UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2018

OR

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

For the transition period from to

Commission File Number: 001-37496

RAPID7, INC.

(Exact Name of Registrant as Specified in its Charter)

Delaware	35-2423994
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
100 Summer Street Boston, MA	02110
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: (617) 247-1717

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

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

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

Large accelerated filer	☐	Accelerated filer	☒
Non-accelerated filer	☐	Small reporting company	☐
Emerging growth company	☒

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 13(a) of the Exchange Act. ☒

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

As of November 1, 2018, there were 47,324,670 shares of the registrant’s common stock, $0.01 par value per share, outstanding.

Table of Contents

		Page
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)	1
	Consolidated Balance Sheets	1
	Consolidated Statements of Operations	2
	Consolidated Statements of Comprehensive Loss	3
	Consolidated Statements of Cash Flows	4
	Notes to Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	25
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	44
Item 4.	Controls and Procedures	44
PART II.	OTHER INFORMATION	46
Item 1.	Legal Proceedings	46
Item 1A.	Risk Factors	46
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	69
Item 3.	Defaults Upon Senior Securities	69
Item 4.	Mine Safety Disclosures	69
Item 5.	Other Information	69
Item 6.	Exhibits	70

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PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

RAPID7, INC.

Consolidated Balance Sheets (Unaudited)

(in thousands, except share and per share data)

	September 30, 2018			December 31, 2017
Assets
Current assets:
Cash and cash equivalents	$	131,160		$	51,562
Short-term investments	140,633			39,178
Accounts receivable, net of allowance for doubtful accounts of $1,477 and $1,478 at September 30, 2018 and December 31, 2017, respectively	53,771			73,661
Deferred contract acquisition and fulfillment costs, current portion	10,376			—
Prepaid expenses and other current assets	11,616			8,877
Total current assets	347,556			173,278
Long-term investments	39,275			1,102
Property and equipment, net	11,859			8,589
Goodwill	83,164			83,164
Intangible assets, net	16,023			16,640
Deferred contract acquisition and fulfillment costs, non-current portion	23,174			—
Other assets	906			1,363
Total assets	$	521,957		$	284,136
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	2,766		$	2,240
Accrued expenses	27,392			29,728
Deferred revenue, current portion	159,408			155,811
Other current liabilities	838			1,706
Total current liabilities	190,404			189,485
Convertible senior notes, net	172,165			—
Deferred revenue, non-current portion	63,680			68,689
Other long-term liabilities	2,607			1,809
Total liabilities	428,856			259,983
Stockholders’ equity:
Preferred stock, $0.01 par value per share; 10,000,000 shares authorized at September 30, 2018 and December 31, 2017; 0 shares issued at September 30, 2018 and December 31, 2017	—			—
Common stock, $0.01 par value per share; 100,000,000 shares authorized at September 30, 2018 and December 31, 2017; 47,773,400 and 44,540,544 shares issued at September 30, 2018 and December 31, 2017, respectively; 47,286,592 and 44,053,736 shares outstanding at September 30, 2018 and December 31, 2017, respectively	473			441
Treasury stock, at cost, 486,808 shares at September 30, 2018 and December 31, 2017	(4,764		)	(4,764		)
Additional paid-in-capital	549,101			463,428
Accumulated other comprehensive loss	(144		)	(39		)
Accumulated deficit	(451,565		)	(434,913		)
Total stockholders’ equity	93,101			24,153
Total liabilities and stockholders’ equity	$	521,957		$	284,136

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

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RAPID7, INC.

Consolidated Statements of Operations (Unaudited)

(in thousands, except share and per share data)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
Revenue:
Products	$	43,829		$	29,626		$	118,151		$	82,736
Maintenance and support	10,614			11,654			31,977			33,794
Professional services	7,922			9,241			25,193			26,679
Total revenue	62,365			50,521			175,321			143,209
Cost of revenue:
Products	10,294			6,888			28,380			17,155
Maintenance and support	1,901			1,739			5,757			5,467
Professional services	5,615			5,740			17,660			17,088
Total cost of revenue	17,810			14,367			51,797			39,710
Total gross profit	44,555			36,154			123,524			103,499
Operating expenses:
Research and development	17,111			13,570			49,915			36,836
Sales and marketing	30,570			28,224			90,779			80,166
General and administrative	8,175			7,402			25,056			21,906
Total operating expenses	55,856			49,196			165,750			138,908
Loss from operations	(11,301		)	(13,042		)	(42,226		)	(35,409		)
Other income (expense), net:
Interest income	813			209			1,520			666
Interest expense	(1,679		)	(11		)	(1,681		)	(81		)
Other income (expense), net	181			235			(67		)	349
Loss before income taxes	(11,986		)	(12,609		)	(42,454		)	(34,475		)
Provision for (benefit from) income taxes	(155		)	(2,325		)	71			(2,009		)
Net loss	$	(11,831	)	$	(10,284	)	$	(42,525	)	$	(32,466	)
Net loss per share, basic and diluted	$	(0.25	)	$	(0.24	)	$	(0.92	)	$	(0.76	)
Weighted-average common shares outstanding, basic and diluted	46,914,077			43,279,025			46,139,978			42,693,212

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

2

RAPID7, INC.

Consolidated Statements of Comprehensive Loss (Unaudited)

(in thousands)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
Net loss	$	(11,831	)	$	(10,284	)	$	(42,525	)	$	(32,466	)
Other comprehensive gain (loss):
Change in fair value of investments	(120		)	23			(105		)	(7		)
Adjustment for net losses realized and included in net loss	—			—			—			3
Total change in unrealized losses on investments	(120		)	23			(105		)	(4		)
Comprehensive loss	$	(11,951	)	$	(10,261	)	$	(42,630	)	$	(32,470	)

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

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RAPID7, INC.

Consolidated Statements of Cash Flows (Unaudited)

(in thousands)

	Nine Months Ended September 30,
	2018			2017
Cash flows from operating activities:
Net loss	$	(42,525	)	$	(32,466	)
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
Depreciation and amortization	7,737			5,304
Amortization of debt discount and issuance costs	1,296			—
Stock-based compensation expense	20,999			14,738
Provision for doubtful accounts	480			509
Deferred income taxes	—			(2,632		)
Foreign currency re-measurement loss (gain)	566			(410		)
Other non-cash (income) expense	(345		)	214
Changes in operating assets and liabilities:
Accounts receivable	19,287			130
Deferred contract acquisition and fulfillment costs	(6,385		)	—
Prepaid expenses and other assets	(2,434		)	601
Accounts payable	565			(322		)
Accrued expenses	(2,174		)	803
Deferred revenue	(2,313		)	19,580
Other liabilities	(622		)	(965		)
Net cash (used in) provided by operating activities	(5,868		)	5,084
Cash flows from investing activities:
Business acquisition, net of cash acquired	—			(14,717		)
Purchases of property and equipment	(8,404		)	(3,506		)
Capitalization of internal-use software costs	(2,505		)	(756		)
Purchases of investments	(178,945		)	(21,684		)
Sales/maturities of investments	39,576			24,522
Net cash used in investing activities	(150,278		)	(16,141		)
Cash flows from financing activities:
Proceeds from issuance of convertible senior notes, net of issuance costs paid of $6,471	223,529			—
Purchase of capped calls related to convertible senior notes	(26,910		)	—
Proceeds from secondary public offering, net of offering costs of $608	30,907			—
Deferred business acquisition payment	—			(796		)
Taxes paid related to net share settlement of equity awards	(1,712		)	(468		)
Proceeds from employee stock purchase plan	3,637			2,914
Proceeds from stock option exercises	6,521			4,995
Net cash provided by financing activities	235,972			6,645
Effect of exchange rate changes on cash, cash equivalents and restricted cash	(428		)	319
Net increase (decrease) in cash, cash equivalents and restricted cash	79,398			(4,093		)
Cash, cash equivalents and restricted cash, beginning of period	51,762			53,148
Cash, cash equivalents and restricted cash, end of period	$	131,160		$	49,055
Supplemental cash flow information:
Cash paid for income taxes	$	389		$	759
Non-cash financing activities:
Convertible senior notes issuance costs incurred but not paid	$	462		$	—

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

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RAPID7, INC.

Notes to Consolidated Financial Statements (Unaudited)

Note 1. Description of Business, Basis of Presentation and Consolidation and Significant Accounting Policies

Description of Business

Rapid7, Inc. and its subsidiaries ("we", "us" or "our") are trusted by IT and security professionals around the world to manage risk, simplify modern IT complexity, and drive innovation. Our analytics help transform today's vast amount of security and IT data into the answers needed to securely develop and operate sophisticated IT networks and applications.

In August 2018, we issued $230.0 million aggregate principal amount of 1.25% convertible senior notes due 2023 (the Notes). The total net proceeds from the Notes, after deducting initial purchase discounts and estimated debt issuance costs, were $223.1 million. In connection with the issuance of the Notes, we entered into capped call transactions with certain counterparties (the Capped Calls). We used $26.9 million of the net proceeds from the Notes to purchase the Capped Calls, which have an initial strike price of $41.59 per share which corresponds to the initial conversion price of the Notes. The Capped Calls are expected to offset potential dilution to our common stock upon conversion of the Notes. The Capped Calls have an initial cap price of $63.98 per share, subject to certain adjustments.

Basis of Presentation and Consolidation

The accompanying unaudited consolidated financial statements have been prepared by us in accordance with accounting principles generally accepted in the United States of America (GAAP), as well as pursuant to the rules and regulations of the Securities and Exchange Commission (SEC), regarding interim financial reporting. Accordingly, certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. These consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2017 filed with the SEC on March 8, 2018.

The consolidated financial statements include our results of operations and those of our wholly-owned subsidiaries and reflect all adjustments (consisting solely of normal, recurring adjustments) which are, in the opinion of management, necessary for a fair statement of results for the interim periods presented. All intercompany transactions and balances have been eliminated in consolidation. The results of operations for the three and nine months ended September 30, 2018 are not necessarily indicative of the results to be expected for any future period or the entire fiscal year.

Significant Accounting Policies

For a more complete discussion of our significant accounting policies and other information, the consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2017. As of January 1, 2018, we adopted Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606) (ASU 2014-09), which with its amendments is collectively known as ASC 606. See Accounting Pronouncements Recently Adopted below and Note 2, Revenue from Contract with Customers, for a discussion of the impact of the adoption of this standard, which we have adopted using the modified retrospective transition method, and changes in our accounting policies related to revenue recognition and accounting for costs to obtain and fulfill a customer contract.

Recent Accounting Pronouncements

Accounting Pronouncements Recently Adopted

In December 2017, the SEC issued Staff Accounting Bulletin 118 (SAB 118), which provides guidance for companies analyzing their accounting for the income tax effects of the Tax Cuts and Jobs Act of 2017 (Tax Act). SAB 118 provides that a company may report provisional amounts based on reasonable estimates. The provisional estimates are then subject to adjustment during a measurement period up to one year and should be accounted for as a prospective change. We continue to evaluate our transition tax obligation and expect to finalize our conclusion by the end of fiscal 2018. The provisional amounts recorded are based on our current interpretation and understanding of the Tax Act signed into law in December 2017, are judgmental and may change as we receive additional clarification and implementation guidance. Changes to these provisional amounts could result in additional charges or credits in future reporting periods.

In May 2017, the Financial Accounting Standards Board (FASB), issued ASU 2017-09, Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting, clarifying when a change to the terms or conditions of a share-based payment award must be accounted for as a modification. The ASU required modification accounting if the fair value, vesting condition or the

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classification of the award is not the same immediately before and after a change to the terms and conditions of the award. We adopted this standard on a prospective basis on January 1, 2018. There was no impact to our consolidated financial statements as a result of the adoption.

In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, which provided guidance on the treatment of restricted cash in the statements of cash flows. Amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. We adopted this standard in the first quarter of 2018 utilizing the retrospective transition method. The presentation of restricted cash in the consolidated statements of cash flows was adjusted as a result of adopting this new standard.

In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory. The ASU is intended to improve the accounting for the income tax consequences of intra-entity transfers of assets other than inventory. Current GAAP prohibits the recognition of current and deferred income taxes for an intra-entity asset transfer until the asset has been sold to an outside party. The ASU will allow an entity to recognize the income tax consequences of these transfers when the transfers occur. We adopted this standard on January 1, 2018 and there was no impact to our consolidated financial statements as a result of the adoption.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (ASU 2014-09), which replaced the revenue recognition requirements in FASB ASC Topic 605, Revenue Recognition (ASC 605). The new revenue standard outlines a single, comprehensive model for accounting for revenue from contracts with customers and requires more detailed disclosure to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from such contracts. The new revenue standard provides a five-step analysis of transactions to determine when and how revenue is recognized. The core principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services.

We adopted ASC 606 on January 1, 2018 using the modified retrospective method. Under this method of adoption, we recognized the cumulative effect of initially applying the new revenue standard as an adjustment to the opening balance of accumulated deficit. Comparative prior year periods were not adjusted.

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As a result of applying the modified retrospective method to adopt ASC 606, the following adjustments were made to the consolidated balance sheet as of January 1, 2018:

	As Reported			Adjustments											Adjusted under ASC 606
	December 31, 2017			Term and Perpetual License			Professional Services			Other			Costs to Obtain or Fulfill a Contract		January 1, 2018
	(in thousands)
Cash and cash equivalents	$	51,562		$	—		$	—		$	—		$	—	$	51,562
Short-term investments	39,178			—			—			—			—		39,178
Accounts receivable, net	73,661			—			—			—			—		73,661
Deferred contract acquisition and fulfillment costs, current portion	—			—			—			—			7,844		7,844
Prepaid expenses and other current assets	8,877			—			30			—			—		8,907
Long-term investments	1,102			—			—			—			—		1,102
Property and equipment, net	8,589			—			—			—			—		8,589
Goodwill	83,164			—			—			—			—		83,164
Intangible assets, net	16,640			—			—			—			—		16,640
Deferred contract acquisition and fulfillment costs, non-current portion	—			—			—			—			19,321		19,321
Other assets	1,363			—			—			—			—		1,363
Total assets	$	284,136		$	—		$	30		$	—		$	27,165	$	311,331
Accounts payable	$	2,240		$	—		$	—		$	—		$	—	$	2,240
Accrued expenses	29,728			—			—			—			—		29,728
Deferred revenue, current portion	155,811			(10,912		)	(1,523		)	(1,356		)	—		142,020
Other current liabilities	1,706			—			—			—			—		1,706
Deferred revenue, non-current portion	68,689			17,647			(2,624		)	(339		)	—		83,373
Other long-term liabilities	1,809			—			—			—			429		2,238
Total liabilities	259,983			6,735			(4,147		)	(1,695		)	429		261,305
Common stock	441			—			—			—			—		441
Treasury stock	(4,764		)	—			—			—			—		(4,764		)
Additional paid-in-capital	463,428			—			—			—			—		463,428
Accumulated other comprehensive loss	(39		)	—			—			—			—		(39		)
Accumulated deficit	(434,913		)	(6,735		)	4,177			1,695			26,736		(409,040		)
Total stockholders’ equity	24,153			(6,735		)	4,177			1,695			26,736		50,026
Total liabilities and stockholders’ equity	$	284,136		$	—		$	30		$	—		$	27,165	$	311,331

Term and Perpetual Licenses

Prior to the adoption of ASC 606, we recognized revenue for our term and perpetual licenses over the contractual period of maintenance and support due to the lack of vendor-specific objective evidence of selling price of maintenance and support. Under ASC 606, for our term and perpetual licenses which are not dependent on the continued delivery of content subscriptions, revenue is recognized at the time of delivery. For our perpetual licenses where the utility to the customer is dependent on the continued delivery of content subscriptions, the content subscription renewal option results in a material right with respect to the perpetual license. As a result, revenue related to the sale of these perpetual licenses is recognized ratably over the customer's estimated economic life of 5 years. The net impact of these changes resulted in a $6.7 million adjustment to accumulated deficit with an associated increase to deferred revenue.

Professional Services

Under ASC 605, professional services which were sold with term or perpetual licenses were recognized ratably over the contractual period of maintenance and support. Under ASC 606, these services are deemed distinct performance obligations and therefore recognized as the services are performed. The net impact of these changes resulted in a $4.2 million adjustment to accumulated deficit with an associated decrease to deferred revenue.

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Costs to Obtain or Fulfill a Contract

Prior to the adoption of ASC 606, we expensed sales commissions in the period that they were earned by our employees (which was typically upon signing of an arrangement). Under ASC 606, the direct and incremental costs to obtain contracts with customers, including sales commissions, are deferred and recognized over a period of benefit that we have determined to be 5 years. In addition, under ASC 606, contract fulfillment costs associated with certain of our product offerings are deferred and amortized over the estimated period of benefit. Prior to the adoption of ASC 606, such costs were expensed as incurred. The net impact of these changes resulted in a $27.2 million increase in deferred contract acquisition and fulfillment costs and an adjustment to accumulated deficit.

Income Taxes

Deferred tax liabilities increased by $0.4 million due to the temporary differences between the accounting and tax carrying values of capitalized costs to obtain or fulfill a contract created as a result of the adoption of ASC 606. In addition, the increase in deferred revenue generated additional deferred tax assets. As we fully reserve our deferred tax assets in the jurisdictions impacted by the increase in deferred revenue, this impact was offset by a corresponding increase to our valuation allowance.

Refer to Note 2, Revenue from Contracts with Customers, for additional information including further discussion on the impact of the adoption of ASC 606 and changes in accounting policies relating to revenue recognition and accounting for costs to obtain or fulfill a customer contract.

Accounting Pronouncements Not Yet Effective

In August 2018, the FASB issued ASU 2018-15, Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40): Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That is a Service Contract, whichaligns the requirements for capitalizing implementation costs in cloud computing arrangements with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. The new standard will be effective for us in the first quarter of 2020, with early adoption permitted. Entities can choose to adopt the new guidance prospectively or retrospectively. We are currently in the process of evaluating the effects of this pronouncement on our consolidated financial statements.

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement, which eliminates, modifies and adds disclosure requirements for fair value measurements. The new standard will be effective for us in the first quarter of 2020, with early adoption permitted. This ASU is not expected to have an impact on our consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, Leases, which was further clarified by ASU 2018-10, Codification Improvements to Topic 842, Leases, and ASU 2018-11, Leases (Topic 842): Targeted Improvements, both issued in July 2018. ASU 2016-02 requires companies to recognize on the balance sheet the assets and liabilities for the rights and obligations created by leased assets along with additional disclosures. The new standard will be effective for us in the first quarter of 2019. The standard requires a transition adoption election using either 1) a modified retrospective approach with periods prior to the adoption date being restated or 2) a prospective adoption approach with a cumulative-effect adjustment recognized to the opening balance of retained earnings on the adoption date with prior periods not restated. We are currently evaluating the impact that the adoption of this ASU will have on our consolidated financial statements. We anticipate adopting this standard on January 1, 2019 using the prospective adoption approach and electing the practical expedients allowed under the standard. Although we have not finalized our evaluation of the impact of adoption of the standard on our consolidated financial statements, we expect there will be a material increase to assets and liabilities related to the recognition of new right-of-use assets and lease liabilities on our balance sheet for leases currently classified as operating leases.

Note 2. Revenue from Contracts with Customers

Effective January 1, 2018, we adopted ASC 606 under the modified retrospective transition method.  This method was applied to contracts that were not complete as of the date of initial application. The following is a summary of new and/or revised significant accounting policies affected by our adoption of ASC 606, which relate primarily to revenue and cost recognition. Refer to Note 2, Summary of Significant Accounting Policies, in our Annual Report on Form 10-K for the year ended December 31, 2017 for the policies in effect for revenue and cost recognition prior to January 1, 2018 and for a discussion of our other significant accounting policies. For further information regarding the impact of the adoption of ASC 606, see Note 1, Accounting Pronouncements Recently Adopted.

We generate products revenue from the sale of (1) term or perpetual software licenses for our Nexpose, Metasploit, AppSpider and Komand products, and associated content subscriptions for our Nexpose and Metasploit products, (2) cloud-based subscriptions

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for our InsightIDR, InsightVM, InsightAppSec, Logentries and InsightOps products and (3) managed services offerings which utilize our products. We also generate appliance revenue that is included in our products revenue. We generate maintenance and support revenue associated with customers’ purchases of our software licenses for Nexpose, Metasploit, AppSpider and Komand. We generate professional service revenue from the sale of our deployment and training services related to our solutions, incident response services and security advisory services. Our deployment services educate and assist our customers on the best use and best practices to deploy our solutions.

In accordance with ASC 606, revenue is recognized when a customer obtains control of promised products or services. The amount of revenue recognized reflects the consideration that we expect to be entitled to receive in exchange for these products or services. To achieve the core principle of this standard, we apply the following five steps:

1) Identify the contract with a customer

We consider the terms and conditions of the contracts and our customary business practices in identifying our contracts under ASC 606. We determine we have a contract with a customer when the contract is approved, we can identify each party’s rights regarding the services to be transferred, we can identify the payment terms for the services, and we have determined the customer has the ability and intent to pay and the contract has commercial substance. We apply judgment in determining the customer’s ability and intent to pay, which is based on a variety of factors, including the customer’s historical payment experience or, in the case of a new customer, credit and financial information pertaining to the customer.

2) Identify the performance obligations in the contract

Performance obligations promised in a contract are identified based on the products and services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the product or service either on its own or together with other resources that are readily available from third parties or from us, and are distinct in the context of the contract, whereby the transfer of the products or services is separately identifiable from other promises in the contract.

3) Determine the transaction price

The transaction price is determined based on the consideration to which we expect to be entitled in exchange for transferring products or services to the customer. Variable consideration is included in the transaction price if, in our judgment, it is probable that no significant future reversal of cumulative revenue under the contract will occur.

In instances where the timing of revenue recognition differs from the timing of invoicing, we have determined our contracts generally do not include a significant financing component. The primary purpose of our invoicing terms is to provide customers with simplified and predictable ways of purchasing our products and services, not to receive financing from our customers or to provide customers with financing. Examples include invoicing at the beginning of a subscription term with revenue recognized ratably over the contract period.

4) Allocate the transaction price to performance obligations in the contract

If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price (“SSP”).

5) Recognize revenue when or as we satisfy a performance obligation

Revenue is recognized at the time the related performance obligation is satisfied by transferring the promised product or service to a customer. Revenue is recognized when control of the products or services are transferred to our customers, in an amount that reflects the consideration that we expect to receive in exchange for those products or services.

The following table summarizes revenue from contracts with customers for the three and nine months ended September 30, 2018:

	Three Months Ended September 30, 2018		Nine Months Ended September 30, 2018
	(in thousands)
Subscription revenue	$	35,860	$	95,990
Term and perpetual software licenses	7,461		19,717
Maintenance and support	10,614		31,977
Professional services	7,922		25,193
Other	508		2,444
Total revenue	$	62,365	$	175,321

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The following table summarizes the revenue by region based on the shipping address of customers who have contracted to use our product or service for the three and nine months ended September 30, 2018:

	Three Months Ended September 30, 2018		Nine Months Ended September 30, 2018
	(in thousands)
United States	$	51,341	$	143,372
All other	11,024		31,949
Total revenue	$	62,365	$	175,321

Subscription Revenue

Subscription revenue consists of revenue from our cloud-based subscription, managed services offerings and content subscriptions associated with our software licenses. We generate cloud-based subscription revenue primarily from sales of subscriptions to access our cloud platform, together with related support services to our customers. These arrangements do not provide the customer with the right to take possession of our software operating on our cloud platform at any time. Instead, customers are granted continuous access to our cloud platform over the contractual period. Revenue is recognized over time on a ratable basis over the contract term beginning on the date that our service is made available to the customer. Our cloud-based subscription contracts generally have terms of 1 to 3 years which are billed in advance and non-cancellable. Managed services offerings consist of fees generated when we operate our software and provide our capabilities on behalf of our customers. Revenue is recognized on a ratable basis over the contract term beginning on the date that our service is made available to the customer. Our managed services offerings generally have terms of 1 to 3 years which are billed in advance and non-cancellable. Revenue related to our content subscriptions associated with our software licenses is recognized ratably over the contractual period. Some of our customers have the option to purchase additional subscription and support services at a stated price. These options generally do not provide a material right as they are priced at our SSP.

Certain subscription contracts contain service level commitments, which entitle our customers to receive service credits and, in certain cases, refunds, if our services do not meet certain levels. These service credits and refunds represent variable consideration. We have historically not experienced any significant incidents affecting the defined levels of reliability and performance as required by our subscription contracts and accordingly, no estimated refunds have been considered in the allocation of the transaction price.

Term and Perpetual Software Licenses

For our perpetual software licenses where the utility to the customer is dependent on the continued delivery of content subscriptions, the content subscription renewal options result in a material right with respect to the perpetual software license. As a result, the revenue attributable to the perpetual software license is recognized ratably over the customer’s estimated economic life of 5 years, which represents a longer period of time in comparison to the initial contractual period of maintenance and support. The estimated economic life of 5 years represents the period which the customer is expected to benefit from the material right. We estimated this period of benefit by taking into consideration several factors, including the terms and conditions of our customer contracts and renewals and the expected useful life of our technology.

For our term software licenses where the utility to the customer is dependent on the continued delivery of content subscriptions, we recognize the license revenue over the contractual term of the arrangement as a material right does not exist.

For our term and perpetual software licenses which are not dependent on the continued delivery of content subscriptions, the license is considered distinct from the maintenance and support, and we therefore recognize revenue attributable to the license at the time of delivery.

Maintenance and Support

Maintenance and support services are sold with our perpetual and term software licenses. As maintenance and support services are distinct from the perpetual and term software license, revenue attributable to maintenance and support services is recognized ratably over the contractual period.

Professional Services

All of our professional services are considered distinct performance obligations when sold stand alone or with other products. These contracts generally have terms of one year or less. For the majority of these contracts, revenue is recognized over time based upon the proportion of work performed to date.

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Other

Other revenue primarily includes revenue from delivery of appliances and other miscellaneous revenue.

Contracts with Multiple Performance Obligations

The majority of our contracts with customers contain multiple performance obligations. For these contracts, we account for individual performance obligations separately if they are considered distinct. The transaction price is allocated to the separate performance obligations on a relative SSP basis. We determine SSP based on our overall pricing objectives, taking into consideration market conditions and other factors, including the geographic locations of our customers and selling method (i.e., partner or direct).

Contract Balances

Contract liabilities consist of deferred revenue and include payments received in advance of performance under the contract. Such amounts are recognized as revenue over the contractual period consistent with the above methodology. For the three and nine months ended September 30, 2018, we recognized revenue of $53.1 million and $113.1 million, respectively, that was included in the corresponding contract liability balance at the beginning of the period presented.

We receive payments from customers based upon contractual billing schedules. Accounts receivable are recorded when the right to consideration becomes unconditional. Contract assets, or unbilled receivables, include amounts related to our contractual right to consideration for both completed and partially completed performance obligations that may not have been invoiced. As of January 1, 2018 and September 30, 2018, contract assets of $0.3 million and $0.6 million, respectively, are included in prepaid expenses and other current assets in our consolidated balance sheet.

Costs to Obtain or Fulfill a Contract

We capitalize commission expenses paid to internal sales personnel and partner referral fees that are incremental to obtaining customer contracts. These costs are recorded as deferred contract acquisition costs in the consolidated balance sheets. Costs to obtain a contract for a new customer, up-sell or cross-sell are amortized on a straight-line basis over an estimated period of benefit of 5 years. We determined the estimated period of benefit by taking into consideration the contractual term and expected renewals of customer contracts, our technology and other factors, including the fact that commissions paid on renewals are not commensurate with commissions paid on initial sales transactions. We periodically review the carrying amount of deferred contract acquisition costs to determine whether events or changes in circumstances have occurred that could impact the period of benefit.

Commissions paid relating to contract renewals are deferred and amortized on a straight-line basis over the related renewal period. Costs to obtain a contract for professional services arrangements are expensed as incurred in accordance with the practical expedient as the contractual period of our professional services arrangements are one year or less.

Amortization expense associated with deferred contract acquisition costs is recorded to sales and marketing expense in the accompanying consolidated statements of operations.

We capitalize costs incurred to fulfill our contracts that relate directly to the contract, are expected to generate resources that will be used to satisfy our performance obligations and are expected to be recovered through revenue generated under the contract. Contract fulfillment costs are amortized on a straight-line basis over the estimated period of benefit and recorded as cost of products in our consolidated statement of operations.

The following table summarizes the activity of the deferred contract acquisition and fulfillment costs for the nine months ended September 30, 2018:

	Nine Months Ended September 30, 2018
	(in thousands)
Beginning balance	$	27,165
Capitalization of contract acquisition and fulfillment costs	13,391
Amortization of deferred contract acquisition and fulfillment costs	(7,006		)
Ending balance	$	33,550

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Transaction price allocated to the remaining performance obligations

The following table includes estimated revenue expected to be recognized in the future related to performance obligations that are unsatisfied or partially unsatisfied as of September 30, 2018. The estimated revenues do not include unexercised contract renewals.

	Remainder of 2018		2019		2020 and thereafter
	(in thousands)
Subscription revenue	$	34,573	$	77,739	$	29,218
Term and perpetual software licenses	6,038		17,383		22,761
Maintenance and support	9,780		19,440		5,479

The amounts presented in the table above primarily consist of fixed fees which are typically recognized ratably as the performance obligation is satisfied.

As of September 30, 2018, the estimated revenue expected to be recognized in the future related to professional services is $10.7 million. We will recognize this revenue as the professional services are completed, which is expected to occur within the next 12 months or less.

Transition Disclosures

In accordance with the modified retrospective method transition requirements, we will present the financial statement line items impacted and adjusted to compare to presentation under ASC 605 for each of the interim and annual periods during the first year of our adoption of ASC 606.

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The following tables summarize the impact as of and for the three and nine months ended September 30, 2018:

	As of September 30, 2018
Balance Sheet	As Reported under ASC 606			Proforma as if ASC 605 was in effect
	(in thousands)
Cash and cash equivalents	$	131,160		$	131,160
Short-term investments	140,633			140,633
Accounts receivable, net	53,771			53,771
Deferred contract acquisition and fulfillment costs, current portion	10,376			—
Prepaid expenses and other current assets	11,616			11,359
Long-term investments	39,275			39,275
Property and equipment, net	11,859			11,859
Goodwill	83,164			83,164
Intangible assets, net	16,023			16,023
Deferred contract acquisition and fulfillment costs, non-current portion	23,174			—
Other assets	906			906
Total assets	$	521,957		$	488,150
Accounts payable	2,766			2,766
Accrued expenses	27,392			27,392
Deferred revenue, current portion	159,408			165,673
Other current liabilities	838			838
Convertible senior notes, net	172,165			172,165
Deferred revenue, non-current portion	63,680			46,331
Other long-term liabilities	2,607			2,178
Total liabilities	428,856			417,343
Common stock	473			473
Treasury stock	(4,764		)	(4,764		)
Additional paid-in-capital	549,101			549,101
Accumulated other comprehensive loss	(144		)	(144		)
Accumulated deficit	(451,565		)	(473,859		)
Total stockholders’ equity	93,101			70,807
Total liabilities and stockholders’ equity	$	521,957		$	488,150

Total reported assets were $33.8 million greater than the proforma balance sheet, which assumes the previous guidance, remained in effect as of September 30, 2018, largely due to deferred contract acquisition and fulfillment costs of $33.6 million.

Total reported liabilities were $11.5 million greater than the proforma balance sheet primarily due to changes in deferred revenue and deferred tax liabilities.

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	Three Months Ended September 30, 2018						Nine Months Ended September 30, 2018
Statement of Operations	As Reported under ASC 606			Proforma as if ASC 605 was in effect			As Reported under ASC 606			Proforma as if ASC 605 was in effect
	(in thousands, except share and per share data)
Revenue:
Products	$	43,829		$	45,310		$	118,151		$	124,119
Maintenance and support	10,614			11,467			31,977			34,707
Professional services	7,922			8,730			25,193			26,459
Total revenue	62,365			65,507			175,321			185,285
Cost of revenue:
Products	10,294			10,256			28,380			28,346
Maintenance and support	1,901			1,901			5,757			5,757
Professional services	5,615			5,609			17,660			17,645
Total cost of revenue	17,810			17,766			51,797			51,748
Total gross profit	44,555			47,741			123,524			133,537
Operating expenses:
Research and development	17,111			17,111			49,915			49,915
Sales and marketing	30,570			32,468			90,779			97,213
General and administrative	8,175			8,175			25,056			25,056
Total operating expenses	55,856			57,754			165,750			172,184
Loss from operations	(11,301		)	(10,013		)	(42,226		)	(38,647		)
Other income (expense), net:
Interest income	813			813			1,520			1,520
Interest expense	(1,679		)	(1,679		)	(1,681		)	(1,681		)
Other income (expense), net	181			181			(67		)	(67		)
Loss before income taxes	(11,986		)	(10,698		)	(42,454		)	(38,875		)
Provision for income taxes	(155		)	(155		)	71			71
Net loss	$	(11,831	)	$	(10,543	)	$	(42,525	)	$	(38,946	)
Net loss per share, basic and diluted	$	(0.25	)	$	(0.22	)	$	(0.92	)	$	(0.84	)
Weighted-average common shares outstanding, basic and diluted	46,914,077			46,914,077			46,139,978			46,139,978

The following summarizes the significant changes on the consolidated statement of operations for the three and nine months ended September 30, 2018 as a result of the adoption of ASC 606 on January 1, 2018 compared to if we had continued to recognize revenue under ASC 605:

• Products revenue decreased$1.5 million and $6.0 million for the three and nine months ended September 30, 2018, respectively, under ASC 606 primarily due to perpetual licenses revenue which are dependent on the continued delivery of content subscriptions and the change in the allocation of contract consideration to a relative fair value method under ASC 606 from residual method under ASC 605. As a result of the allocation change, more contract consideration is allocated to license revenue under ASC 606. Given the utility of certain of our perpetual license products are dependent on the continued delivery of content subscriptions, the content subscription renewal option results in a material right with respect to the perpetual license. As a result, revenue allocated to the perpetual license is recognized ratably over the customer's estimated economic life of 5 years rather than over the contractual period of maintenance and support, typically one to three years.

• Maintenance and support revenue decreased$0.8 million and $2.7 million for the three and nine months ended September 30, 2018, respectively, under ASC 606 primarily due to the change in the allocation of contract consideration to the relative fair value method under ASC 606 from the residual method under ASC 605. As a result of the allocation change, more contract consideration is allocated to license revenue under ASC 606.

• Professional services revenue decreased$0.8 million and $1.3 million for the three and nine months ended September 30, 2018, respectively, under ASC 606 primarily due to professional services sold together with term or perpetual licenses.

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Under ASC 606, the professional services represent distinct performance obligations and therefore are recognized as services are performed. Under ASC 605, professional services sold together with term or perpetual licenses were recognized ratably over the contractual period of maintenance and support.

• Sales and marketing expense decreased$1.9 million and $6.4 million for the three and nine months ended September 30, 2018, respectively, under ASC 606 primarily due to the capitalization of commissions considered direct and incremental costs to obtain a contract partially offset by amortization of capitalized commissions.

	Nine Months Ended September 30, 2018
Statement of Cash Flows	As Reported under ASC 606			Proforma as if ASC 605 was in effect
	(in thousands)
Net loss	$	(42,525	)	$	(38,946	)
Adjustments to reconcile net loss to net cash used in operating activities	30,733			30,733
Changes in operating assets and liabilities:
Accounts receivable	19,287			19,287
Deferred contract acquisition and fulfillment costs	(6,385		)	—
Prepaid expenses and other assets	(2,434		)	(2,207		)
Accounts payable	565			565
Accrued expenses	(2,174		)	(2,174		)
Deferred revenue	(2,313		)	(12,504		)
Other liabilities	(622		)	(622		)
Net cash used in operating activities	$	(5,868	)	$	(5,868	)

The adoption of ASC 606 resulted in offsetting changes in operating assets and liabilities and had no impact on net cash flow from operations.

Note 3. Fair Value Measurements

We measure certain financial assets and liabilities at fair value. Fair value is determined based upon the exit price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants, as determined by either the principal market or the most advantageous market. Inputs used in the valuation techniques to derive fair values are classified based on a three-level hierarchy, as follows:

Level 1: Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets.

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

Level 3: Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the asset or liability.

We consider an active market to be one in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis, and we consider an inactive market to be one in which there are infrequent or few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers.

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The following table presents our financial assets measured and recorded at fair value on a recurring basis using the above input categories:

	As of September 30, 2018
	Level 1		Level 2		Level 3		Total
	(in thousands)
Description:
Assets:
Money market funds	$	87,829	$	—	$	—	$	87,829
U.S. government agencies	61,376		—		—		61,376
Commercial paper	—		62,881		—		62,881
Corporate bonds	—		45,090		—		45,090
Agency bonds	—		16,509		—		16,509
Asset-backed securities	—		7,475		—		7,475
Total assets	$	149,205	$	131,955	$	—	$	281,160

	As of December 31, 2017
	Level 1		Level 2		Level 3		Total
	(in thousands)
Description:
Assets:
Money market funds	$	95	$	—	$	—	$	95
U.S. government agencies	11,869		—		—		11,869
Commercial paper	—		12,942		—		12,942
Corporate bonds	—		12,964		—		12,964
Asset-backed securities	—		2,505		—		2,505
Total assets	$	11,964	$	28,411	$	—	$	40,375

As of September 30, 2018, the fair value of our 1.25% convertible senior notes due 2023, as further described in Note 6, Convertible Senior Notes and Capped Calls, was $255.3 million based upon quoted market prices. We consider the fair value of the Notes to be a Level 2 measurement due to limited trading activity of the Notes. We had no liabilities measured and recorded at fair value on a recurring basis as of December 31, 2017.

Our investments, which are all classified as available-for-sale, consisted of the following:

	As of September 30, 2018
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(in thousands)
Description:
U.S. government agencies	$	61,437	$	—	$	(61	)	$	61,376
Commercial paper	56,146		—		—			56,146
Corporate bonds	38,445		1		(44		)	38,402
Agency bonds	16,544		—		(35		)	16,509
Asset-backed securities	7,480		—		(5		)	7,475
Total assets	$	180,052	$	1	$	(145	)	$	179,908

Our available-for-sale investments as of September 30, 2018 includes $6.7 million of commercial paper and $6.7 million of corporate bonds investments which are classified as cash and cash equivalents as the original maturity was less than three months.

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	As of December 31, 2017
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(in thousands)
Description:
U.S. government agencies	$	11,880	$	—	$	(11	)	$	11,869
Commercial paper	12,942		—		—			12,942
Corporate bonds	12,991		—		(27		)	12,964
Asset-backed securities	2,506		—		(1		)	2,505
Total assets	$	40,319	$	—	$	(39	)	$	40,280

As of September 30, 2018 and December 31, 2017, our available-for-sale investments had maturities ranging from three months to two years.

For all of our investments for which the amortized cost basis was greater than the fair value at September 30, 2018 and December 31, 2017, we have concluded that there is no plan to sell the security nor is it more likely than not that we would be required to sell the security before its anticipated maturity. In making the determination as to whether the unrealized loss is other-than-temporary, we considered the length of time and extent the investment has been in an unrealized loss position, the financial condition and near-term prospects of the issuers, the issuers’ credit rating and the time to maturity.

Note 4. Property and Equipment

Property and equipment are recorded at cost and consist of the following:

	As of September 30, 2018			As of December 31, 2017
	(in thousands)
Computer equipment and software	$	18,106		$	16,205
Furniture and fixtures	4,762			4,034
Leasehold improvements	13,703			9,079
Total	36,571			29,318
Less accumulated depreciation	(24,712		)	(20,729		)
Property and equipment, net	$	11,859		$	8,589

Depreciation expense was $1.6 million and $1.2 million for the three months ended September 30, 2018 and 2017, respectively, and $4.6 million and $3.4 million for the nine months ended September 30, 2018 and 2017, respectively.

Note 5. Goodwill and Intangible Assets

Goodwill was $83.2 million as of September 30, 2018 and December 31, 2017.

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The following table presents details of our intangible assets, which include acquired identifiable intangible assets and capitalized internal-use software costs:

		As of September 30, 2018							As of December 31, 2017
	Weighted- Average Life (years)	Gross Carrying Amount		Accumulated Amortization			Net Book Value		Gross Carrying Amount		Accumulated Amortization			Net Book Value
		(in thousands)
Intangible assets subject to amortization:
Developed technology	5.7	$	20,611	$	(8,459	)	$	12,152	$	20,611	$	(5,756	)	$	14,855
Customer relationships	6.7	1,000		(466		)	534		1,000		(351		)	649
Trade names	6.1	519		(514		)	5		519		(510		)	9
Non-compete agreements	2.0	40		(40		)	—		40		(40		)	—
Total acquired intangible assets		22,170		(9,479		)	12,691		22,170		(6,657		)	15,513
Internal-use software		3,667		(335		)	3,332		1,162		(35		)	1,127
Total intangible assets		$	25,837	$	(9,814	)	$	16,023	$	23,332	$	(6,692	)	$	16,640

Amortization expense was $1.1 million and $0.9 million for the three months ended September 30, 2018 and 2017, respectively, and $3.1 million and $1.9 million for the nine months ended September 30, 2018 and 2017, respectively.

Estimated future amortization expense of the acquired identifiable intangible assets and completed capitalized internal-use software costs as of September 30, 2018 was as follows (in thousands):

2018 (for the remaining three months)	$	1,069
2019	4,250
2020	4,192
2021	3,300
2022	1,095
2023 and thereafter	—
Total	$	13,906

The table above excludes the impact of $2.1 million of capitalized internal-use software costs for projects that have not been completed as of September 30, 2018, and therefore, we have not determined the useful life of the software, nor have all the costs associated with these projects been incurred.

Note 6. Convertible Senior Notes and Capped Calls

In August 2018, we issued $200.0 million aggregate principal amount of convertible senior notes due August 1, 2023 and an additional $30.0 million aggregate principal amount of such notes pursuant to the exercise in full of the over-allotment options of the initial purchasers (collectively, the Notes). The Notes are our senior unsecured obligations and bear interest at a fixed rate of 1.25% per annum, payable semi-annually in arrears on February 1 and August 1 of each year, commencing on February 1, 2019. The Notes will mature on August 1, 2023, unless earlier converted, redeemed or repurchased. The total net proceeds from the Notes offering, after deducting initial purchase discounts and estimated debt issuance costs was $223.1 million. The Notes are governed by an indenture between the Company, as an issuer, and U.S. National Association, as trustee (the Indenture).

Each $1,000 principal amount of the Notes is initially convertible into 24.0460 shares of our common stock, the Conversion Option, which is equivalent to an initial conversion price of approximately $41.59 per share, subject to adjustment upon the occurrence of specified events. The 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 February 1, 2023, only under the following circumstances: (1) during any calendar quarter commencing after the calendar quarter ending on December 31, 2018 (and only during such calendar quarter), if the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price of the Notes on each applicable trading day; (2) during the five business day period after any five consecutive trading day period (measurement period) in which the trading price (as defined in the Indenture) 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 of the Notes on each such trading day; (3)  if we call any or all

18

of the Notes for redemption, at any time prior to the close of business on the scheduled trading day immediately preceding the redemption date; or (4) upon the occurrence of specified corporate events (as set forth in the Indenture). On or after February 1, 2023 until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert their Notes at any time, regardless of the foregoing circumstances. 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, in the manner and subject to the terms and conditions provided in the Indenture. We may not redeem the Notes prior to August 6, 2021. On or after August 6, 2021, we may redeem for cash all or any portion of the Notes, at our option, if the last reported sale price of our common stock has been at least 130% of the conversion price then in effect for at least 20 trading days (whether or not consecutive) during any 30 consecutive trading day period (including the last trading day of such period) ending on, and including the trading day immediately preceding, the date on which we provide the redemption notice at a redemption price equal to 100% principal amount of the Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. If we undergo a fundamental change (as set forth in the Indenture) at any time prior to the maturity date, holders of the Notes, will have the right, at their option, to require us to repurchase for cash all or any portion of their Notes at a repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date. In addition, following certain corporate events that occur prior to the maturity date or following our issuance of a notice of redemption, in each case as described in the Indenture, we will increase the conversion rate for a holder of the Notes who elects to convert its Notes in connection with such a corporate event or during the related redemption period in certain circumstances. During the three months ended September 30, 2018, none of the conditions allowing holders of the Notes to convert their Notes had been met. The Notes are therefore not convertible as of September 30, 2018 and are classified as long-term debt.

The foregoing description is qualified in its entirety by reference to the text of the Indenture and the Form of the Notes, which are incorporated by reference as Exhibits 4.1 and 4.2 to this Quarterly Report on Form 10-Q.

In accounting for the transaction, the Notes have been separated into liability and equity components. The initial carrying amount of the liability component was calculated by measuring the fair value of a similar debt instrument that does not have an associated convertible feature. The initial carrying amount of the equity component representing the Conversion Option was $53.8 million and was determined by deducting the fair value of the liability component from the par value of the Notes. The equity component was recorded as an increase to additional paid-in capital and is not remeasured as long as it continues to meet the conditions for equity classification. The excess of the principal amount of the Notes over the initial carrying amount of the liability component, the debt discount, is amortized to interest expense over the contractual term of the Notes at an effective interest rate of 7.37%.

In accounting for the debt issuance costs of $6.9 million related to the Notes, we allocated the total amount incurred to the liability and equity components of the Notes based on their relative values. Issuance costs attributable to the liability component were $5.3 million and will be amortized to interest expense using the effective interest method over the contractual term of the Notes. Issuance costs attributable to the equity component of $1.6 million were netted with the equity component in additional paid-in capital.

The net carrying amount of the liability component of the Notes was as follows:

	As of September 30, 2018
	(in thousands)
Principal	$	230,000
Unamortized debt discount	(52,641		)
Unamortized issuance costs	(5,194		)
Net carrying amount	$	172,165

The net carrying amount of the equity component was as follows:

	As of September 30, 2018
	(in thousands)
Debt discount for conversion option	$	53,820
Issuance costs	(1,622		)
Net carrying amount	$	52,198

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Interest expense related to the Notes was as follows:

	Three and Nine Months Ended September 30, 2018
	(in thousands)
Contractual interest expense	$	383
Amortization of debt discount	1,180
Amortization of issuance costs	116
Total interest expense	$	1,679

In connection with the offering of the Notes, we entered into privately negotiated capped call transactions with certain counterparties, the (Capped Calls). The Capped Calls each have an initial strike price of $41.59 per share, subject to certain adjustments, which correspond to the initial conversion price of the Notes. The Capped Calls have initial cap prices of $63.98 per share, subject to certain adjustments. The Capped Calls are expected to offset potential dilution to our common stock upon conversion of the Notes, with such offset subject to a cap based on the cap price. The Capped Calls cover, subject to anti-dilution adjustments, approximately 5.5 million shares of our common stock. For accounting purposes, the Capped Calls are separate transactions, and not part of the terms of the Notes. The Capped Calls are recorded in stockholders' equity and are not accounted for as derivatives. Accordingly, the cost of $26.9 million incurred in connection with the Capped Calls was recorded as a reduction to additional paid-in capital.

The debt discount and the difference between the calculation of the book and tax allocation of debt issuance costs between the liability and equity components of the Notes, resulted in a difference between the carrying amount and tax basis of the Notes. This taxable temporary difference resulted in the recognition of a $13.0 million deferred tax liability which was recorded as a reduction to additional paid-in capital. The creation of the deferred tax liability represents a source of future taxable income which supports realization of a portion of our deferred tax assets. Therefore, we released $13.0 million of our valuation allowance which was recorded as an offsetting increase to additional paid-in capital. Accordingly, the net impact to additional paid-in capital as a result of the recognition of the deferred tax liability and the release of the valuation allowance was zero.

The net impact to our stockholders' equity, included in additional paid-in capital, of the above components of the Notes was as follows (in thousands):

Conversion option	$	53,820
Purchase of capped calls	(26,910		)
Issuance costs	(1,622		)
Total	$	25,288

Note 7. Stockholders' Equity

On January 30, 2018, we completed a public offering of 5,950,000 shares of our common stock, of which 1,500,000 shares of common stock were sold by us and 4,450,000 shares of common stock were sold by certain existing stockholders, at an offering price of $22.00 per share, including 770,000 shares pursuant to the underwriters' option to purchase additional shares from the selling stockholders. Our net proceeds from the offering were $30.9 million, after deducting underwriting discounts and commissions and our offering expenses. We did not receive any of the proceeds from the sale of shares by the selling stockholders.

Note 8. Stock-Based Compensation Expense

(a) General

Stock-based compensation expense for restricted stock, restricted stock units, stock options and issuances of common stock pursuant to our employee stock purchase plan was classified in the accompanying consolidated statements of operations as follows:

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	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
	(in thousands)
Stock-based compensation expense:
Cost of revenue	$	478	$	305	$	1,321	$	815
Research and development	2,984		1,986		8,400		5,188
Sales and marketing	2,066		1,512		5,684		4,694
General and administrative	1,896		1,485		5,594		4,041
Total stock-based compensation expense	$	7,424	$	5,288	$	20,999	$	14,738

We recognize compensation cost of all awards on a straight-line basis over the applicable vesting period, which is generally four years.

(b) Restricted Stock and Restricted Stock Units

Restricted stock and restricted stock unit activity during the nine months ended September 30, 2018 was as follows:

	Restricted Stock				Restricted Stock Units
	Shares		Weighted-Average Grant Date Fair Value		Shares		Weighted-Average Grant Date Fair Value
Unvested balance as of December 31, 2017	210,083		$	18.00	1,988,509		$	14.77
Granted	—		—		1,941,370		24.46
Vested	(140,974	)	18.81		(731,183	)	17.10
Forfeited	(700	)	23.01		(207,521	)	18.58
Unvested balance as of September 30, 2018	68,409		$	16.28	2,991,175		$	20.22

As of September 30, 2018, the unrecognized compensation expense related to our unvested restricted stock and restricted stock units expected to vest was $57.2 million. This unrecognized compensation expense will be recognized over an estimated weighted-average amortization period of 2.9 years.

(c) Stock Options

Stock option activity during the nine months ended September 30, 2018 was as follows:

	Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (in years)	Aggregate Intrinsic Value (in thousands)
Outstanding as of December 31, 2017	4,684,954		$	9.68
Granted	107,850		24.44
Exercised	(849,338	)	7.75			$	17,897
Forfeited/cancelled	(88,107	)	15.48
Outstanding as of September 30, 2018	3,855,359		$	10.38	6.5	$	102,325
Vested and exercisable as of September 30, 2018	2,615,648		$	8.57	5.8	$	74,159

As of September 30, 2018, the unrecognized compensation expense related to our unvested stock options expected to vest was $7.8 million. This unrecognized compensation expense will be recognized over an estimated weighted-average amortization period of 2.1 years.

The total fair value of stock options vested in the nine months ended September 30, 2018 was $4.2 million. The weighted-average grant date fair value of stock options granted in the nine months ended September 30, 2018 was $11.86 per share.

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(d) Employee Stock Purchase Plan

Under the Rapid7, Inc. 2015 Employee Stock Purchase Plan (ESPP), employees may set aside up to 15% of their gross earnings, on an after-tax basis, to purchase our common stock at a discounted price, which is calculated at 85% of the lesser of: (i) the market value of our common stock at the beginning of each offering period and (ii) the market value of our common stock on the applicable purchase date.

On March 15, 2017, we issued 138,085 shares of common stock to employees for aggregate proceeds of $1.5 million. The purchase prices of the shares of common stock were $10.60 and $12.79 per share, which were discounted in accordance with the terms of the ESPP from the closing prices of our common stock on March 16, 2016 of $12.47 and on March 15, 2017 of $15.05, respectively.

On September 15, 2017, we issued 109,144 shares of common stock to employees for aggregate proceeds of $1.4 million. The purchase price of the shares of common stock was $12.96 per share, which was discounted in accordance with the terms of the ESPP from the closing price of our common stock on March 16, 2017 of $15.25.

On March 15, 2018, we issued 123,607 shares of common stock to employees for aggregate proceeds of $1.6 million. The purchase prices of the shares were $12.96 and $14.78 per share, which were discounted in accordance with the terms of the ESPP from the closing prices of our common stock on March 16, 2017 of $15.25 and on September 18, 2017 of $17.39, respectively.

On September 14, 2018, we issued 96,108 shares of common stock to employees for aggregate proceeds of $2.0 million. The purchase prices of the shares were $21.96 and $14.78 per share, which were discounted in accordance with the terms of the ESPP from the closing prices of our common stock on March 16, 2018 of $25.84 and on September 18, 2017 of $17.39, respectively.

Note 9. Net Loss per Share

The following table summarizes the computation of basic and diluted net loss per share of our common stock for the three and nine months ended September 30, 2018 and 2017:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
	(in thousands, except share and per share data)
Numerator:
Net loss	$	(11,831	)	$	(10,284	)	$	(42,525	)	$	(32,466	)
Denominator:
Weighted-average common shares outstanding, basic and diluted	46,914,077			43,279,025			46,139,978			42,693,212
Net loss per share attributable to common stockholders, basic and diluted	$	(0.25	)	$	(0.24	)	$	(0.92	)	$	(0.76	)

The following potentially dilutive securities outstanding, prior to the use of the treasury stock method or if-converted method, have been excluded from the computation of diluted weighted-average shares outstanding for the respective periods below because they would have been anti-dilutive:

	Three and Nine Months Ended September 30,
	2018	2017
Options to purchase common stock	3,855,359	4,778,250
Unvested restricted stock	68,409	278,701
Unvested restricted stock units	2,991,175	2,069,623
Shares to be issued under ESPP	16,651	9,614
Total	6,931,594	7,136,188

Additionally, the 5.5 million shares underlying the conversion option of the Notes are not considered in the calculation of diluted net loss per share as the effect would be anti-dilutive. The Notes are not convertible as of September 30, 2018. We expect to settle the principal amount of the Notes in cash and therefore use the treasury stock method for calculating any

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potential dilutive effect of the conversion spread on diluted net income per share, if applicable. The conversion spread will have a dilutive impact on diluted net income per share when the average market price of our common stock for a given period of time exceeds the initial conversion price of $41.59 per share for the Notes.

Note 10. Commitments and Contingencies

(a) Warranty

We provide limited product warranties. Historically, any payments made under these provisions have been immaterial.

(b) Litigation and Claims

In November 2016, Rapid7 LLC and two of our then executive officers were named as defendants in a class action lawsuit which alleged violations of certain Massachusetts wage and hour laws. In the first quarter of 2018, we increased our litigation accrual by $0.4 million to $0.6 million which reflects the amount of the settlement agreement entered into in July 2018. As of September 30, 2018, the $0.6 million is recorded as an accrued expense in our consolidated balance sheet.

In October 2018, Finjan, Inc. filed a complaint against us and our wholly-owned subsidiary, Rapid7 LLC, in the United States District Court, District of Delaware, alleging patent infringement of seven patents held by them. In the complaint, Finjan sought unspecified damages, attorney fees and injunctive relief. We intend to vigorously contest Finjan's claims. This litigation is still in its early stages and the final outcome, including our liability, if any, with respect to Finjan's claims, is uncertain.

In addition, from time to time, we are a party to litigation or subject to claims incident to the ordinary course of business. Although the results of litigation and claims cannot be predicted with certainty, we currently believe that the final outcome of these ordinary course matters will not have a material adverse effect on our business, financial condition or results of operations. Regardless of the outcome, litigation can have an adverse impact on us because of defense and settlement costs, diversion of management resources and other factors.

(c) Indemnification Obligations

We agree to standard indemnification provisions in the ordinary course of business. Pursuant to these provisions, we agree to indemnify, hold harmless and reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our customers, in connection with any United States patent, copyright or other intellectual property infringement claim by any third party arising from the use of our products or services in accordance with the agreement or arising from our gross negligence, willful misconduct or violation of the law (provided that there is not gross or willful misconduct on the part of the other party) with respect to our products or services. The term of these indemnification provisions is generally perpetual from the time of execution of the agreement. We carry insurance that covers certain third-party claims relating to our services and limits our exposure. We have never incurred costs to defend lawsuits or settle claims related to these indemnification provisions.

As permitted under Delaware law, we have entered into indemnification agreements with our officers and directors, indemnifying them for certain events or occurrences while they serve as officers or directors of the company.

Note 11. Segment Information and Information about Geographic Areas

We operate in one segment. Our chief operating decision maker is our Chief Executive Officer, who makes operating decisions, assesses performance and allocates resources on a consolidated basis.

Net revenues by geographic area presented based upon the location of the customer were as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
	(in thousands)
North America	$	53,232	$	42,966	$	149,177	$	121,177
Other	9,133		7,555		26,144		22,032
Total	$	62,365	$	50,521	$	175,321	$	143,209

Of the total net revenues generated in North America, 96% and 93% of the revenues were generated in the United States for the three months ended September 30, 2018 and 2017, respectively, and 96% and 93% of the revenues were generated in the United States for the nine months ended September 30, 2018 and 2017, respectively.

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Property and equipment, net by geographic area was as follows:

	As of September 30, 2018		As of December 31, 2017
	(in thousands)
United States	$	10,626	$	7,182
Other	1,233		1,407
Total	$	11,859	$	8,589

Note 12. Related Party Transactions

In October 2015, McAfee LLC (formerly known as Intel Security) announced the end-of-sale for the McAfee Vulnerability Manager to customers and partners, effective January 11, 2016, with end-of-life to follow, and announced that we were named their exclusive vulnerability management partner. Under the terms of the commercial agreement, we incur partner referral fees as customers transition from McAfee Vulnerability Manager to Nexpose. During the three and nine months ended September 30, 2018, we incurred partner referral fees of $0.1 million and $0.7 million, respectively, payable to McAfee LLC. On February 6, 2017, Michael Berry, a member of our Board of Directors, became the Chief Financial Officer of McAfee LLC.

Note 13. Subsequent Event

On October 15, 2018, we acquired tCell.io, Inc. (tCell), a leading provider of web application threat defense and monitoring for total cash consideration of $14.4 million. Certain retained employees and non-employee contractors of tCell received an aggregate of 112,924 restricted stock units which will vest over a maximum of three years. The acquisition will be accounted for under the acquisition method of accounting with the operations of the newly acquired entity included in our operating results from the date of acquisition. 

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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 in conjunction with (1) our consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and (2) the audited consolidated financial statements and the related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations for the fiscal year ended December 31, 2017 included in our Annual Report on Form 10-K, filed with the SEC on March 8, 2018.

This Quarterly Report on Form 10-Q contains “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. These statements are often identified by the use of words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “project,” “will,” “would” or the negative or plural of these words or similar expressions or variations and such forward-looking statements include, but are not limited to, statements with respect to our outlook; the impact of new accounting standards; deferred revenue; our transition to subscription, our business strategy, plans and objectives for future operations; and our future financial and business performance. The events described in these forward-looking statements are subject to a number of risks, uncertainties, assumptions 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. You should not rely upon forward-looking statements as predictions of future events. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.

Overview

Organizations of all sizes are faced with a more sophisticated and motivated set of cyber attackers. Coupled with an increasingly complex IT environment and expanding attack surface, which is driven by mobility and a shift to the cloud, security and IT teams are struggling to maintain adequate levels of cyber security, provide visibility to their management teams, and meet increasing regulatory requirements. At the same time, they must navigate a shortage of capable cyber security professionals. Out of these challenges, the concept of Security Operations, or SecOps, is emerging. SecOps is a movement that recognizes that Security and IT Operations must work together to deliver better security and more nimbly adapt to emerging threats, without adding significant resources. SecOps requires solutions that provide visibility, analytics and automation that enable IT, Security and DevOps to work together to achieve significantly higher levels of productivity and success.

Rapid7 is a leading provider of security and IT analytics and automation solutions for SecOps, and is trusted by professionals around the world to provide visibility, analytics and automation to help manage risk, simplify IT complexity and drive innovation. Our solutions, which include vulnerability management, incident detection and response, security information and event management, or SIEM, application security testing, log analytics, and security orchestration and automation, all focus on the critical needs of enterprises for greater visibility into their environments, analytics that provide context to complex data, and automation that enables SecOps teams to scale and to more efficiently address critical security and IT tasks.

We combine our extensive experience in collecting data from an ever-expanding IT environment, our deep insight into attacker behaviors and techniques, and our powerful and proprietary analytics to provide solutions that can quickly and efficiently identify and prioritize risks and active threats in an enterprise’s IT environment. Our broad data collection capabilities encompass endpoints, servers, applications, users, cloud-based assets, client devices, network activity, log data and information from third-party applications. We also provide workflows and automations that can enable and accelerate remediation of these risks and active threats. We have designed our solutions to be easy to deploy and use for security and IT teams of all sizes.

We offer analytic solutions across the following three core areas of SecOps:

• Our Vulnerability Management offerings include our industry-leading vulnerability management, web application security testing and attack simulation products. These solutions provide enterprises with comprehensive, yet prioritized, visibility into potential cyber risks across their IT environment. We have also added remediation workflows to help ensure that these risks can be easily mitigated.

• Our Incident Detection and Response solutions are designed to enable organizations to rapidly detect and respond to cyber security incidents and breaches across physical, virtual and cloud assets, including those associated with the behaviors of their users. These solutions combine the collection of massive amounts of data with our core analytics and machine-learning-driven user behavioral analytics to simplify the task of identifying and responding to potential breaches.

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• Our IT Analytics and Automation solutions are designed to allow operations teams to quickly gain visibility into their IT environment and facilitate automated workflows to eliminate repetitive, manual and labor-intensive tasks.

Finally, to complement our SecOps products, we offer a range of managed services based on our software solutions and professional services, including incident response services, security advisory services, and deployment and training.

We market and sell our products and professional services to global organizations of all sizes, including mid-market businesses, enterprises, non-profits, educational institutions and government agencies. Our customers span a wide variety of industries such as technology, energy, financial services, healthcare and life sciences, manufacturing, media and entertainment, retail, education, real estate, transportation, government and professional services. As of September 30, 2018, we had approximately 7,400 customers in 127 countries, including 52% of the Fortune 100. Our revenue was not concentrated with any individual customer or group of customers, and no customer represented more than 2% of our revenue for the three and nine months ended September 30, 2018 and 2017.

We sell our products and professional services through direct inside and field sales teams and indirect channel partner relationships. Our global sales teams focus on both new customer acquisition as well as up-selling and cross-selling additional offerings to our existing customers. Our sales teams are organized by geography, consisting of the Americas; Europe, the Middle East and Africa, or EMEA; and Asia Pacific, or APAC, as well as by target organization size. Our inside sales team primarily focuses on small and middle-market enterprises, while Fortune 500 enterprises are generally handled by our globally distributed direct field sales teams. Our highly technical sales engineers help define customer use cases, manage solution evaluations and train channel partners.

Recent Developments

In October 2018, we acquired tCell.io, Inc. (tCell), a leading provider of web application threat defense and monitoring for total cash consideration of $14.4 million.

In September 2018, we announced the upcoming availability of InsightConnect, a security orchestration and automation solution that helps security teams reduce manual workloads, create efficiency without sacrificing control, and work more effectively with IT and development teams. In addition, we announced that our Vulnerability Management (InsightVM) and Incident Detection and Response (InsightIDR) solutions will include pre-built automation functionality for some of the most common use cases so that customers can begin benefiting immediately. From within those solutions, customers could then implement orchestration and automation processes for threat containment, vulnerability remediation, case management, and more. Global rollout of InsightConnect and the automation functionality within InsightVM and InsightIDR began in October 2018 and is expected to continue through early 2019.

In August 2018, we issued $230.0 million aggregate principal amount of 1.25% convertible senior notes due August 1, 2023 (the Notes). The total net proceeds from the offering, after deducting initial purchase discounts and estimated debt issuance costs, were $223.1 million. In connection with the issuance of the Notes, we entered into capped call transactions with certain counterparties (the Capped Calls). We used $26.9 million of the net proceeds from the Notes to purchase the Capped Calls, which have an initial strike price of $41.59 per share which corresponds to the initial conversion price of the Notes. The Capped Calls are expected to offset potential dilution to our common stock upon conversion of the Notes. The Capped Calls have an initial cap price of $63.98 per share, subject to certain adjustments.

Our Business Model

We have offerings in three key areas: (1) Vulnerability Management, which includes our InsightVM, Nexpose, InsightAppSec, AppSpider and Metasploit products, (2) Incident Detection and Response, which includes our InsightIDR and Managed Detection and Response products as well as our incident response services and (3) IT Analytics and Automation Solutions, which includes our Logentries, InsightOps and Komand products.

We offer our products through a variety of delivery models to meet the needs of our diverse customer base, including:

• Cloud-based subscriptions, which provide our software capabilities to our customers through cloud access and on a Software as a Service basis. Our InsightIDR, InsightVM, InsightAppSec, Logentries and InsightOps products are offered as cloud-based subscriptions, generally with one to three-year terms.

• Managed services, through which we operate our products and provide our capabilities on behalf of our customers. Our Managed Vulnerability Management (InsightVM), Managed Application Security (AppSpider) and Managed Detection and Response (InsightIDR) products are offered on a managed service basis, generally pursuant to one to three-year agreements.

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• Licensed software, including both term and perpetual licenses, and the simultaneous sale of maintenance and support. Our Nexpose, Metasploit and AppSpider products are offered through term or perpetual software licenses. Our customers who purchase software licenses also purchase maintenance and support, which provides our customers with telephone and web-based support and ongoing bug fixes and repairs during the term of the maintenance and support agreement, and our customers who purchase our Nexpose and Metasploit products also purchase content subscriptions, which provide them with real-time access to the latest vulnerabilities and exploits. Our maintenance and support and content subscription agreements are typically for one to three-year terms. In addition, our Komand product is offered through term licenses.

We also offer various professional services across all of our offerings, including deployment and training services related to our software and cloud-based products, incident response services and security advisory services. Customers can purchase our professional services together with o