surrounding how data transfers from the European Economic Area to the United States will be authorized in the future. Future laws, regulations, standards and other obligations, and changes in the interpretation of existing laws, regulations, standards and other obligations could impair our or our customers’ ability to collect, use or disclose information relating to individuals, which could decrease demand for our applications, require us to restrict our business operations, increase our costs and impair our ability to maintain and grow our customer base and increase our revenue. In addition, government agencies or private organizations may begin to impose taxes, fees or other charges for accessing the Internet, commerce conducted via the Internet or validation that particular processes follow the latest standards. These changes could limit the viability of cloud computing services such as ours. If we are not able to adjust to changing laws, regulations and standards related to the Internet, our business may be adversely affected.

Prospective customers that have not yet embraced cloud computing solutions may continue to be reluctant, slow, or unwilling to do so, any of which could harm our business and operating results.

We do not know whether the trend of adoption of enterprise cloud computing solutions from which we have benefited in the past will continue in the future at the same overall growth rates. Many organizations have invested substantial personnel and financial resources to integrate enterprise software into their businesses over time, and some have been reluctant or unwilling to migrate to cloud computing solutions. Furthermore, some organizations have been reluctant or unwilling to use cloud computing solutions because they have concerns regarding the risks associated with the security of their data, the physical location of data centers in which their data is stored and processed, and the reliability of the technology delivery model associated with these solutions. In addition, if either we or other cloud computing providers experience security incidents, loss of customer data, disruptions in delivery, or other problems, the market for cloud computing solutions as a whole, including for our products and services, will be negatively impacted. For these and other reasons, there is a substantial risk that enterprises (including Global 2000 enterprises on which we are dependent for sales growth) that have not yet embraced cloud computing solutions will continue to be reluctant, slow, or be unwilling to do so, or willing to do so only to a limited extent, any of which could harm our business.

Foreign currency exchange rate fluctuations could harm our financial results.

We conduct significant transactions, including revenue transactions and intercompany transactions, in currencies other than the U.S. Dollar or the functional operating currency of the transactional entities. In addition, our international subsidiaries maintain significant net assets that are denominated in currencies other than the functional operating currencies of these entities. Accordingly, changes in the value of currencies relative to the U.S. Dollar may impact our consolidated revenues and operating results due to transactional and translational remeasurement that is reflected in our earnings. It is particularly difficult to forecast any impact from exchange rate movements, so there is risk that unanticipated currency fluctuations could adversely affect our results or cause our results to differ from investor exp