10-Q 1 appf9301710-q.htm FORM 10-Q FOR Q3 2017 Document

 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
(Mark one)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2017.
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to ________.

Commission File Number 001-37468
AppFolio, Inc.
(Exact name of registrant as specified in its charter)

Delaware
 
26-0359894
(State of incorporation or organization)
 
(I.R.S. Employer Identification No.)
50 Castilian Drive
Santa Barbara, California
 
93117
(Address of principal executive offices)
 
(Zip Code)
 (805) 364-6093
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report)
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 o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES x NO o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
 
¨
 
Accelerated filer
x
 
 
 
 
 
Non-accelerated filer
 
¨  (Do not check if a smaller reporting company)
 
Smaller reporting company
¨
 
 
 
 
 
 
 
 
 
 
Emerging growth company
x
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act. x

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

As of October 23, 2017, the number of shares of the registrant’s Class A common stock outstanding was 14,506,412 and the number of shares of the registrant’s Class B common stock outstanding was 19,440,672.
.



TABLE OF CONTENTS
 
Section
 
Page No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 




CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2017, or Quarterly Report, includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, which statements are subject to considerable risks and uncertainties. Forward-looking statements include all statements that are not statements of historical facts contained in this Quarterly Report and can be identified by words such as “anticipates,” “believes,” “seeks,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts, “projects,” “should,” “could,” “will,” “would” or similar expressions and the negatives of those expressions. In particular, forward looking statements contained in this Quarterly Report relate to, among other things, our future or assumed financial condition, results of operations, business forecasts and plans, capital needs and financing plans, research and product development plans, growth in the size of our business and number of customers, strategic plans and objectives, acquisitions and investments, and the application of accounting guidance. We caution you that the foregoing list may not include all of the forward-looking statements made in this Quarterly Report.

Forward-looking statements represent our management’s current beliefs and assumptions based on information currently available. Forward-looking statements involve numerous known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. We discuss these risks and uncertainties in greater detail in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Quarterly Report and
in the section entitled “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016, or Annual Report, as well as in our other filings with the Securities and Exchange Commission, or SEC. You should read this Quarterly Report, and the other documents we have filed with the SEC, with the understanding that our actual future results may be materially different from the results expressed or implied by these forward-looking statements.

Moreover, we operate in an evolving environment. New risks and uncertainties emerge from time to time and it is not possible for our management to predict all risks and uncertainties, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual future results to be materially different from those expressed or implied by any forward-looking statements.

Except as required by applicable law or the rules of the NASDAQ Stock Market, we assume no obligation to update any forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

We qualify all of our forward-looking statements by these cautionary statements.


1


PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements

APPFOLIO, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(in thousands, except par values)
 
 
 
September 30,
2017
 
December 31,
2016
Assets
 
 
 
 
Current assets
 
 
 
 
Cash and cash equivalents
 
$
14,781

 
$
10,699

Investment securities—current
 
28,396

 
15,473

Accounts receivable, net
 
3,419

 
2,511

Prepaid expenses and other current assets
 
4,393

 
3,537

Total current assets
 
50,989

 
32,220

Investment securities—noncurrent
 
20,423

 
26,688

Property and equipment, net
 
7,005

 
7,077

Capitalized software, net
 
17,320

 
15,539

Goodwill
 
6,737

 
6,737

Intangible assets, net
 
2,054

 
3,105

Other assets
 
1,219

 
1,217

Total assets
 
$
105,747

 
$
92,583

Liabilities and Stockholders’ Equity
 
 
 
 
Current liabilities
 
 
 
 
Accounts payable
 
$
1,164

 
$
937

Accrued employee expenses
 
8,169

 
7,550

Accrued expenses
 
5,908

 
4,044

Deferred revenue
 
7,508

 
7,638

Other current liabilities
 
1,083

 
1,192

Total current liabilities
 
23,832

 
21,361

Other liabilities
 
1,238

 
1,540

Total liabilities
 
25,070

 
22,901

Commitments and contingencies (Note 6)
 

 

Stockholders’ equity:
 
 
 
 
Preferred stock, $0.0001 par value, 25,000 authorized and no shares issued and outstanding as of September 30, 2017 and December 31, 2016
 

 

Class A common stock, $0.0001 par value, 250,000 shares authorized as of September 30, 2017 and December 31, 2016; 14,494 and 11,691 shares issued and outstanding as of September 30, 2017 and December 31, 2016, respectively;
 
1

 
1

Class B common stock, $0.0001 par value, 50,000 shares authorized as of September 30, 2017 and December 31, 2016; 19,448 and 22,028 shares issued and outstanding as of September 30, 2017 and December 31, 2016, respectively;
 
3

 
3

Additional paid-in capital
 
150,520

 
146,692

Accumulated other comprehensive loss
 
(23
)
 
(51
)
Accumulated deficit
 
(69,824
)
 
(76,963
)
Total stockholders’ equity
 
80,677

 
69,682

Total liabilities and stockholders’ equity
 
$
105,747

 
$
92,583

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of these statements.

2


APPFOLIO, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(in thousands, except per share amounts)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Revenue
$
37,903

 
$
28,162

 
$
105,906

 
$
77,576

Costs and operating expenses:
 
 
 
 
 
 
 
Cost of revenue (exclusive of depreciation and amortization)
14,053

 
11,645

 
40,747

 
33,387

Sales and marketing
7,257

 
6,979

 
21,556

 
22,097

Research and product development
4,367

 
3,464

 
11,998

 
9,531

General and administrative
5,405

 
4,642

 
15,310

 
12,580

Depreciation and amortization
3,237

 
2,636

 
9,347

 
7,112

Total costs and operating expenses
34,319

 
29,366

 
98,958

 
84,707

Income (loss) from operations
3,584

 
(1,204
)
 
6,948

 
(7,131
)
Other expense, net
(5
)
 
(12
)
 
(93
)
 
(34
)
Interest income, net
155

 
102

 
377

 
221

Income (loss) before provision for income taxes
3,734

 
(1,114
)
 
7,232

 
(6,944
)
Provision for income taxes
52

 
11

 
93

 
48

Net income (loss)
$
3,682

 
$
(1,125
)
 
$
7,139

 
$
(6,992
)
 
 
 
 
 
 
 
 
Net income (loss) per common share:
 
 
 
 
 
 
 
Basic
$
0.11

 
$
(0.03
)
 
$
0.21

 
$
(0.21
)
Diluted
$
0.10

 
$
(0.03
)
 
$
0.20

 
$
(0.21
)
Weighted average common shares outstanding:
 
 
 
 
 
 
 
Basic
33,905

 
33,600

 
33,817

 
33,529

Diluted
35,205

 
33,600

 
35,091

 
33,529

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of these statements.


3



APPFOLIO, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
(in thousands)


 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
Net income (loss)
$
3,682

 
$
(1,125
)
 
$
7,139

 
$
(6,992
)
Other comprehensive income (loss):
 
 
 
 
 
 
 
Changes in unrealized gains (losses) on investment securities
26

 
(96
)
 
28

 
277

Comprehensive income (loss)
$
3,708

 
$
(1,221
)
 
$
7,167

 
$
(6,715
)
The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of these statements.


4



APPFOLIO, INC.
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(UNAUDITED)
(in thousands)


 
 
 
 
 
 
 
 
 
 
 
Accumulated
 
 
 
 
 
 
 
 
 
 
 
 
 
Additional
 
Other
 
 
 
 
 
Common Stock
 
Common Stock
 
Paid-in
 
Comprehensive
 
Accumulated
 
 
 
Class A
 
Class B
 
Capital
 
(Loss)/Income
 
Deficit
 
Total
 
Shares
 
Amount
 
Shares
 
Amount
 
 
 
 
 
 
 
 
Balance at December 31, 2016
11,691

 
$
1

 
22,028

 
$
3

 
$
146,692

 
$
(51
)
 
$
(76,963
)
 
$
69,682

Exercise of stock options
133

 

 

 
 
 
508

 

 

 
508

Stock-based compensation

 

 

 

 
4,674

 

 

 
4,674

Vesting of restricted stock units, net of shares withheld for taxes
81

 

 

 

 
(1,421
)
 

 

 
(1,421
)
Vesting of early exercised shares

 

 

 

 
67

 

 

 
67

Conversion of Class B stock to Class A stock
2,580

 

 
(2,580
)
 

 

 

 

 

Issuance of restricted stock awards
9

 

 

 

 

 

 

 

Other comprehensive income

 

 

 

 

 
28

 

 
28

Net income

 

 

 

 

 

 
7,139

 
7,139

Balance at September 30, 2017
14,494

 
$
1

 
19,448

 
$
3

 
$
150,520

 
$
(23
)
 
$
(69,824
)
 
$
80,677

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of these statements.


5


APPFOLIO, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
 
 
 
Nine Months Ended
September 30,
 
2017
 
2016
Cash from operating activities
 
 
 
Net income (loss)
$
7,139

 
$
(6,992
)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
Depreciation and amortization
9,347

 
7,112

Purchased investment premium, net of amortization
(22
)
 
185

Amortization of deferred financing costs
48

 
48

Loss on disposal of property and equipment
94

 
33

Stock-based compensation
4,304

 
2,844

Lease abandonment

 
161

Changes in operating assets and liabilities:

 

Accounts receivable
(908
)
 
(659
)
Prepaid expenses and other current assets
(856
)
 
(804
)
Other assets
(54
)
 
(163
)
Accounts payable
369

 
(1,109
)
Accrued employee expenses
846

 
(144
)
Accrued expenses
1,713

 
1,354

Deferred revenue
(130
)
 
1,674

Other liabilities
(334
)
 
1,183

Net cash provided by operating activities
21,556

 
4,723

Cash from investing activities
 
 
 
Purchases of property and equipment
(1,680
)
 
(3,560
)
Additions to capitalized software
(8,085
)
 
(8,554
)
Purchases of investment securities
(17,597
)
 
(24,334
)
Sales of investment securities
15

 
10,016

Maturities of investment securities
10,974

 
17,112

Purchases of intangible assets
(1
)
 
(2
)
Net cash used in investing activities
(16,374
)
 
(9,322
)
Cash from financing activities
 
 
 
Proceeds from stock option exercises
508

 
260

Tax withholding for net share settlement
(1,608
)
 
(85
)
Principal payments under capital lease obligations

 
(24
)
Proceeds from issuance of debt
88

 
87

Principal payments on debt
(88
)
 
(99
)
Net cash (used in) provided by financing activities
(1,100
)
 
139

Net increase (decrease) in cash and cash equivalents
4,082

 
(4,460
)
Cash and cash equivalents
 
 
 
Beginning of period
10,699

 
12,063

End of period
$
14,781

 
$
7,603

 
 
 
 

6


APPFOLIO, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
 
 
 
Nine Months Ended
September 30,
 
2017
 
2016
Noncash investing and financing activities
 
 
 
Purchases of property and equipment included in accounts payable and accrued expenses
$
271

 
$
112

Additions of capitalized software included in accrued employee expenses
231

 
231

Stock-based compensation capitalized for software development
548

 
308

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of these statements.

7


APPFOLIO, INC.
NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
1. Nature of Business
AppFolio, Inc. (“we” or “AppFolio”) provides industry-specific, cloud-based software solutions for small and medium-sized businesses (“SMBs”) in the property management industry and solo practitioners and small law firms in the legal industry. We refer to solo practitioners and small law firms as SMBs in connection with our legal vertical in this Quarterly Report. Our platform is designed to be the system of record to automate essential business processes and the system of engagement to enhance business interactions between our customers and their clients and vendors. We also offer optional, but often mission-critical, Value+ services, which are seamlessly built into our core solutions.
2. Summary of Significant Accounting Policies
Basis of Presentation and Significant Accounting Policies
The accompanying unaudited Condensed Consolidated Financial Statements were prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information. Certain information and disclosures normally included in consolidated financial statements prepared in accordance with GAAP have been condensed or omitted. Accordingly, these Condensed Consolidated Financial Statements should be read in conjunction with our audited consolidated financial statements and the related notes included in our Annual Report filed with the SEC on February 27, 2017. The year-end condensed balance sheet was derived from our audited consolidated financial statements. Our unaudited interim Condensed Consolidated Financial Statements have been prepared on a basis consistent with that used to prepare our audited annual consolidated financial statements and include, in the opinion of management, all adjustments, consisting of normal and recurring items, necessary for the fair statement of the Condensed Consolidated Financial Statements. The operating results for the nine months ended September 30, 2017, are not necessarily indicative of the results expected for the full year ending December 31, 2017.
Changes in Accounting Policies
Except as described below under Recently Adopted Accounting Pronouncements, there have been no significant changes in our accounting policies from those disclosed in our annual consolidated financial statements and the related notes included in our Annual Report.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. On an ongoing basis, management evaluates its estimates based on historical data and experience, as well as various other factors that management believes to be 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.

8


Net Income (Loss) per Share
The net income (loss) per common share was the same for our Class A and Class B common shares because they are entitled to the same liquidation and dividend rights and are therefore combined in the table below. The following table presents a reconciliation of our weighted average number of Class A and Class B common shares used to compute net income (loss) per share (in thousands):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2017
 
2016
 
2017
 
2016
Weighted average shares outstanding
 
33,923

 
33,668

 
33,848

 
33,617

Less: Weighted average unvested restricted shares subject to repurchase
 
18

 
68

 
31

 
88

Weighted average common shares outstanding; basic
 
33,905

 
33,600

 
33,817

 
33,529

 
 
 
 
 
 
 
 
 
Weighted average common shares outstanding; basic
 
33,905

 
33,600

 
33,817

 
33,529

Plus: Weighted average options, RSUs and restricted shares used to compute diluted net income per share
 
1,300

 

 
1,274

 

Weighted average common shares outstanding; diluted
 
35,205

 
33,600

 
35,091

 
33,529

Approximately 571,000 shares of performance based options ("PSOs") and performance based restricted stock units ("PSUs") are not included in the computations of diluted and anti-dilutive shares for the three and nine month periods ended September 30, 2017, as they are considered contingently issuable upon the satisfaction of pre-defined performance measures and their respective performance measures have not been met.
For the three and nine months ended September 30, 2016, we reported a net loss and therefore all potentially dilutive common shares are anti-dilutive and have been excluded from the calculation of net loss per share. The following table presents the number of anti-dilutive common shares excluded from the calculation of weighted average number of shares used to compute diluted net income (loss) per share for the three and nine months ended September 30, 2017 and 2016 (in thousands):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2017
 
2016
 
2017
 
2016
Options to purchase common stock
 

 
1,764

 

 
1,764

Unvested restricted stock awards
 

 
59

 

 
59

Unvested restricted stock units
 
13

 
480

 
13

 
480

Contingent restricted stock units (1)
 
6

 
27

 
6

 
27

Total shares excluded from net income (loss) per common share
 
19

 
2,330

 
19

 
2,330

(1) Included in the anti-dilutive shares above are fixed price restricted stock unit (“RSU”) commitments for which the number of shares has not been determined at the grant date. The number of RSU shares with a fixed price included in the table above are 6,000 and 27,000 shares at September 30, 2017 and 2016, respectively. The number of shares have been determined by dividing the fixed price commitment to issue shares in the future by the closing price of our stock as of the applicable reporting period date.
Recently Adopted Accounting Pronouncements
Under the Jumpstart our Business Startups Act (the “JOBS Act”), we meet the definition of an emerging growth company. We have irrevocably elected to opt out of the extended transition period for complying with new or revised accounting standards pursuant to Section 107(b) of the JOBS Act.
In March 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-09, Compensation - Stock Compensation (Topic 781), Improvements to Employee Share-Based Payment Accounting ("ASU 2016-09"), which amends and simplifies the accounting for share-based payment awards in three areas: (1) income tax consequences, (2) classification of awards as either equity or liabilities, and (3) classification on the statement of cash flows. ASU 2016-19 also provides an accounting policy election to account for forfeitures as they occur. We adopted this guidance on January 1, 2017. The impact on the Company’s consolidated financial statements was not material due to the full valuation allowance on

9


our deferred tax assets. We have elected to continue to estimate forfeitures expected to occur to determine the amount of compensation cost to be recognized each period.
Recent Accounting Pronouncements Not Yet Adopted
In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, as amended which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers ( the “new revenue standard”). The new revenue standard will be effective on January 1, 2018 and early adoption is permitted. The standard permits the use of either a full retrospective or modified retrospective transition method.

The Company will adopt the new revenue standard as of January 1, 2018, using the modified retrospective transition method and is currently evaluating the expected impact of the adoption on its consolidated financial statements and related disclosures. Under the modified retrospective transition method, we will be required to calculate and record the cumulative effect of adopting the new revenue standard as an adjustment to our opening balance of our retained earnings on January 1, 2018, within our Quarterly Report on Form 10-Q for the first quarter of 2018. Prior periods will not be retrospectively adjusted.
Based on our ongoing assessment, we do not expect there will be a material impact on our revenue upon adoption. While we are continuing to assess all potential impacts of the standard, we believe the most significant impact relates to recognizing the costs of obtaining customer contracts. Under the Company's current policy election under GAAP, sales commissions and other incremental costs to acquire contracts are expensed as incurred. Under the new revenue standard, such costs will be deferred and recognized over a period of time. The Company is in the process of implementing the necessary changes to its accounting policies, processes, internal controls and information systems that will be required to meet the new standard’s reporting and disclosure requirements.
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) ("ASU 2016-02"). Under ASU 2016-02, an entity will be required to recognize right-of-use assets and lease liabilities on its balance sheet and disclose key information about leasing arrangements. ASU 2016-02 offers specific accounting guidance for a lessee, a lessor and sale and leaseback transactions. Lessees and lessors are required to disclose qualitative and quantitative information about leasing arrangements to enable a user of the financial statements to assess the amount, timing and uncertainty of cash flows arising from leases. For public companies, ASU 2016-02 is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period, and requires a modified retrospective adoption, with early adoption permitted. We anticipate this standard will have a material impact on our consolidated financial statements. While we are continuing to assess all potential impacts of the standard, we currently believe the most significant impact relates to our accounting and reporting of our operating leases on our balance sheet.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"), which amends the current accounting guidance and requires the measurement of all expected losses based on historical experience, current conditions and reasonable and supportable forecasts. This guidance amends the accounting for credit losses for available-for-sale securities and purchased financial assets with credit deterioration. ASU 2016-13 is effective for annual periods beginning after December 15, 2019, and interim periods within those annual periods. Early adoption is permitted for any interim or annual period after December 15, 2018. We do not expect the adoption of this guidance to have a material impact on our financial condition, results of operations, cash flows or disclosures.
    
In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments ("ASU 2016-15"), which provides cash flow statement classification guidance for debt prepayment or debt extinguishment costs; settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing; contingent consideration payments made after a business combination; proceeds from the settlement of insurance claims; proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies; distributions received from equity method investees; beneficial interests in securitization transactions; and separately identifiable cash flows and application of the predominance principle. ASU 2016-15 is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. We have not determined the effect of this guidance on our statement of cash flows.
    
In October 2016, the FASB issued ASU No. 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory ("ASU 2016-16"), which changes the timing of when certain intercompany transactions are recognized within the provision for income taxes. ASU 2016-16 is effective on January 1, 2018. Early adoption is permitted. We have not determined the effect of this guidance on our financial condition, results of operations, cash flows or disclosures.


10


In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash ("ASU 2016-18"), which provides amendments to current guidance to address the classification and presentation of changes in restricted cash in the statement of cash flows. ASU 2016-18 is effective on January 1, 2018 and early adoption is permitted. We are still evaluating the effect of this guidance on our financial statements. We expect that adoption will change the current presentation of restricted cash on our statement of cash flows as well as require additional disclosures to reconcile cash and cash equivalents per the balance sheet to cash and cash equivalents on the statement of cash flows.

In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment ("ASU 2017-04"), which eliminates Step 2 from the goodwill impairment test. The annual, or interim, goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In addition, income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit should be considered when measuring the goodwill impairment loss, if applicable. ASU 2017-04 also eliminates the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. ASU 2017-04 is effective for public entities for fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on dates after January 1, 2017. We do not expect the adoption of this guidance to have a material impact on our financial condition, results of operations, cash flows or disclosures.

In March 2017, the FASB issued ASU No. 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities (“ASU 2017-08”). ASU 2017-08 shortens the amortization period for certain callable debt securities held at a premium. Specifically, ASU 2017-08 requires the premium to be amortized to the earliest call date. ASU 2017-08 does not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. For public companies, ASU 2017-08 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted, including adoption in an interim period. The amendments should be applied on a modified retrospective basis, with a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. We do not expect the adoption of this guidance to have a material impact on our financial condition, results of operations, cash flows or disclosures since our current accounting policy is in accordance with ASU 2017-08.

In May 2017, the FASB issued ASU 2017-09, Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting ("ASU 2017-09"). ASU 2017-09 clarifies when changes to the terms or conditions of a share-based payment award must be accounted for as modifications. The new guidance will reduce diversity in practice and result in fewer changes to the terms of an award being accounted for as modifications. Under ASU 2017-09, an entity will not apply modification accounting to a share-based payment award if the award’s fair value, vesting conditions and classification as an equity or liability instrument are the same immediately before and after the change. ASU 2017-09 will be applied prospectively to awards modified on or after the adoption date. The guidance is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Early adoption is permitted. We do not expect the adoption of this guidance to have a material impact on our financial condition, results of operations, cash flows or disclosures.

11


3. Investment Securities and Fair Value Measurements
Investment Securities
Investment securities classified as available-for-sale consisted of the following at September 30, 2017 and December 31, 2016 (in thousands):
 
September 30, 2017
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
Corporate bonds
$
34,558

 
$
11

 
$
(19
)
 
$
34,550

Agency securities
11,302

 

 
(17
)
 
11,285

Certificates of deposit
2,982

 
3

 
(1
)
 
2,984

Total available-for-sale investment securities
$
48,842

 
$
14

 
$
(37
)
 
$
48,819

 
December 31, 2016
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
Corporate bonds
$
30,492

 
$
9

 
$
(56
)
 
$
30,445

Agency securities
6,248

 

 
(20
)
 
6,228

Certificates of deposit
5,472

 
16

 

 
5,488

Total available-for-sale investment securities
$
42,212

 
$
25

 
$
(76
)
 
$
42,161

As of September 30, 2017, the unrealized losses on investment securities which have been in a net loss position for 12 months or greater were not material. These unrealized losses are considered temporary and there were no impairments considered to be "other-than-temporary" based on our evaluation of available evidence, which includes our intent to hold these investments to maturity or a recovery of the cost basis.
At September 30, 2017 and December 31, 2016, the contractual maturities of our investments did not exceed 36 months. The fair values of available-for-sale investments, by remaining contractual maturity, are as follows (in thousands):
 
September 30, 2017
 
December 31, 2016
 
Amortized Cost
 
Estimated Fair Value
 
Amortized Cost
 
Estimated Fair Value
Due in 1 year or less
$
28,398

 
$
28,396

 
$
15,475

 
$
15,473

Due after 1 year through 3 years
20,444

 
20,423

 
26,737

 
26,688

Total available-for-sale investment securities
$
48,842

 
$
48,819

 
$
42,212

 
$
42,161


12


During the nine months ended September 30, 2017 and 2016, we had sales and maturities (which includes calls) of investment securities, as follows (in thousands):
 
Nine Months Ended September 30, 2017
 
Gross Realized Gains
 
Gross Realized Losses
 
Gross Proceeds from Sales
 
Gross Proceeds from Maturities
Agency securities
$
1

 
$

 
$
15

 
$
1,044

Corporate bonds

 

 

 
7,440

Certificates of deposit

 

 

 
2,490

 
$
1

 
$

 
$
15

 
$
10,974

 
Nine Months Ended September 30, 2016
 
Gross Realized Gains
 
Gross Realized Losses
 
Gross Proceeds from Sales
 
Gross Proceeds from Maturities
Agency securities
$
5

 
$

 
$
3,005

 
$
9,557

Corporate bonds
1

 

 
5,011

 
2,480

Treasury bills

 

 
2,000

 
3,830

Certificates of Deposit

 

 

 
1,245

 
$
6

 
$

 
$
10,016

 
$
17,112

Interest income from investment securities, net of the amortization and accretion of the premium and discount, for the three months ended September 30, 2017 and 2016, was $0.2 million and $0.1 million, respectively and $0.5 million and $0.3 million for the nine months ended September 30, 2017 and 2016, respectively.
Fair Value Measurements
Recurring Fair Value Measurements
Financial assets and financial liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The following tables summarize our financial assets measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016, by level within the fair value hierarchy (in thousands):
 
September 30, 2017
 
Level 1
 
Level 2
 
Level 3
 
Total Fair
Value
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
3,910

 
$

 
$

 
$
3,910

Available-for-sale investment securities:
 
 
 
 
 
 
 
Corporate bonds

 
34,550

 

 
34,550

Agency securities

 
11,285

 

 
11,285

Certificates of deposit
2,984

 

 

 
2,984

Total
$
6,894

 
$
45,835

 
$

 
$
52,729


13


 
December 31, 2016
 
Level 1
 
Level 2
 
Level 3
 
Total Fair
Value
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
4,849

 
$

 
$

 
$
4,849

Available-for-sale investment securities:
 
 
 
 
 
 
 
Corporate bonds

 
30,445

 

 
30,445

Agency securities

 
6,228

 

 
6,228

Certificates of deposit
5,488

 

 

 
5,488

Total
$
10,337

 
$
36,673

 
$

 
$
47,010

The carrying amounts of cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities approximate fair value because of the short maturity of these items.
There were no changes to our valuation techniques used to measure asset and liability fair values on a recurring basis during the nine months ended September 30, 2017. The valuation techniques for the items in the table above are as follows:
Cash and Cash Equivalents
As of September 30, 2017 and December 31, 2016, cash and cash equivalents include cash invested in money market funds. Fair value is based on market prices for identical assets.
Available-for-Sale Investment Securities
The fair value of our investment securities and certificates of deposit is based on pricing determined using inputs other than quoted prices that are observable either directly or indirectly 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.
Non-Recurring Fair Value Measurements
Certain assets, including goodwill, intangible assets and our note receivable with SecureDocs, are also subject to measurement at fair value on a non-recurring basis using Level 3 measurement when they are deemed to be impaired as a result of an impairment review. For the nine months ended September 30, 2017 and 2016, no impairments were identified on those assets required to be measured at fair value on a non-recurring basis.
4. Internal-Use Software Development Costs
Internal-use software development costs were as follows (in thousands):
 
 
September 30,
2017
 
December 31,
2016
Internal use software development costs, gross
 
$
41,902

 
$
33,545

Less: Accumulated amortization
 
(24,582
)
 
(18,006
)
Internal use software development costs, net
 
$
17,320

 
$
15,539


Capitalized software development costs were $2.9 million and $3.3 million for the three months ended September 30, 2017 and 2016, respectively, and were $8.4 million and $8.8 million for the nine months ended September 30, 2017 and 2016, respectively. Amortization expense with respect to software development costs totaled $2.3 million and $1.7 million for the three months ended September 30, 2017 and 2016, respectively, and $6.6 million and $4.4 million for the nine months ended September 30, 2017 and 2016, respectively.


14



Future amortization expense with respect to capitalized software development costs as of September 30, 2017, is estimated as follows (in thousands):
Years Ending December 31,
2017
 
$
2,409

2018
 
8,431

2019
 
5,153

2020
 
1,327

    Total amortization expense
 
$
17,320


5. Intangible Assets
Intangible assets consisted of the following as of September 30, 2017 and December 31, 2016 (in thousands):
 
 
September 30, 2017
 
 
Gross Carrying
Value
 
Accumulated
Amortization
 
Net Carrying
Value
Customer relationships
 
$
790

 
$
(510
)
 
$
280

Technology
 
4,811

 
(3,671
)
 
1,140

Trademarks
 
930

 
(508
)
 
422

Partner relationships
 
680

 
(567
)
 
113

Non-compete agreements
 
40

 
(33
)
 
7

Domain names
 
273

 
(273
)
 

Patents
 
285

 
(193
)
 
92

 
 
$
7,809

 
$
(5,755
)
 
$
2,054


 
 
December 31, 2016
 
 
Gross Carrying
Value
 
Accumulated
Amortization
 
Net Carrying
Value
Customer relationships
 
$
790

 
$
(392
)
 
$
398

Technology
 
4,811

 
(3,070
)
 
1,741

Trademarks
 
930

 
(416
)
 
514

Partner relationships
 
680

 
(397
)
 
283

Non-compete agreements
 
40

 
(23
)
 
17

Domain names
 
273

 
(241
)
 
32

Patents
 
284

 
(164
)
 
120

 
 
$
7,808

 
$
(4,703
)
 
$
3,105

Amortization expense for the three months ended September 30, 2017 and 2016 was $0.4 million for each period and for the nine months ended September 30, 2017 and 2016 was $1.1 million for each period.


15


As of September 30, 2017, estimated future amortization of intangible assets was as follows (in thousands):
Years Ending December 31,
2017
 
$
329

2018
 
929

2019
 
352

2020
 
259

2021
 
124

Thereafter
 
61

    Total amortization expense
 
$
2,054

6. Commitments and Contingencies
Lease Obligations
As of September 30, 2017, we had operating lease obligations of approximately $9.6 million through 2022. We recorded rent expense of $0.5 million for each three month period ended September 30, 2017 and 2016, and $1.5 million for each nine month period ended September 30, 2017 and 2016.
In February 2017, we signed a lease amendment relating to the property located at 50 Castilian Drive in Santa Barbara, California, our corporate headquarters. This amendment extends the term from February 2018 to December 2021. The total commitment under this lease extension is $3.1 million. All of the other terms and conditions of the lease agreement remain the same.
Line of Credit
We are party to a Credit Agreement with Wells Fargo, as administrative agent, and the lenders that are parties thereto (as amended, the “Credit Agreement”). Under the terms of the Credit Agreement, the lenders made available to us a $25.0 million revolving line of credit (the “Revolving Facility”). Borrowings under the Revolving Facility are subject to the satisfaction of customary conditions. The Revolving Facility matures on October 9, 2020; however, we can make payments on, and cancel in full, the Revolving Facility at any time without premium or penalty.
As of September 30, 2017 and December 31, 2016, there was no outstanding balance under the Credit Agreement and we are in compliance with the financial covenants under the Revolving Facility.
Insurance
We have a wholly owned subsidiary, Terra Mar Insurance Company, Inc. (“Terra Mar”), which was established to provide our customers with the option to purchase tenant liability insurance. If our customers choose to use our insurance services, they are issued an insurance policy underwritten by our third-party service provider. The policy has a limit of $100,000 per incident for each insured residence. We have entered into a reinsurance agreement with our third-party service provider and, as a result, we assume a 100% quota share of the tenant liability insurance provided to our customers through our third-party service provider. Included in cost of revenue we accrue for reported claims and an estimate of losses incurred but not reported by our property manager customers, as we bear the risk related to claims. Our liability for reported claims and incurred but not reported claims as of September 30, 2017 and December 31, 2016 was $0.4 million and $0.3 million, respectively, and is included in Other current liabilities on the Condensed Consolidated Balance Sheets.
Included in Other assets as of September 30, 2017 and December 31, 2016, are $1.5 million and $1.2 million, respectively, of deposits held with a third party related to requirements to maintain collateral for our insurance services.

Litigation
From time to time, we may become subject to certain legal proceedings, including without limitation claims and/or litigation matters, arising in the ordinary course of business. We are not currently a party to any such legal proceedings, nor are we aware of any pending or threatened litigation, that we believe would have a material adverse effect on our business, operating results, cash flows or financial condition should such proceedings be resolved unfavorably.

16


Indemnification
In the ordinary course of business, we may provide indemnification of varying scope and terms to customers, investors, directors and officers with respect to certain matters, including, but not limited to, losses arising out of our breach of any applicable agreements, services to be provided by us, or intellectual property infringement claims made by third parties. These indemnification provisions may survive termination of the underlying agreement and the maximum potential amount of future payments we could be required to make under these indemnification provisions may not be subject to maximum loss clauses. The maximum potential amount of future payments we could be required to make under these indemnification provisions is indeterminable. We have never paid a material claim, nor have any legal claims been brought against us in connection with these indemnification arrangements. As of September 30, 2017 and December 31, 2016, we had not accrued a liability for these indemnification arrangements because we determined that the likelihood of incurring a payment obligation, if any, in connection with these indemnification arrangements is not probable or reasonably possible and the amount or range of amounts of any such liability is not reasonably estimable.
7. Stock-Based Compensation
Stock Options
A summary of our stock option activity for the nine months ended September 30, 2017, is as follows (number of shares in thousands):
 
 
Number of
Shares
 
Weighted
Average
Exercise
Price per Share
 
Weighted
Average
Remaining
Contractual Life
in Years
Options outstanding as of December 31, 2016
 
1,718

 
$
8.75

 
8.2
Options granted
 
172

 
24.77

 
 
Options exercised
 
(133
)
 
3.83

 
 
Options cancelled/forfeited
 
(29
)
 
9.84

 
 
Options outstanding as of September 30, 2017
 
1,728

 
$
10.70

 
7.9
During the nine months ended September 30, 2017, we granted PSOs to purchase up to 172,000 shares of our Class A common stock. The PSOs have a weighted average exercise price of $24.77 per share. Vesting of the PSOs is based on the achievement of pre-established performance metrics for the year ended December 31, 2019, and continued employment throughout the performance period. Of the PSOs granted during 2017, 132,000 shares would vest based upon the maximum payout of 165% when the 2019 free cash flow performance metric meets the maximum achievement of 150%. For performance at 100% of the targeted 2019 free cash flow metric, approximately 61% of the PSOs would vest. For performance at 80% of the targeted metric, approximately 48% of the PSOs would vest. For performance below 80% of the 2019 targeted metric, no PSOs would vest, all previously recognized compensation expense for the PSOs would be reversed, and no compensation expense would be recognized. The remaining 40,000 PSOs granted during 2017 have a pre-established adjusted gross margin target for 2019. PSOs tied to the gross margin performance metric have two levels of vesting, with 50% vesting based upon the achievement of 110% of the targeted amount and the remaining 50% vesting upon the achievement of 115% of the targeted amount. If the 110% performance target is not met, no shares will vest and all previously recognized expense for those PSOs would be reversed and no compensation expense would be recognized.
Included in the options outstanding as of September 30, 2017 are 500,000 PSOs granted in 2016, which vest based on the achievement of a pre-established free cash flow performance metric for the years ended December 31, 2017 and 2018. The number of PSOs granted in 2016 related to the performance metrics for the years ended December 31, 2017 and 2018, assumes achievement of the performance metric at the maximum level, which is 150% of the targeted performance metric. For performance at 100% of the targeted metric, approximately 67% of the PSOs would vest. For performance at 80% of the targeted metric, approximately 53% would vest. For performance below 50% of the 2017 targeted metric or 80% of the 2018 targeted metric, no PSOs would vest, all previously recognized compensation expense for PSOs would be reversed, and no compensation expense would be recognized.
During the nine months ended September 30, 2017, 247,000 of the PSOs vested based on the achievement of 148% of the pre-established free cash flow performance metric for the year ended December 31, 2016, and 3,000 PSOs were cancelled as a result of the PSOs being granted at 150% of the target metric. During the year ended December 31, 2016, $1.0 million of expense was recognized related to the PSOs that vested during the nine months ended September 30, 2017.

17


We recognize expense for the PSOs based on the grant date fair value of the PSOs that we determine are probable of vesting. Adjustments to compensation expense are made each period based on changes in our estimate of the number of PSOs that are probable of vesting. Our stock-based compensation expense for stock options, including the PSOs, for the three months ended September 30, 2017 and 2016, was $0.7 million and $0.7 million, respectively, and $2.0 million and $1.6 million for the nine months ended September 30, 2017 and 2016, respectively.
The fair value of stock options granted is estimated on the date of grant using the Black-Scholes option-pricing model. The following table summarizes information relating to our stock options granted during the three and nine months ended September 30, 2017 and 2016
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2017
 
2016
 
2017
 
2016
Stock options granted (in thousands)
 

 

 
172

 
750

Weighted average exercise price per share
 
$

 
$

 
$
24.77

 
$
12.85

Weighted average grant-date fair value per share
 
$

 
$

 
$
9.58

 
$
4.85

Weighted average Black-Scholes model assumptions:
 
 
 
 
 
 
 
 
Risk-free interest rate
 
%
 
%
 
2.02
%
 
1.45
%
Expected term (in years)
 

 

 
6.4

 
5.9

Expected volatility
 
%
 
%
 
35
%
 
37
%
Expected dividend yield
 

 

 

 


As of September 30, 2017, the total estimated remaining stock-based compensation expense for unvested stock options, including the PSOs, was $2.7 million, which is expected to be recognized over a weighted average period of 1.5 years.
Restricted Stock Units
A summary of activity in connection with our RSUs for the nine months ended September 30, 2017, is as follows (number of shares in thousands):
 
 
Number of Shares
 
Weighted- Average Grant Date Fair Value per Share
Unvested as of December 31, 2016
 
496

 
$
13.34

Granted
 
307

 
25.64

Vested
 
(139
)
 
12.81

Forfeited
 
(46
)
 
16.17

Unvested as of September 30, 2017
 
618

 
$
19.36


During the nine months ended September 30, 2017, we granted a total of 307,000 RSUs: 194,000 RSUs vest annually over four years; 100,000 PSUs vest based upon achievement of a pre-established free cash flow performance metric for the year ended December 31, 2019, and continued employment throughout the performance period; and 13,000 PSUs were granted and vested as a result of the attainment of the 2016 performance metric. The number of PSUs granted, as included in the above table, assumes achievement of the performance metric at 100% of the targeted performance metric. The actual number of shares to be issued at the end of the performance period will range from 0% to 165% of the initial target awards. For performance at 150% of the targeted metric in 2019, 165% of the PSUs would vest. For performance below 80% of the targeted metric in 2019, no PSUs would vest and no compensation expense would be recognized, and all previously recognized compensation expense for PSUs would be reversed.
During the nine months ended September 30, 2017, 41,000 of the PSUs vested based on the achievement of 148% of the pre-established free cash flow performance metric for the year ended December 31, 2016, and an additional 13,000 PSUs were granted and vested as a result of the attainment of the 2016 performance metric as approved by our Board of Directors. During the year ended December 31, 2016, $479,000 of expense was recognized related to the PSUs vested during the nine months ended September 30, 2017.
Included in the unvested RSUs as of September 30, 2017 are 56,000 PSUs granted in 2016, which vest based on the achievement of a pre-established free cash flow performance metric for the years ended December 31, 2017 and 2018, and continued employment throughout the performance period. The number of PSUs granted in 2016 related to the performance metrics for the

18


years ended December 31, 2017 and 2018, and assumed achievement of the performance metric at 100% of the targeted performance metric. The actual number of shares to be issued at the end of the performance period will range from 0% to 150% of the initial target awards. For performance at 150% of the targeted metric, 150% of the PSUs would vest. For performance below 50% of the targeted metric for 2017 or 80% of the targeted metric for 2018, no PSUs would vest and no compensation expense would be recognized, and all previously recognized compensation expense for PSUs would be reversed.
We recognize expense for the PSUs based on the grant date fair value of the PSUs that we determine are probable of vesting. Adjustments to compensation expense are made each period based on changes in our estimate of the number of PSUs that are probable of vesting. Our stock-based compensation expense for the RSUs and PSUs for the three months ended September 30, 2017 and 2016, was $1.0 million and $571,000, respectively, and $2.6 million and $1.2 million for the nine months ended September 30, 2017 and 2016, respectively.
As of September 30, 2017, the total remaining estimated stock-based compensation expense for the RSUs and PSUs was $9.2 million, which is expected to be recognized over a weighted average period of 2.6 years.
Restricted Stock Awards
A summary of activity in connection with our restricted stock awards for the nine months ended September 30, 2017, follows (number of shares in thousands): 
 
 
Number of
Shares
 
Weighted-Average
Grant Date
Fair Value per Share
Unvested as of December 31, 2016
 
46

 
$
8.55

Granted
 
9

 
33.30

Vested
 
(38
)
 
9.33

Forfeited
 

 

Unvested as of September 30, 2017
 
17

 
$
19.79

We have the right to repurchase any unvested restricted stock awards. Restricted stock awards vest over a four-year period for employees and a one-year period for non-employee directors. We recognized stock-based compensation expense for restricted stock awards of $84,000 and $113,000 for the three months ended September 30, 2017 and 2016, respectively, and $274,000 and $342,000 for the nine months ended September 30, 2017 and 2016, respectively.
As of September 30, 2017, the total remaining stock-based compensation expense for unvested restricted stock awards with a repurchasing right was $268,000 which is expected to be recognized over a weighted average period of 0.8 years.

8. Income Taxes
Our effective tax rate differs from the U.S. Federal statutory rate of 34% primarily because our previously reported losses have been offset by a valuation allowance due to uncertainty as to the realization of those losses.
For the three and nine months ended September 30, 2017, we recorded income tax expense of $52,000 and $93,000, respectively, on pre-tax income of $3.7 million and $7.2 million, respectively, for an effective tax rate of 1.4% and 1.3%, respectively. The income tax expense is based on our payments of state minimum taxes, alternative minimum tax ("AMT") (net of available AMT credit), and the amortization of tax deductible goodwill that is not an available source of income to realize the deferred tax asset.
For the three and nine months ended September 30, 2016, we recorded income tax expense of $11,000 and $48,000, respectively, on pre-tax losses of $1.1 million and $6.9 million, respectively for an effective tax rate of (1.0)% and (0.7)%, respectively. The income tax expense is based on our payments of state minimum taxes and the amortization of tax deductible goodwill that is not an available source of income to realize the deferred tax asset.

19


9. Revenue and Other Information
The following table presents our revenue categories for the three and nine months ended September 30, 2017 and 2016 (in thousands): 
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2017
 
2016
 
2017
 
2016
Core solutions
 
$
14,670

 
$
11,302

 
$
41,682

 
$
31,637

Value+ services
 
21,752

 
15,684

 
60,053

 
42,338

Other
 
1,481

 
1,176

 
4,171

 
3,601

Total revenues
 
$
37,903

 
$
28,162

 
$
105,906

 
$
77,576


Core solutions revenue includes our subscription fees which are designed to scale to the size of our customers’ businesses. We recognize subscription revenue ratably over the terms of the subscription agreements, which typically range from one month to one year. Revenue from subscription services is impacted by a number of factors, including the change in the number and type of our customers, the size and needs of our customers’ businesses, and our customer renewal rates. 
Value+ services revenue includes subscriptions and usage-based fees. Subscription Value+ services include website hosting services and contact center services. Usage-based Value+ services include fees for electronic payment processing, applicant screening services, our tenant liability insurance program, collections, and online vacancy advertising services. Revenue from Value+ services is impacted by a number of factors, including the number of new and existing customers that adopt and utilize our Value+ service, the size and needs of our customers and our customer renewal rates.

Other revenue includes revenue from one-time services related to on-boarding customers to our core solutions, website design services and online vacancy advertising services offered to legacy RentLinx customers.

Our revenue is generated primarily from U.S. customers. All of our property and equipment is located in the U.S.



20




21


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

The following discussion and analysis of our financial condition and results of operations should be read together with our Condensed Consolidated Financial Statements and the related notes included elsewhere in this Quarterly Report and in our Annual Report. This discussion and analysis contains forward-looking statements that are based on our current expectations and reflect our plans, estimates and anticipated future financial performance. These statements involve numerous risks and uncertainties. Our actual results may differ materially from those expressed or implied by these forward-looking statements as a result of many factors, including those set forth in the section entitled “Risk Factors” in Part I, Item 1A of our Annual Report. Please also refer to the section of this Quarterly Report entitled "Cautionary Note Regarding Forward-Looking Statements" for additional information.
Overview
AppFolio is a provider of industry-specific, cloud-based software solutions for SMBs in the property management and legal industries. We were formed in 2006 with a vision to revolutionize the way that SMBs grow and compete by enabling their digital transformation.

Our platform is designed to be the system of record to automate essential business processes and the system of engagement to enhance business interactions between our customers and their clients and vendors. Our property management software provides small and medium-sized property managers with an end-to-end solution to many of their business needs, enabling them to manage their portfolio of properties quickly and easily in a single, integrated environment. Our legal software provides solo practitioners and small law firms with a streamlined practice and case management solution, allowing them to manage much of their case load within a single system. We also offer optional, but often mission-critical, Value+ services, which are seamlessly built into our core solutions.
We launched our first product, APM, a property management solution, in 2008. Recognizing that our customers would benefit from additional mission-critical services that they can purchase as needed, we launched our first Value+ service in 2009 by offering website design and hosting services to our property manager customers. Our websites give our customers a professional online presence and serve as the hub for our system of engagement. In 2010, we commenced the roll out of our electronic payments platform with the introduction of ACH payment processing and, in 2011, we launched resident screening as additional Value+ services. In 2012, we introduced our tenant liability insurance program as a further Value+ service. Also in 2012, after completing our market validation process, we decided to enter the legal market. We expedited our time-to-market by acquiring MyCase, a legal practice and case management solution, and we leveraged our AppFolio Business System, including our experience gained in the property management vertical, to advance our software solution in the legal vertical. In 2013, we extended our website design and hosting services to our law firm customers and expanded our electronic payments platform for property managers by allowing residents to pay rent by electronic cash payment and credit or debit card. In 2014, we launched an additional Value+ service for our property manager customers with our contact center to resolve or route incoming maintenance requests. In 2016, we launched premium leads and debt collection services as additional Value+ services to our property manager customers to assist with filling vacancies and collecting their tenants' unpaid rent. Also in 2016, we expanded our electronic payments platform in the legal vertical by allowing clients of our legal customers to pay their legal bills by credit card, debit card, or ACH. In September 2017, we announced the upcoming release of a new Value+ service, renters insurance, which expands on our existing tenant liability insurance program and offers additional coverage for tenant’s personal belongings. We also enhanced our electronic payments platform with the addition of same day ACH payments for owner contributions and eCheck payables. Through our disciplined market validation approach and ongoing investment in product development, we continuously update our software solutions through new and innovative core functionality and Value+ services, as well as assess opportunities in adjacent markets and new verticals.
We have focused on growing our revenue by increasing the size of our customer base, retaining customers, introducing new or expanded Value+ services, increasing the adoption and utilization of our Value+ services by new and existing customers, and increasing the number of units under management. We define our customer base as the number of customers subscribing to our core solutions, exclusive of free trials. We intend to continue to invest in revenue growth opportunities over time in our current markets, adjacent markets, and new verticals.

22


Customer count and property manager units under management are summarized in the table below:
 
September 30,
 
June 30,
 
March 31,
 
December 31,
 
September 30,
 
June 30,
 
2017
 
2016
Property manager
11,258

 
10,820

 
10,468

 
10,038

 
9,612

 
9,275

Property manager units under management (in millions)
3.08

 
2.93

 
2.83

 
2.68

 
2.53

 
2.41

Law firm
9,214

 
8,913

 
8,676

 
8,135

 
7,799

 
7,349

We have invested in growth in a disciplined manner across our organization, and intend to continue to do so. These investments to grow our business will continue to increase our costs and operating expenses on an absolute basis. Many of these investments will occur in advance of our realization of revenue or any other benefit and will make it difficult to determine if we are allocating our resources efficiently. We expect cost of revenue, research and product development expense, sales and marketing expense, and general and administrative expense to decrease as a percentage of revenue over the long term as revenue increases and we gain additional operating leverage in our business. As a result of this increased operating leverage, we expect our operating margins will improve over the long term.
To date, we have experienced rapid revenue growth due to our investments in research and product development, sales and marketing, customer service and support, and infrastructure. During the nine months ended September 30, 2017, we have derived more than 90% of our revenue from our property management solution.
We have managed, and plan to continue to manage, our business towards the achievement of long-term growth that we believe will positively impact long-term stockholder value, and not towards the realization of short-term financial or business metrics, or short-term stockholder value.
Key Components of Results of Operations
Revenue
We charge our customers on a subscription basis for our core solutions and certain of our Value+ services. Our subscription fees are designed to scale to the size of our customers’ businesses. We recognize subscription revenue ratably over the terms of the subscription agreements, which typically range from one month to one year. We generally invoice our customers for subscription services in monthly, quarterly or annual installments, typically in advance of the subscription period. Revenue from subscription services is impacted by a number of factors, including the change in the number and type of our customers, the size and needs of our customers’ businesses, our customer renewal rates, and the level of adoption of our Value+ subscription services by new and existing customers.
We also charge our customers usage-based fees for using certain Value+ services, although fees for electronic payment processing are generally paid by the clients of our customers. Usage-based fees are charged on a flat fee per transaction basis with no minimum usage commitments. We recognize revenue for usage-based services in the period the service is rendered. We generally invoice our customers for usage-based services on a monthly basis for services rendered in the preceding month. Revenue from usage-based services is impacted by a number of factors, including the number of new and existing customers that adopt and utilize our Value+ services, the size and needs of our customers and our customer renewal rates.
We experience some seasonality in our Value+ services revenue, primarily with respect to the screening services we provide to our property manager customers. These customers historically have processed fewer applications for new tenants during the fourth quarter holiday season; therefore, revenue associated with our screening services and new tenant applications typically declines in the fourth quarter of the year. As a result of this seasonal decline in revenue, we have typically experienced slower sequential revenue growth or a sequential decline in revenue in the fourth quarter of each of our most recent fiscal years. We expect this seasonality to continue in the foreseeable future.
We also offer our assistance to our customers with on-boarding to our core solutions, as well as website design services. These services are generally purchased as part of a subscription agreement, and are typically performed within the first several months of the arrangement. We generally invoice our customers for other services in advance of the services being completed. We recognize revenue for these other services upon completion of the related service. We also generate revenue from legacy RentLinx customers by providing services that allow these customers to advertise rental houses and apartments online. Revenue

23


derived from customers using the RentLinx services outside of our property manager core solution platform is being recorded under Other revenue.
Costs and Operating Expenses
Cost of Revenue. Cost of revenue consists of personnel-related costs (including salaries, incentive-based compensation, benefits, and stock-based compensation) for our employees focused on customer service and the support of our operations, platform infrastructure costs (such as data center operations and hosting-related costs), fees paid to third-party service providers, payment processing fees, and allocated shared costs. We typically allocate shared costs across our organization based on headcount within the applicable part of our organization. Cost of revenue excludes amortization of capitalized software development costs and acquired technology. We intend to continue to invest in customer service and support, and the expansion of our technology infrastructure as we grow the number of our customers and roll out additional Value+ services. We also intend to expand our Value+ offerings over time, which will impact cost of revenue both in absolute dollars and overall percentage of revenue.
Sales and Marketing. Sales and marketing expense consists of personnel-related costs (including salaries, sales commissions, incentive-based compensation, benefits, and stock-based compensation) for our employees focused on sales and marketing, costs associated with sales and marketing activities, and allocated shared costs. Marketing activities include advertising, online lead generation, lead nurturing, customer and industry events, and the creation of industry-related content and collateral. Sales commissions and other incremental costs to acquire customers and grow adoption and utilization of our Value+ services by new and existing customers are expensed as incurred. We focus our sales and marketing efforts on generating awareness of our software solutions, creating sales leads, establishing and promoting our brands, and cultivating an educated community of successful and vocal customers. We intend to continue to invest in sales and marketing as we grow to increase the size of our customer base and increase the adoption and utilization of Value+ services by our new and existing customers.

Research and Product Development. Research and product development expense consists of personnel-related costs (including salaries, incentive-based compensation, benefits, and stock-based compensation) for our employees focused on research and product development, fees for third-party development resources, and allocated shared costs. Our research and product development efforts are focused on enhancing the ease of use and functionality of our existing software solutions by adding new core functionality, Value+ services and other improvements, as well as developing new products and services. We capitalize the portion of our software development costs that meets the criteria for capitalization. Amortization of capitalized software development costs is included in depreciation and amortization expense. We intend to continue to invest in research and product development as we continue to introduce new core functionality, roll out new Value+ services, develop new products and services, and expand into adjacent markets and new verticals.
General and Administrative. General and administrative expense consists of personnel-related costs (including salaries, incentive-based compensation, benefits, and stock-based compensation) for employees in our executive, finance, information technology, or IT, human resources, corporate development, legal and administrative organizations. In addition, general and administrative expense includes fees for third-party professional services (including consulting, legal and audit services), other corporate expenses, and allocated shared costs. We intend to incur incremental general and administrative costs associated with supporting the growth of our business.
Depreciation and Amortization. Depreciation and amortization expense includes depreciation of property and equipment, amortization of capitalized software development costs and amortization of intangible assets. We depreciate or amortize property and equipment, software development costs and intangible assets over their expected useful lives on a straight-line basis, which approximates the pattern in which the economic benefits of the assets are consumed. As we continue to invest in our research and product development organization and the development or acquisition of new technology, we expect to have increased capitalized software development costs and incremental amortization.

Interest Income (Expense). Interest income includes interest earned on investment securities, amortization and accretion of the premium and discounts paid from the purchase of investment securities, interest earned on notes receivable and on cash deposited within our bank accounts. Interest expense includes interest paid on outstanding borrowings under our Credit Agreement.


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Results of Operations
The following table sets forth our results of operations for the periods presented in dollars (in thousands) and as a percentage of revenue:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2017
 
2016
 
2017
 
2016
 
Amount
 
%
 
Amount
 
%
 
Amount
 
%
 
Amount
 
%
Consolidated Statements of Operations Data:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Revenue
$
37,903

 
100.0
 %
 
$
28,162

 
100.0
 %
 
$
105,906

 
100.0
 %
 
$
77,576

 
100.0
 %
Costs and operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of revenue (exclusive of depreciation and amortization) (1)
14,053

 
37.1

 
11,645

 
41.4

 
40,747

 
38.5

 
33,387

 
43.0

Sales and marketing (1)
7,257

 
19.1

 
6,979

 
24.8

 
21,556

 
20.4

 
22,097

 
28.5

Research and product development (1)
4,367

 
11.5

 
3,464

 
12.3

 
11,998

 
11.3

 
9,531

 
12.3

General and administrative (1)
5,405

 
14.3

 
4,642

 
16.5

 
15,310

 
14.5

 
12,580

 
16.2

Depreciation and amortization
3,237

 
8.5

 
2,636

 
9.4

 
9,347

 
8.8

 
7,112

 
9.2

Total costs and operating expenses
34,319

 
90.5

 
29,366

 
104.3

 
98,958

 
93.4

 
84,707

 
109.2

Income (loss) from operations
3,584

 
9.5

 
(1,204
)
 
(4.3
)
 
6,948

 
6.6

 
(7,131
)
 
(9.2
)
Other expense, net
(5
)
 

 
(12
)
 

 
(93
)
 
(0.1
)
 
(34
)
 

Interest income, net
155

 
0.4

 
102

 
0.4

 
377

 
0.4

 
221

 
0.3

Income (loss) before provision for income taxes
3,734

 
9.9

 
(1,114
)
 
(4.0
)
 
7,232

 
6.8

 
(6,944
)
 
(9.0
)
Provision for income taxes
52

 
0.1

 
11

 

 
93

 
0.1

 
48

 
0.1

Net income (loss)
$
3,682

 
9.7
 %
 
$
(1,125
)
 
(4.0
)%
 
$
7,139

 
6.7
 %
 
$
(6,992
)
 
(9.0
)%

(1) Includes stock-based compensation expense as follows (in thousands):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2017
 
2016
 
2017
 
2016
Costs and operating expenses:
 
 
 
 
 
 
 
Cost of revenue (exclusive of depreciation and amortization)
 
$
189

 
$
138

 
$
527

 
$
321

Sales and marketing
 
186

 
124

 
516

 
296

Research and product development
 
173

 
109

 
471

 
264

General and administrative
 
1,040

 
918

 
2,790

 
1,963

Total stock-based compensation expense
$
1,588

 
$
1,289

 
$
4,304

 
$
2,844




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Comparison of the Three and Nine Months Ended September 30, 2017 and 2016
Revenue
 
 
Three Months Ended
September 30,
 
Change
 
Nine Months Ended
September 30,
 
Change
 
 
2017
 
2016
 
Amount
 
%
 
2017
 
2016
 
Amount
 
%
 
 
(dollars in thousands)
Core solutions
 
$
14,670

 
$
11,302

 
$
3,368

 
30
%
 
$
41,682

 
$
31,637

 
$
10,045

 
32
%
Value+ services
 
21,752

 
15,684

 
6,068

 
39
%
 
60,053

 
42,338

 
17,715

 
42
%
Other
 
1,481

 
1,176

 
305

 
26
%
 
4,171

 
3,601

 
570

 
16
%
Total revenues
 
$
37,903

 
$
28,162

 
$
9,741

 
35
%
 
$
105,906

 
$
77,576

 
$
28,330

 
37
%

Revenue increased $9.7 million, or 35%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016, mainly reflecting a 17% increase in the number of property manager customers. The overall increase was mostly attributable to revenue from Value+ services, which increased by $6.1 million, or 39%. The increase in Value+ services was mainly driven by increased usage of our electronic payments platform and screening services by a larger property manager customer base and an increase in units under management of 22%. We also experienced growth in our other Value+ services, including tenant liability insurance, customer contact center, website hosting services and premium lead services within our Value+ services. The overall increase in revenue was also attributable to growth in revenue from our Core solutions of $3.4 million, or 30%, driven by growth in the number of our customers and units under management.
Revenue increased $28.3 million, or 37%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016, mainly reflecting a 17% increase in the number of property manager customers. The overall increase was mostly attributable to revenue from Value+ services, which increased by $17.7 million, or 42%. The increase in Value+ services was mainly driven by increased usage of our electronic payments platform and screening services by a larger property manager customer base and increase in the number of units under management. We also experienced revenue growth in our other Value+ services, including tenant liability insurance, customer contact center, website hosting services and premium lead services within our Value+ services. The overall increase in revenue was also attributable to growth in revenue from our Core solutions of $10.0 million, or 32%, driven by growth in the number of our customers and units under management.
For the nine months ended September 30, 2017 and 2016, we derived more than 90% of our revenue from our property manager customers.
Cost of Revenue (Exclusive of Depreciation and Amortization)
 
 
Three Months Ended September 30,
 
Change
 
Nine Months Ended
September 30,
 
Change
 
 
2017
 
2016
 
Amount
 
%
 
2017
 
2016
 
Amount
 
%
 
 
(dollars in thousands)
Cost of revenue (exclusive of depreciation and amortization)
 
$
14,053

 
$
11,645

 
$
2,408

 
21
%
 
$
40,747

 
$
33,387

 
$
7,360

 
22
%
Percentage of revenue
 
37.1
%
 
41.4
%
 
 
 
 
 
38.5
%
 
43.0
%
 
 
 
 
Cost of revenue (exclusive of depreciation and amortization) increased $2.4 million, or 21%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016. The increase was primarily due to increased expenditures to third parties of $1.6 million directly associated with the increased adoption and utilization of our Value+ services, as evidenced by the 39% increase in Value+ services revenues. There was also an increase in personnel-related costs of $0.6 million to support the continued growth of our business.
As a percentage of revenue, cost of revenue (exclusive of depreciation and amortization) improved to 37.1% from 41.4% for the three months ended September 30, 2017 compared to the three months ended September 30, 2016. This improvement was primarily driven by our ability to increase revenue with a more moderate increase in personnel-related costs, and a slight improvement in pricing with our third-party service providers as we continue to grow.
Cost of revenue (exclusive of depreciation and amortization) increased $7.4 million, or 22%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016. The increase was primarily due to increased third-

26


party costs of $4.9 million driven by increased Value+ services revenue and an increase in head-count and personnel-related costs of $1.7 million due to the continued growth of our business.
As a percentage of revenue, cost of revenue (exclusive of depreciation and amortization) improved to 38.5% from 43.0% for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016. This improvement was primarily driven by our ability to increase revenue with a more moderate increase in personnel-related costs, and an improvement in pricing with our third-party services providers as we continue to grow.
Sales and Marketing
 
 
Three Months Ended September 30,
 
Change
 
Nine Months Ended
September 30,
 
Change
 
 
2017
 
2016
 
Amount
 
%
 
2017
 
2016
 
Amount
 
%
 
 
(dollars in thousands)
Sales and marketing
 
$
7,257

 
$
6,979

 
$
278

 
4
%
 
$
21,556

 
$
22,097

 
$
(541
)
 
(2
)%
Percentage of revenue
 
19.1
%
 
24.8
%
 
 
 
 
 
20.4
%
 
28.5
%
 
 
 
 
Sales and marketing expense increased by $0.3 million or 4% for the three months ended September 30, 2017 compared to the three months ended September 30, 2016. This increase was the result of an increase in personnel-related costs in our sales and marketing organization to support our revenue growth.
    
Sales and marketing expense decreased $0.5 million, or 2%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016. The decrease was the result of a decrease in allocated and other operating costs of $0.3 million and a decrease in personnel related costs of $0.2 million as we gain efficiencies in our expenses relative to revenue growth.
Research and Product Development
 
 
Three Months Ended September 30,
 
Change
 
Nine Months Ended September 30,
 
Change
 
 
2017
 
2016
 
Amount
 
%
 
2017
 
2016
 
Amount
 
%
 
 
(dollars in thousands)
Research and product development
 
$
4,367

 
$
3,464

 
$
903

 
26
%
 
$
11,998

 
$
9,531

 
$
2,467

 
26
%
Percentage of revenue
 
11.5
%
 
12.3
%
 
 
 
 
 
11.3
%
 
12.3
%
 
 
 
 
Research and product development expense increased $0.9 million, or 26%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016. The increase was the result of an increase in personnel-related costs, net of capitalized software development costs, due to headcount growth within our research and product development organizations.
    
Research and product development expense increased $2.5 million, or 26%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016. The increase was primarily the result of an increase in personnel-related costs, net of capitalized software development costs, due to headcount growth within our research and product development organizations.
General and Administrative
 
 
Three Months Ended
September 30,
 
Change
 
Nine Months Ended
September 30,
 
Change
 
 
2017
 
2016
 
Amount
 
%
 
2017
 
2016
 
Amount
 
%
 
 
(dollars in thousands)
General and administrative
 
$
5,405

 
$
4,642

 
$
763

 
16
%
 
$
15,310

 
$
12,580

 
$
2,730

 
22
%
Percentage of revenue
 
14.3
%
 
16.5
%
 
 
 
 
 
14.5
%
 
16.2
%
 
 
 
 
General and administrative expense increased $0.8 million, or 16%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016. The increase was primarily the result of increased personnel-related costs of $0.6 million due to headcount growth and an increase in incentive-based compensation.

27



General and administrative expense increased $2.7 million, or 22%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016. The increase was primarily the result of an increase in personnel-related costs of $2.8 million due to headcount growth and an increase in incentive-based compensation.
Depreciation and Amortization
 
 
Three Months Ended September 30,
 
Change
 
Nine Months Ended September 30,
 
Change
 
 
2017
 
2016
 
Amount
 
%
 
2017
 
2016
 
Amount
 
%
 
 
(dollars in thousands)
Depreciation and amortization
 
$
3,237

 
$
2,636

 
$
601

 
23
%
 
$
9,347

 
$
7,112

 
$
2,235

 
31
%
Percentage of revenue
 
8.5
%
 
9.4
%
 
 
 
 
 
8.8
%
 
9.2
%
 
 
 
 
Depreciation and amortization expense increased $0.6 million, or 23%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016. The increase was the result of increased amortization expense of $0.6 million associated with higher capitalized software development balances.

Depreciation and amortization expense increased $2.2 million, or 31%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016. The increase was the result of increased amortization expense of $2.2 million associated with higher capitalized software development balances.
Interest Income, net