10-Q 1 a2225601z10-q.htm 10-Q

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

Form 10-Q

(Mark One)    

ý

 

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

For the quarterly period ended June 30, 2015

or

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 001-36841



INOVALON HOLDINGS, INC.
(Exact name of registrant as specified in its charter)



Delaware
(State or other jurisdiction of
incorporation or organization)
  47-1830316
(I.R.S. Employer
Identification No.)

4321 Collington Road,
Bowie, Maryland

(Address of principal executive offices)

 

20716
(Zip Code)

(301) 809-4000
Registrant's telephone number, including area code

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

        Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý    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.

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

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

        As of August 5, 2015, the registrant had 25,436,749 shares of Class A common stock outstanding and 122,291,720 shares of Class B common stock outstanding.

   


Table of Contents


INOVALON HOLDINGS, INC.

FORM 10-Q
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2015

TABLE OF CONTENTS

 
   
  Page  

PART I—FINANCIAL INFORMATION

       

Item 1.

 

Condensed Consolidated Financial Statements (Unaudited)

    1  

 

Condensed Consolidated Balance Sheets

    1  

 

Condensed Consolidated Statements of Income

    2  

 

Condensed Consolidated Statements of Comprehensive Income

    3  

 

Condensed Consolidated Statements of Stockholders' Equity (Deficit)

    4  

 

Condensed Consolidated Statements of Cash Flows

    5  

 

Notes to Condensed Consolidated Financial Statements

    6  

Item 2.

 

Management's Discussion and Analysis of Financial Condition and Results of Operations

    18  

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

    36  

Item 4.

 

Controls and Procedures

    37  

PART II—OTHER INFORMATION

   
 
 

Item 1.

 

Legal Proceedings

    38  

Item 1A.

 

Risk Factors

    38  

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

    38  

Item 3.

 

Defaults Upon Senior Securities

    38  

Item 4.

 

Mine Safety Disclosures

    38  

Item 5.

 

Other Information

    38  

Item 6.

 

Exhibits

    39  

SIGNATURES

   
40
 


Table of Contents

PART I—FINANCIAL INFORMATION

Item 1.    Condensed Consolidated Financial Statements

        


INOVALON HOLDINGS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and par value amounts)

 
  June 30,
2015
  December 31,
2014
 
 
  (Unaudited)
   
 

ASSETS

             

Current assets:

             

Cash and cash equivalents

  $ 194,433   $ 162,567  

Short-term investments

    602,559      

Accounts receivable (net of allowances of $705 and $1,827 at June 30, 2015 and December 31, 2014, respectively)

    86,960     43,938  

Prepaid expenses and other current assets

    7,514     6,015  

Income tax receivable

        6,797  

Deferred income taxes

    437     491  

Total current assets

    891,903     219,808  

Non-current assets:

             

Property, equipment and capitalized software, net

    53,817     50,962  

Goodwill

    62,269     62,269  

Intangible assets, net

    6,644     7,447  

Other assets

    1,645     2,083  

Total assets

  $ 1,016,278   $ 342,569  

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)

             

Current liabilities:

             

Accounts payable

  $ 10,322   $ 10,974  

Accrued compensation

    13,912     15,305  

Other current liabilities

    2,082     1,992  

Deferred revenue

    2,433     3,904  

Income tax payable

    8,715      

Deferred rent

    624     567  

Credit facilities

    16,250     18,750  

Capital lease obligation

    117     99  

Total current liabilities

    54,455     51,591  

Non-current liabilities:

             

Credit facilities, less current portion

    273,750     281,250  

Capital lease obligation, less current portion

    272     168  

Deferred rent

    2,321     2,619  

Deferred income taxes

    12,314     15,163  

Total liabilities

    343,112     350,791  

Commitments and contingencies (Note 9)

             

Stockholders' equity (deficit):

             

Common stock, $0.000005 par value, 900,000,000 shares authorized, zero shares issued and outstanding at each of June 30, 2015 and December 31, 2014, respectively

         

Class A common stock, $0.000005 par value, 750,000,000 shares authorized, 25,436,749 and 11,109,285 shares issued and outstanding at June 30, 2015 and December 31, 2014, respectively

         

Class B common stock, $0.000005 par value, 150,000,000 shares authorized, 122,291,720 and 122,257,145 shares issued and outstanding at June 30, 2015 and December 31, 2014, respectively

    1     1  

Preferred stock, $0.0001 par value, 100,000,000 shares authorized, zero shares issued and outstanding at June 30, 2015 and December 31, 2014, respectively

         

Additional paid-in-capital

    453,445     110,317  

Retained earnings

    221,372     181,477  

Treasury stock, at cost, zero shares at June 30, 2015 and 11,109,285 at December 31, 2014

        (300,017 )

Accumulated other comprehensive loss

    (1,652 )    

Total stockholders' equity (deficit)

    673,166     (8,222 )

Total liabilities and stockholders' equity (deficit)

  $ 1,016,278   $ 342,569  

   

See notes to condensed consolidated financial statements.

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INOVALON HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited, in thousands, except per-share amounts)

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2015   2014   2015   2014  

Revenue

  $ 117,618   $ 100,957   $ 211,251   $ 185,631  

Expenses:

                         

Cost of revenue(1)

    33,602     28,899     65,453     57,486  

Sales and marketing(1)

    2,377     1,612     4,227     2,945  

Research and development(1)

    5,504     5,144     10,915     11,192  

General and administrative(1)

    25,327     21,341     49,585     41,275  

Depreciation and amortization

    4,812     5,114     9,727     9,969  

Total operating expenses

    71,622     62,110     139,907     122,867  

Income from operations

    45,996     38,847     71,344     62,764  

Other income and (expenses):

                         

Interest income

    615     1     623     3  

Interest expense

    (1,105 )   (49 )   (2,208 )   (62 )

Income before taxes

    45,506     38,799     69,759     62,705  

Provision for income taxes

    19,370     15,169     29,864     24,518  

Net income

  $ 26,136   $ 23,630   $ 39,895   $ 38,187  

Net income attributable to common stockholders, basic and diluted

  $ 26,131   $ 23,630   $ 39,891   $ 38,187  

Net income per share attributable to common stockholders, basic and diluted:

                         

Basic net income per share

  $ 0.18   $ 0.18   $ 0.28   $ 0.28  

Diluted net income per share

  $ 0.17   $ 0.17   $ 0.27   $ 0.28  

Weighted average shares of common stock outstanding:

                         

Basic

    147,648     134,523     141,524     134,585  

Diluted

    151,299     136,814     145,149     135,635  

                                                 

                         

(1)    Includes stock-based compensation expense as follows:

                   

Cost of revenue

  $ 29   $   $ 57   $  

Sales and marketing

    41         56      

Research and development

    298         660      

General and administrative

    1,554     436     2,921     822  

Total stock-based compensation expense

  $ 1,922   $ 436   $ 3,694   $ 822  

   

See notes to condensed consolidated financial statements.

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INOVALON HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited, in thousands)

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2015   2014   2015   2014  

Net income

  $ 26,136   $ 23,630   $ 39,895   $ 38,187  

Other comprehensive income:

                         

Net change in unrealized gains and (losses) on available-for-sale investments

    (1,652 )       (1,652 )    

Comprehensive income

  $ 24,484   $ 23,630   $ 38,243   $ 38,187  

   

See notes to condensed consolidated financial statements

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INOVALON HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)

(Unaudited, in thousands, except share amounts)

 
   
   
   
   
  Issued Class A & B
Common Stock
   
   
   
   
   
   
 
 
  Preferred Stock   Common Stock   Treasury Stock    
   
  Accumulated
Other
Comprehensive
Loss
  Total
Stockholders'
Equity
(Deficit)
 
 
  Additional
Paid-in
Capital
  Retained
Earnings
 
 
  Shares   Amount   Shares   Amount   Shares   Amount   Shares   Amount  

Balance—December 31, 2014

      $       $     133,366,430   $ 1     (11,109,285 ) $ (300,017 ) $ 110,317   $ 181,477   $   $ (8,222 )

Issuance of common stock upon initial public offering, net of offering costs

                    14,255,518                 359,170             359,170  

Issuance of treasury stock upon initial public offering, net of offering costs

                            11,109,285     300,017     (20,115 )           279,902  

Stock compensation expense

                    71,946                 3,623             3,623  

Exercise of stock options

                    34,575                 227             227  

Tax benefit from exercise of non-qualified stock options

                                    223             223  

Other comprehensive loss

                                            (1,652 )   (1,652 )

Net income

                                        39,895         39,895  

Balance—June 30, 2015

      $       $     147,728,469   $ 1       $   $ 453,445   $ 221,372   $ (1,652 ) $ 673,166  

   

See notes to condensed consolidated financial statements.

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INOVALON HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

 
  Six Months Ended
June 30,
 
 
  2015   2014  

Cash flows from operating activities:

             

Net income

  $ 39,895   $ 38,187  

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

             

Stock-based compensation expense

    3,694     822  

Depreciation

    8,924     7,003  

Amortization of intangibles

    803     2,966  

Amortization/accretion of premiums or discounts on short-term investments

    455      

Deferred income taxes

    (2,795 )   1,378  

Loss on disposal of long-lived assets

    4      

Loss on impairment of long-lived assets

        131  

Changes in assets and liabilities:

             

Accounts receivable

    (43,021 )   (25,358 )

Prepaid expenses and other current assets

    (1,499 )   (1,335 )

Income taxes receivable

    6,797     4,772  

Other assets

    308     (831 )

Accounts payable

    (139 )   738  

Accrued compensation

    (712 )   3,173  

Other liabilities

    19     148  

Deferred rent

    (241 )   (35 )

Deferred revenue

    (1,471 )   (129 )

Income taxes payable

    8,715     615  

Net cash provided by operating activities

    19,736     32,245  

Cash flows from investing activities:

             

Purchases of short-term investments

    (611,095 )    

Maturities and sales of short-term investments

    6,429      

Purchases of property and equipment

    (2,391 )   (3,312 )

Investment in capitalized software

    (10,282 )   (7,541 )

Proceeds from sale of property and equipment

        22  

Net cash used in investing activities

    (617,339 )   (10,831 )

Cash flows from financing activities:

             

Proceeds from issuance of common stock, net of underwriters' discount

    362,082      

Proceeds from issuance of treasury stock, net of underwriters' discount

    282,172      

Payment of offering costs

    (5,182 )    

Repayment of credit facility borrowings

    (10,000 )    

Repurchase of common stock

        (9,066 )

Dividends paid

        (2,852 )

Capital lease obligations paid

    (53 )   (67 )

Excess tax benefits from share-based compensation

    223      

Proceeds from exercise of stock options

    227     57  

Net cash provided by (used in) financing activities

    629,469     (11,928 )

Increase in cash and cash equivalents

    31,866     9,486  

Cash and cash equivalents, beginning of period

    162,567     110,594  

Cash and cash equivalents, end of period

  $ 194,433   $ 120,080  

Supplementary cash flow disclosure:

             

Cash paid during the period for:

             

Income taxes, net of refunds

  $ 16,924   $ 17,756  

Interest

    2,189      

Non-cash investing activities:

             

Capital lease obligations incurred

    175     14  

Accounts payable for purchases of and investment in property, equipment and capitalized software

    1,576     2,320  

Accrued compensation for investment in capitalized software

    297     616  

   

See notes to condensed consolidated financial statements.

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INOVALON HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. ORGANIZATION AND BASIS OF PRESENTATION

        The accompanying unaudited consolidated financial statements have been prepared by Inovalon Holdings, Inc. (the "Company") in accordance with accounting principles generally accepted in the United States ("GAAP") for interim financial reporting and as required by Rule 10-01 of Regulation S-X. Accordingly, the unaudited consolidated financial statements may not include all of the annual information and notes required by GAAP pursuant to such rules and regulations. In the opinion of the Company's management, the accompanying unaudited consolidated financial statements contain all adjustments, consisting of items of a normal and recurring nature, necessary to present fairly the Company's financial position as of June 30, 2015 and the results of operations, comprehensive income and cash flows for the three and six month periods ended June 30, 2015 and 2014. The results of operations for the three and six month periods ended June 30, 2015 are not necessarily indicative of the results to be expected for the full year. The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts of assets and liabilities, disclosures of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenue and expenses during the reported period. Significant estimates made by management include, but are not limited to: revenue recognition, specifically selling prices associated with the individual elements in multiple element arrangements; accounts receivable allowances; estimates of the fair value of the Company's pre-IPO common stock and the related estimates of the fair value of stock-based awards; fair value of intangibles and goodwill; depreciable lives of property, equipment and capitalized software; and useful lives of intangible assets. Actual results could differ from management's estimates, and such differences could be material to the Company's consolidated financial position and results of operations. The Company's management considers events or transactions that occur after the balance sheet date but before the financial statements are issued to provide additional evidence relative to certain estimates or to identify matters that require additional disclosure. Subsequent events have been evaluated through the date of issuance of these financial statements.

        On February 18, 2015, the Company completed its initial public offering of 22,222,222 shares of Class A common stock and, upon the underwriters' exercise of their option to purchase additional shares, issued an additional 3,142,581 shares of Class A common stock for a total of 25,364,803 shares issued (the "IPO"). All of the shares issued in the IPO were primary shares offered by the Company as none of the Company's stockholders sold any shares in the IPO. The offering price of the shares sold in the IPO was $27.00 per share, resulting in net proceeds to the Company, after the underwriters' discounts and commissions and other expenses, payable by the Company, of approximately $639.1 million.

        The Company is a leading technology company that combines advanced cloud-based data analytics and data-driven intervention platforms to achieve meaningful impact in clinical and quality outcomes, utilization, and financial performance across the healthcare landscape. The value that the Company delivers to its clients is achieved by turning data into insights and those insights into action. Through the Company's large proprietary datasets, advanced integration technologies, sophisticated predictive analytics, and deep subject matter expertise, the Company delivers seamless, end-to-end platforms that bring the benefits of big data and large-scale analytics to the point of care. The Company's analytics platforms identify gaps in care, quality, data integrity, and financial performance, in its clients' datasets. The Company's data-driven intervention platforms enable clients to take the insights derived from the analytics and implement unique, patient-level solutions, drive impact and enhance patient engagement.

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INOVALON HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (in thousands)

        Deferred IPO Issuance Costs—The Company capitalizes IPO costs, which primarily consist of direct incremental legal and accounting fees relating to the IPO. The IPO issuance costs were offset against IPO proceeds directly following the consummation of the offering that occurred during February 2015. As of June 30, 2015, there were no deferred IPO issuance costs, and as of December 31, 2014, there was $2,888 deferred as prepaid expenses and other current assets.

        Short-term investments—The Company classifies short-term investments as available-for-sale at the time of purchase and reevaluates such classification as of each balance sheet date. All short-term investments are recorded at estimated fair value. Unrealized gains and losses for available-for-sale securities are included in accumulated other comprehensive loss, a component of stockholders' equity. The Company evaluates its investments to assess whether those with unrealized loss positions are other than temporarily impaired. The Company considers impairments to be other-than-temporary if they are related to deterioration in credit risk, if it is more likely than not that the Company will be required to or if the Company intends to sell the securities before the recovery of their cost basis. Realized gains and losses and declines in value judged to be other than temporary are determined based on the specific identification method and are reported in other income (expense), net, in the consolidated statements of income. Interest, amortization of premiums, and accretion of discount on short-term investments classified as available for sale are included as a component of interest income, in the consolidated statements of income.

        The Company may sell short-term investments at any time, without significant penalty, for use in current operations or for other purposes, even if the short-term investments have not yet reached maturity. As a result, the Company classifies these investments, including securities with maturities beyond 12 months, as current assets in the accompanying consolidated balance sheets.

        Recently Issued Accounting Standards—In May 2014, the Financial Accounting Standards Board ("FASB") issued updated guidance on revenue from contracts with customers. This revenue recognition guidance supersedes existing GAAP guidance, including most industry-specific guidance. The core principle is that an entity 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 or services. The guidance identifies steps to apply in achieving this principle. On July 9, 2015, the FASB approved a one year deferral of the effective date of ASU 2014-09 to January 1, 2018. ASU 2014-09 may be applied either retrospectively or through the use of a modified-retrospective method. We are currently evaluating both methods of adoption as well as the effect ASU 2014-09 will have on the Company's consolidated financial position, annual results of operations and cash flows.

        In April 2015, the FASB issued Accounting Standards Update No. 2015-03, "Simplifying the Presentation of Debt Issuance Costs." This standard amends existing guidance to require the presentation of debt issuance costs in the balance sheet as a deduction from the carrying amount of the related debt liability instead of a deferred charge. It is effective for annual reporting periods beginning after December 15, 2015, but early adoption is permitted. The Company is currently evaluating the impact that the adoption of this standard will have on the Company's financial disclosures and results.

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INOVALON HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

3. NET INCOME PER SHARE (in thousands, except per share amounts)

        During September 2014, the Company completed a holding company reorganization. As part of the reorganization, the Company implemented a multi-class stock structure. The Company has retrospectively presented the impact on net income per share (EPS) of this reorganization by calculating EPS based on the newly authorized, issued and outstanding Class A and Class B common stock. Class A and Class B common stock shares were outstanding during the three and six months ended June 30, 2015. Only shares of Class B common stock were outstanding during the three and six months ended June 30, 2014. Holders of all outstanding classes of common stock participate ratably in earnings on an identical per share basis as if all shares were a single class.

        During the three months ended June 30, 2015, the Company issued restricted share awards of Class A common stock (RSAs) under the 2015 Omnibus Incentive Plan. The Company considers issued and unvested RSAs to be participating securities as the holders of these RSAs have a non-forfeitable right to dividends in the event of the Company's declaration of a dividend for Class A and Class B common shares. Subsequent to the issuance of the participating securities, the Company applied the two-class method required in calculating net income per share of Class A and Class B common stock.

        Undistributed net income for a given period is apportioned to participating securities based on the weighted-average shares of each class of common stock outstanding during the applicable period as a percentage of the total weighted-average shares outstanding during the same period.

        Under the two-class method, net income attributable to common stockholders is determined by allocating undistributed earnings, calculated as net income, less earnings attributable to participating securities. The net income per share attributable to common stockholders is allocated based on the contractual participation rights of the Class A common stock and Class B common stock as if the income for the period has been distributed. As the liquidation and dividend rights are identical for both classes of common stock, the net income attributable to common stockholders is allocated on a proportionate basis.

        Basic net income per share of common stock is computed by dividing the net income attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period. All participating securities are excluded from the basic weighted-average shares of common stock outstanding. Unvested RSAs are excluded from the calculation of the weighted-average shares of common stock until vesting occurs, as the restricted shares are subject to forfeiture and cancellation until vested.

        Diluted net income per share attributable to common stockholders is computed by dividing net income attributable to common stockholders by the weighted-average shares outstanding, including potentially dilutive shares of common stock assuming the dilutive effect of potential shares of common stock for the period determined using the treasury stock method.

        For purposes of the diluted net income per share attributable to common stockholders calculation, unvested shares of common stock resulting from RSAs are considered to be potentially dilutive shares of common stock.

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INOVALON HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

3. NET INCOME PER SHARE (in thousands, except per share amounts) (Continued)

        The numerators and denominators of the basic and diluted EPS computations for our common stock are calculated as follows:

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2015   2014   2015   2014  

Basic

                         

Numerator:

                         

Net income

  $ 26,136   $ 23,630   $ 39,895   $ 38,187  

Undistributed earnings allocated to participating securities

    5         4      

Net income attributable to common stockholders—basic

  $ 26,131   $ 23,630   $ 39,891   $ 38,187  

Denominator:

                         

Weighted average shares used in computing net income per share attributable to common stockholders—basic

    147,648     134,523     141,524     134,585  

Net income per share attributable to common stockholders—basic

  $ 0.18   $ 0.18   $ 0.28   $ 0.28  

Diluted

                         

Numerator:

                         

Net income attributable to common stockholders—diluted

  $ 26,131   $ 23,630   $ 39,891   $ 38,187  

Denominator:

                         

Number of shares used for basic EPS computation

    147,648     134,523     141,524     134,585  

Effect of dilutive securities

    3,651     2,291     3,625     1,050  

Weighted average shares used in computing net income per share attributable to common stockholders—diluted

    151,299     136,814     145,149     135,635  

Net income per share attributable to common stockholders—diluted

  $ 0.17   $ 0.17   $ 0.27   $ 0.28  

        The computation of diluted EPS does not include certain unvested awards, on a weighted average basis, for the three and six months ended June 30, 2015 and 2014, respectively, because their inclusion would have an anti-dilutive effect on EPS. The awards excluded because of their anti-dilutive effect are as follows:

 
  Three
Months
Ended
June 30,
  Six Months
Ended
June 30,
 
 
  2015   2014   2015   2014  

Awards excluded from the computation of diluted net income per share because their inclusion would have been anti-dilutive

    103     4,295     63     4,295  

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INOVALON HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

4. SHORT-TERM INVESTMENTS (in thousands)

        As of June 30, 2015, short-term investments consisted of the following:

 
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair
Value
 

Available-for-sale securities:

                         

Corporate notes and bonds

  $ 430,855   $ 6   $ (1,591 ) $ 429,270  

U.S. agency obligations

    68,343     7     (61 )   68,289  

U.S. treasury securities

    55,434     7     (5 )   55,436  

Commercial paper

    39,259         (17 )   39,242  

Certificates of deposit

    10,320     3     (1 )   10,322  

Total available-for-sale securities

  $ 604,211   $ 23   $ (1,675 ) $ 602,559  

        As of December 31, 2014, the Company held no short-term investments.

        The following table summarizes the estimated fair value of our short-term investments, designated as available-for-sale and classified by the contractual maturity date of the securities as of the dates shown:

 
  June 30,
2015
  December 31,
2014
 

Due in one year or less

  $ 144,711   $  

Due in greater than one year

    457,848      

Total

  $ 602,559   $  

        The Company has certain available-for-sale securities in a gross unrealized loss position, all of which have been in such position for less than 12 months. The Company reviews its debt securities classified as short-term investments on a regular basis to evaluate whether or not any security has experienced an other-than-temporary decline in fair value. The Company considers factors such as the length of time and extent to which the market value has been less than the cost, the financial position and near-term prospects of the issuer and the Company's intent to sell, or whether it is more likely than not the Company will be required to sell the investment before recovery of the investment's amortized-cost basis. If the Company determines that an other-than-temporary decline exists in one of these securities, the unrealized losses attributable to the respective investment would be reclassified to realized loss within the statement of income. For debt securities, the portion of the write-down related to credit loss would be recognized to other income, net in our consolidated statements of income. Any portion not related to credit loss would be included in accumulated other comprehensive income. There were no impairments considered other-than-temporary as of June 30, 2015.

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INOVALON HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

4. SHORT-TERM INVESTMENTS (in thousands) (Continued)

        The following table shows the fair values and the gross unrealized losses of available-for-sale securities that have been in a gross unrealized loss position for less than 12 months, aggregated by investment category as of June 30, 2015:

 
  Estimated
Fair Value
  Gross
Unrealized
Losses
 

Corporate notes and bonds

  $ 409,095   $ (1,591 )

U.S. agency obligations

    52,770     (61 )

U.S. treasury securities

    26,506     (5 )

Commercial paper

    39,242     (17 )

Certificates of deposit

    2,639     (1 )

  $ 530,252   $ (1,675 )

5. FAIR VALUE MEASUREMENTS (in thousands)

        The carrying amounts of accounts receivable and other current assets, accounts payable and accrued liabilities approximate fair value due to their short-term nature. The Company's Credit Facilities (as defined in Note 8 below) approximate fair value because of their floating rate structure.

        Financial assets and financial liabilities recorded at fair value in the consolidated financial statements are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, which are directly related to the amount of subjectivity associated with the inputs to the valuation of these assets or liabilities are as follows:

      Level 1—Observable inputs, such as quoted prices in active markets for identical assets or liabilities.

      Level 2—Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be 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 assets or liabilities.

        Financial assets and financial liabilities measured at fair value are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires judgments and factors specific to the asset or liability.

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INOVALON HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

5. FAIR VALUE MEASUREMENTS (in thousands) (Continued)

        The following table presents the fair value hierarchy for financial assets measured at fair value on a recurring basis as of June 30, 2015:

 
  Level 1   Level 2   Level 3   Total  

Cash Equivalents:

                         

Money market funds

  $ 3,133           $ 3,133  

Corporate notes and bonds

        34,482         34,482  

U.S. agency obligations

        30,207         30,207  

Commercial paper

        43,888         43,888  

Short-term investments:

                         

Corporate notes and bonds

        429,270         429,270  

U.S. agency obligations

        68,289         68,289  

U.S. treasury securities

        55,436         55,436  

Commercial paper

        39,242         39,242  

Certificates of deposit

        10,322         10,322  

Total

  $ 3,133   $ 711,136   $   $ 714,269  

        The Company determines the fair value of its security holdings based on pricing from its pricing vendors. The valuation techniques used to measure the fair value of financial instruments having Level 2 inputs were derived from non-binding consensus prices that are corroborated by observable market data or quoted market prices for similar instruments. Such market prices may be quoted prices in active markets for identical assets (Level 1 inputs) or pricing determined using inputs other than quoted prices that are observable either directly or indirectly (Level 2 inputs). The Company performs procedures to ensure that appropriate fair values are recorded such as comparing prices obtained from other sources.

        As of December 31, 2014, the Company measured its money market investment balances, included in cash and cash equivalents, at fair value based on quoted prices that are equivalent to cost (Level 1); the Company did not have any assets measured at fair value on a recurring basis using significant other observable inputs (Level 2), or significant unobservable inputs (Level 3), or any liabilities measured at fair value as prescribed by ASC 820-10.

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INOVALON HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

6. PROPERTY, EQUIPMENT AND CAPITALIZED SOFTWARE (in thousands)

        Property, equipment and capitalized software consisted of the following:

 
  June 30,
2015
  December 31,
2014
 

Office and computer equipment

  $ 24,740   $ 23,844  

Leasehold improvements

    12,028     11,999  

Purchased software

    10,924     9,916  

Capitalized software

    46,517     39,432  

Furniture and fixtures

    4,984     4,894  

Land

    390     390  

Building

    1,797     1,750  

Work in process

    5,026     2,917  

Total

    106,406     95,142  

Less: accumulated depreciation and amortization

    (52,589 )   (44,180 )

Property, equipment and capitalized software, net

  $ 53,817   $ 50,962  

        The Company leases certain office equipment under capital lease agreements, with bargain purchase options at the end of the lease term. Leased office equipment included in property and equipment and capitalized software, net, at June 30, 2015 and December 31, 2014 was $660 and $961, respectively.

        Depreciation expense for the three months ended June 30, 2015 and 2014 was $4,551 and $3,681, respectively, and $8,924 and $7,003 for the six months ended June 30, 2015 and 2014, respectively. Amortization of the capital leases included in depreciation expense was $26 and $46 for the three months ended June 30, 2015 and 2014, respectively, and $53 and $68 for the six months ended June 30, 2015 and 2014, respectively. At June 30, 2015 and December 31, 2014, the Company had unamortized capitalized software costs, including costs classified as work in progress, of $32,992 and $28,417, respectively.

        At June 30, 2015 and December 31, 2014, work in process consisted primarily of purchased software licenses, computer equipment, and capitalized software, which was not placed into service.

7. GOODWILL AND INTANGIBLE ASSETS (in thousands, except years)

Goodwill

        There was no change in the carrying amount of goodwill during the three and six months ended June 30, 2015.

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INOVALON HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

7. GOODWILL AND INTANGIBLE ASSETS (in thousands, except years) (Continued)

Intangible Assets

        Intangible assets as of June 30, 2015 were as follows:

 
  June 30, 2015  
 
  Gross   Accumulated
Amortization
  Net   Weighted
Average Remaining
Useful Life (years)
 

Proprietary software technologies

  $ 16,077   $ (16,077 ) $      

Trademark

    360     (360 )        

Database

    6,500     (3,772 )   2,728     4.3  

Customer relationships

    13,650     (9,734 )   3,916     9.9  

Total

  $ 36,587   $ (29,943 ) $ 6,644        

        Intangible assets as of December 31, 2014 were as follows:

 
  December 31, 2014  
 
  Gross   Accumulated
Amortization
  Net   Weighted
Average Remaining
Useful Life (years)
 

Proprietary software technologies

  $ 16,077   $ (15,796 ) $ 281     0.3  

Trademark

    360     (360 )        

Database

    6,500     (3,447 )   3,053     4.8  

Customer relationships

    13,650     (9,537 )   4,113     10.4  

Total

  $ 36,587   $ (29,140 ) $ 7,447        

        Amortization expense for the three months ended June 30, 2015 and 2014 was $261 and $1,433, respectively, and $803 and $2,966 for the six months ended June 30, 2015 and 2014, respectively.

        Estimated future amortization expense of intangible assets, based upon the Company's intangible assets at June 30, 2015, is as follows:

 
  Amount  

Year ending December 31:

       

Remainder of 2015

  $ 522  

2016

    1,044  

2017

    1,044  

2018

    1,044  

2019

    814  

Thereafter

    2,176  

Total

  $ 6,644  

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INOVALON HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

8. CREDIT FACILITIES (in thousands)

        On September 19, 2014, the Company entered into a Credit and Guaranty Agreement, with a group of lenders including Goldman Sachs Bank USA, as administrative agent, to provide credit facilities in the aggregate maximum principal amount of $400,000, consisting of a senior unsecured term loan facility in the original principal amount of $300,000 (the "Term Loan Facility"), and a senior unsecured revolving credit facility in the maximum principal amount of $100,000 (the "Revolving Credit Facility"), (together with the Term Loan Facility, the "Credit Facilities").

        Credit facilities consisted of the following:

 
  June 30,
2015
  December 31,
2014
 

Revolving Credit Facility

  $   $  

Term Loan Facility

    290,000     300,000  

Total Credit Facilities

    290,000     300,000  

Less: current portion

    16,250     18,750  

Non-current Credit Facilities

  $ 273,750   $ 281,250  

        The Revolving Credit Facility, with a maximum principal amount of $100,000, became available to the Company on February 18, 2015, upon the consummation of its IPO.

        As of June 30, 2015 and December 31, 2014, the Company was in compliance with the financial covenants of the Credit Facilities.

        Scheduled maturity of the Credit Facilities as of June 30, 2015 follows:

Year ending December 31:
  Amount  

Remainder of 2015

  $ 8,750  

2016

    15,000  

2017

    30,000  

2018

    45,000  

2019

    191,250  

Total

  $ 290,000  

        During the six months ended June 30, 2015, the Company paid $10,000 for the scheduled maturity of the outstanding principal on the Credit Facilities.

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INOVALON HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

9. COMMITMENTS AND CONTINGENCIES (in thousands)

        Operating Leases—The Company leases office space under operating lease arrangements, some of which contain renewal options. Future non-cancellable lease payments as of June 30, 2015 were as follows:

Year ending December 31,
  Amount  

Remainder of 2015

  $ 3,248  

2016

    6,331  

2017

    6,110  

2018

    4,880  

2019

    844  

Total

  $ 21,413  

        Total expense under operating leases was $1,573, and $1,912 during the three months ended June 30, 2015 and 2014, respectively, and $3,200 and $3,799 for the six months ended June 30, 2015 and 2014, respectively. Certain operating leases contain rent escalation clauses, which are recorded on a straight-line basis over the initial term of the lease, with the difference between the rent paid and the straight-line rent recorded as a deferred rent liability. Lease incentives received from landlords are recorded as deferred rent liabilities and are amortized on a straight-line basis over the lease term as a reduction to rent expense. The deferred rent liability was $2,945 and $3,186 at June 30, 2015 and December 31, 2014, respectively.

        Capital Leases—The total capital lease liability at June 30, 2015 and December 31, 2014 was $389 and $267, respectively, which approximates fair value due to the short duration of the obligations.

        Litigation—From time to time, the Company is involved in various litigation matters arising out of the normal course of business. The Company consults with legal counsel on those issues related to litigation and seeks input from other experts and advisors with respect to such matters. Estimating the probable losses or a range of probable losses resulting from litigation, government actions and other legal proceedings is inherently difficult and requires an extensive degree of judgment, particularly where the matters involve indeterminate claims for monetary damages, may involve discretionary amounts, present novel legal theories, are in the early stages of the proceedings, or are subject to appeal. Whether any losses, damages or remedies ultimately resulting from such matters could reasonably have a material effect on the Company's business, financial condition, results of operation, or cash flows will depend on a number of variables, including, for example, the timing and amount of such losses or damages (if any) and the structure and type of any such remedies. The Company's management does not presently expect any litigation matters to have a material adverse impact on the consolidated financial statements of the Company.

10. STOCK-BASED COMPENSATION (in thousands, except share and per share amounts, and percentages)

        On February 18, 2015, the date of the completion of the Company's IPO, the Company's 2015 Omnibus Incentive Plan (the "2015 Plan") became effective. The 2015 Plan provides for the grant of incentive stock options, within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"), to the Company's employees and any parent and subsidiary employees, and for

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INOVALON HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

10. STOCK-BASED COMPENSATION (in thousands, except share and per share amounts, and percentages) (Continued)

the grant of non-qualified stock options, stock appreciation rights, restricted stock, RSUs, dividend equivalent rights, cash-based awards (including annual cash incentives and long-term cash incentives), and any combination thereof to the Company's employees, directors, and consultants and to employees, directors, and consultants of certain affiliated entities. The Company has reserved for issuance under the 2015 Plan shares of its Class A common stock equal to the sum of: (i) 7,335,430 shares of Class A common stock; and (ii) the number of shares of its Class A common stock in respect of the number of shares of its common stock underlying awards granted under the Company's 2007 Long-Term Incentive Plan, which was terminated upon completion of the IPO, (6,940,055 as of June 30, 2015), that are forfeited, canceled, or expire (whether voluntarily or involuntarily).

Restricted Stock Awards

        On May 28, 2015, the Company granted 71,946 RSAs pursuant to the 2015 Plan. RSAs granted to directors fully vest upon the one year anniversary of the award grant date, and RSAs granted to employees vest ratably over five years on each anniversary of the award grant date. Upon vesting, the Company will deliver shares of the Company's Class A common stock to the holders. Pursuant to the terms of the awards, any unvested shares terminate upon the RSA holders' separation from the Company. The grant date fair value of the RSAs was $2,000, in aggregate, or $27.80 per RSA. The Company will recognize share-based compensation expense following the straight-line method, net of estimated forfeitures over the requisite service period. The Company estimates future forfeitures at the date of grant and revises the estimates, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Restricted Stock Units

        On March 5, 2015, the Company granted 76,273 RSUs pursuant to the 2015 Plan. The awards granted vest ratably over five years on each anniversary of the award grant date, and upon vesting, the Company will deliver to the holder shares of the Company's Class A common stock under the 2015 Plan. Pursuant to the terms of the awards, any unvested shares terminate upon the RSU holders' separation from the Company. The grant date fair value of the RSUs was $2,337, in aggregate, or $30.64 per RSU. The Company will recognize share-based compensation expense following the straight-line method, net of estimated forfeitures over the requisite service period. The Company estimates future forfeitures at the date of grant and revises the estimates, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Employee Stock Purchase Plan

        On February 18, 2015, the date of the completion of the Company's IPO, the 2015 Employee Stock Purchase Plan ("2015 ESPP") became effective. The 2015 ESPP provides for six-month purchase periods (commencing each March 1 and September 1) and that the purchase price for shares of Class A common stock purchased under the 2015 ESPP will be 85% of the fair market value of the Company's Class A common stock on the last day of the applicable offering period. Eligible employees will be able to select a rate of payroll deduction between 1% and 15% of their base cash compensation subject to a maximum payroll deduction per offering period of $7,500. The 2015 ESPP is intended to qualify as an employee stock purchase plan under Section 423 of the Code. The Company reserved 1,833,857 shares of Class A common stock for issuance under the 2015 ESPP.

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

        The following discussion and analysis should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2014, as filed with the Securities and Exchange Commission (the "SEC") on March 31, 2015. Unless we otherwise indicate or the context requires, references to the "Company," "Inovalon," "we," "our," and "us" refer to Inovalon Holdings, Inc. and its consolidated subsidiaries.

Note Regarding Forward-Looking Statements

        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 (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). All statements contained in this Quarterly Report other than statements of historical fact, including but not limited to statements regarding our future results of operations and financial position, our business strategy and plans, market growth, and our objectives for future operations, are forward-looking statements. The words "believe," "may," "will," "estimate," "continue," "anticipate," "intend," "expect," and similar expressions are intended to identify forward-looking statements. We have based these forward-looking statements largely on our current expectations and projections about future events and trends that we believe may affect our financial condition, results of operations, business strategy, short-term and long-term business operations and objectives and financial needs. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible for our management to predict all risks, 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 results to differ materially from those contained in any forward-looking statements we may make. In light of these risks, uncertainties and assumptions, the future events and trends discussed in this Quarterly Report may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements.

        Factors that may cause actual results to differ from expected results include, among others:

    our future financial performance, including our ability to continue and manage our growth;

    our ability to retain our client base;

    the effect of the concentration of our revenue among our top clients;

    our ability to innovate and adapt our platforms and toolsets;

    the effects of regulations applicable to us, including regulations relating to data protection and data privacy;

    the effects of consolidation in the managed care industry;

    the effects of tax legislation changes in jurisdictions within which we operate;

    the ability to protect the privacy of our clients' data and prevent security breaches;

    the effect of competition on our business; and

    the efficacy of our platforms and toolsets.

        Forward-looking statements are only current predictions and are subject to known and unknown risks, uncertainties, and other factors that may cause our actual results, levels of activity, performance, or achievements to be materially different from those anticipated by such statements. These factors include, among other factors, those set forth in our Annual Report on Form 10-K for the fiscal year ended December 31, 2014, under the heading Part I, Item 1A, "Risk Factors".

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        You should not rely upon forward-looking statements as predictions of future events. The events and circumstances reflected in the forward-looking statements may not be achieved or occur. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. We are under no duty to, and we disclaim any obligation to, update any of these forward- looking statements after the date of this Quarterly Report or to conform these statements to actual results or revised expectations.


Overview

        We are a leading technology company that combines advanced cloud-based data analytics and data-driven intervention platforms to achieve meaningful impact in clinical and quality outcomes, utilization, and financial performance across the healthcare landscape. We deliver value to our clients by turning data into insights and those insights into action. Currently, our clients include health plans, hospitals, physicians, patients, pharmaceutical companies and researchers.

        Our large proprietary datasets, advanced integration technologies, sophisticated predictive analytics, and deep subject matter expertise allow us to provide seamless, end-to-end platforms that bring the benefits of big data and large-scale analytics to the point of care. Our data analytics platforms identify gaps in care, quality, data integrity, and financial performance in our clients' datasets. Our data-driven intervention platforms enable our clients to take the insights derived from the analytics and implement unique, patient-level solutions, drive impact and enhance patient engagement.

        We generate the substantial majority of our revenue through the sale or subscription licensing of our cloud-based data analytics and data-driven intervention platform services. Since our inception, we have experienced significant growth.

        Our revenue for the three and six months ended June 30, 2015, was $117.6 million and $211.3 million, respectively, representing 17% and 14% growth over the three and six months ended June 30, 2014, respectively. Net income for the three and six months ended June 30, 2015 was $26.1 million and $39.9 million, respectively, representing 22% and 19% of revenue for the three and six months ended June 30, 2014, respectively. For the three and six months ended June 30, 2015, we generated Adjusted EBITDA of $52.7 million and $84.8 million, respectively, representing a 17% and 14% increase over the same periods, respectively, in the prior year, and generated an Adjusted EBITDA margin of 44.8% and 40.1% for the three and six months ended June 30, 2015. Non-GAAP net income for the three and six months ended June 30, 2015 was $27.4 million and $42.5 million, respectively, representing 23% and 20% of revenue, respectively. Adjusted EBITDA, Adjusted EBITDA margin, and Non-GAAP net income are measures that are not presented in accordance with GAAP. For a reconciliation of net income to Adjusted EBITDA and Non-GAAP net income, and definitions of the measures including why they are useful, see "Non-GAAP Financial Measures," provided below.

        On February 18, 2015, we completed our initial public offering of 22,222,222 shares of Class A common stock and, upon the underwriters' exercise of their option to purchase additional shares, issued an additional 3,142,581 shares of Class A common stock for a total of 25,364,803 shares issued (the "IPO"). All of the shares issued in the IPO were primary shares offered by us as none of our stockholders sold any shares in the IPO. The offering price of the shares sold in the IPO was $27.00 per share, resulting in net proceeds to us, after underwriters' discounts and commissions and other expenses payable by us, of $639.1 million. Our Class A common stock is currently traded on the NASDAQ Global Select Market under the symbol "INOV."

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Quarterly Key Metrics

        We review certain metrics quarterly, including the key metrics shown in the table below. We believe that these metrics are indicative of our overall level of analytical activity and the underlying growth in our business.

 
  As of June 30,  
 
  2015   2014  

Quarterly Key Metrics (in thousands)(1):

             

MORE2 Registry® dataset metrics

             

Unique patient count(2)

    123,385     112,325  

Medical event count(3)

    9,761,208     8,687,886  

Trailing 12 month Patient Analytics Months (PAM)(4)

    18,791,504     14,511,058  

(1)
MORE2 Registry® dataset metrics and Trailing 12 month PAM, each of which is presented in the table, are key operating metrics that management uses to assess our level of operational activity. While we believe that each of these metrics is indicative of our overall level of analytical activity and the underlying growth in our business, increases or decreases in these metrics do not necessarily correlate to proportional increases or decreases in revenue, Adjusted EBITDA, net income or Non-GAAP net income. For instance, although increased levels of analytical activity historically have corresponded to increases in revenue over the long term, differences in fees charged for different analytical packages exist and differences in how analytics trigger the applicability of our cloud-based data-driven intervention platforms may result in increases in analytical activity that do not result in proportional increases in revenue, Adjusted EBITDA, net income or Non-GAAP net income (and vice versa). Accordingly, while we believe the presentation of these operating metrics is helpful to investors in understanding our business; these metrics have limitations and should not be considered as substitutes for analysis of our financial results reported under GAAP. In addition, we believe that other companies, including companies in our industry, do not present similar operating metrics and that there is no commonly accepted method of calculating these metrics, which may reduce their usefulness as comparative measures.

(2)
Unique patient count is defined as each unique, longitudinally matched, de-identified natural person represented in our MORE2 Registry® as of the end of the period presented.

(3)
Medical event count is defined as the total number of discrete medical events as of the end of the period presented (for example, a discrete medical event typically results from the presentation of a patient to a physician for the diagnosis of diabetes and congestive heart failure in a single visit, the presentation of a patient to an emergency department for chest pain, etc.).

(4)
PAM is defined as the sum of the analytical processes performed on each respective patient within patient populations covered by clients under contract. As used in the metric, an "analytical process" is a distinct set of data calculations undertaken by us which is initiated and completed by our analytical platform to examine a specific question such as whether a patient is believed to have a condition such as diabetes, or worsening of the disease, during a specific time period.


Trends and Factors Affecting Our Future Performance

        A number of factors influence our growth and performance. We see many of these factors as being more quantitatively driven, such as the rate of growth of the underlying data counts within our datasets, the ongoing investment in innovation, and our level of analytical activity. Additionally, there are several factors that influence our growth and performance that are less quantitatively driven, including seasonality, macro-economic forces, and trends within healthcare (such as payment models,

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incentivization, and regulatory oversight), that can be driven by changes in federal and state laws and regulations, as well as private sector market forces.

        Growth of Datasets.    Healthcare costs in the United States have been increasing significantly for many years. This rise in healthcare costs has driven a broad transition from consumption-based payment models to quality and value-based payment models across the healthcare landscape. As a result, the specific disease and comorbidity status, clinical and quality outcomes, resource utilization, and care details of the individual patient have become increasingly relevant to the various constituents across the healthcare delivery system. Concurrently, the count and complexity of diseases, diagnostics, and treatmentsas well as payment models and regulatory oversight requirementshave soared. In this setting, granular data has become critical to determining and improving quality and financial performance in healthcare. Our MORE2 Registry® is our largest principal dataset and serves as a proxy for our general growth of datasets. The growth of our datasets that inform our analytical capabilities and comparative analytics is a key aspect of our provision of value to our clients and is indicative of our overall growth and capabilities.

        Innovation and Platform Development.    Our business model is based upon our ability to deliver value to our clients through the combination of advanced, cloud-based data analytics and cloud-based data-driven intervention platforms focused on the achievement of meaningful and measureable improvements in clinical and quality outcomes, utilization, and financial performance in healthcare. Our ability to deliver this value is dependent in part on our ability to continue to innovate, design new capabilities, and bring these capabilities to market in an enterprise scale. Our continued ability to innovate our platform and bring differentiated capabilities to market is an important aspect of our business success, and accordingly, we expect investment in innovation to increase as a percentage of revenue when examined on a full year basis, although, timing of investment may vary from quarter to quarter. Our investment in innovation includes costs for research and development, capitalized software development, and expenditures related to hardware and software platforms on which our data analytics and data-driven interventions capabilities are deployed as summarized below (in thousands, except percentages).

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2015   2014   2015   2014  

Investment in Innovation:

                         

Research and development(1)

  $ 5,504   $ 5,144   $ 10,915   $ 11,192  

Capitalized software development(2)

    5,237     4,054     9,745     7,678  

Research and development infrastructure investments(3)

    439     1,856     539     2,940  

Total investment in innovation

  $ 11,180   $ 11,054   $ 21,199   $ 21,810  

As a percentage of revenue

                         

Research and development(1)

    5 %   5 %   5 %   6 %

Capitalized software development(2)

    5 %   4 %   5 %   4 %

Research and development infrastructure investments(3)

    0 %   2 %   0 %   2 %

Total investment in innovation

    10 %   11 %   10 %   12 %

(1)
Research and development primarily includes employee costs related to the development and enhancement of our service offerings.

(2)
Capitalized software development includes capitalized costs incurred to develop and enhance functionality for our data analytics and data-driven intervention platforms.

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(3)
Research and development infrastructure investments include strategic expenditures related to hardware and software platforms under development or enhancement.

        Data Analytics and Data-Driven Intervention Mix.    Our business and operational models are highly scalable and leverage variable costs to support revenue generating activities. Our data analytic service costs are less variable in nature and require lower incremental capital expenditures. As a result, following initial development and deployment investments, our big data analytics platform and data technology capabilities allow us to process significant volumes of transactions with lower incremental costs. Conversely, our data-driven intervention service costs are generally variable in nature and require incremental costs to generate additional revenue. As a result, the mix of our data analytics and data interventions activities affects our financial performance. Over the past several years the percentage of our business which is derived from data and analytics subscription fees has been increasing, as has the portion of the data-driven intervention platform services that are fully automated. Key metrics and measures regarding data analytics and data-driven intervention mix are presented annually, as such we provide key metrics and measures for data analytics and data-driven intervention mix on an annual basis.

        Client and Analytical Process Count Growth.    Our business is generally driven by the number of underlying patients for which our analytics and data-driven intervention platforms are being utilized. In addition to this patient count, however, the number of specific analytical processes and data-driven interventions services for which any one specific patient population is engaged, is also a driver. As such, increasing the size, number, and analytical portfolio penetration of populations for which we provide our analytics and data-driven intervention platform services is important to the overall growth of our business. In general, as the application of our analytics and data-driven intervention platform services deliver value, our clients often engage with us to utilize additional analytics and data-driven intervention platform services. Our ability to deliver demonstrable value, retain clients, add new clients, and realize growth within existing clients affects our financial performance. On an annual basis we track the number of patient populations for which we are engaged to provide data analytics and provide data-driven intervention services (each engagement memorialized with a contracted statement of work, or SOW).

        In addition, we track the number of analytical processes that we run on patients each month in fulfillment of our client contracts, as totaled for the trailing 12 months. We believe that PAM is indicative of our overall level of analytical activity, and we expect our period-to-period comparisons of our PAM to be indicative of underlying growth of our business, although changes in levels of analytical activity do not always directly translate to changes in financial performance of our business. Differences in fees charged for different analytical packages exist and differences in how analytics trigger the applicability of our data-driven intervention platforms may result in increases in analytical activity that do not result in proportional increases in revenue, Adjusted EBITDA, net income or Non-GAAP net income (and vice versa). Therefore, in situations in which a new engaged client SOW is initiated for analytical processes that have a higher than average fee rate, revenue could expand disproportionately faster than the increase in PAM.

        Seasonality.    We typically experience the highest level of revenue in the second quarter of each year, which coincides with specific accreditation and regulatory deadlines. In particular, as a result of certain data filing deadlines established by CMS, state departments of health, and the National Committee for Quality Assurance, or NCQA, clients typically engage us to perform higher levels of data-driven analytics and data-driven interventions during the first two quarters of each year when compared to other quarters of the year. Conversely, the third quarter of the year has relatively few such deadlines and, as such, typically has lower levels of analytics engagement activity than other quarters of the year.

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        Macro-Economic and Macro-Industry Trends.    Our clients are affected, sometimes directly, and sometimes counter-intuitively, by macro-economic trends such as economic growth (or economic recession), inflation, and unemployment. Further, industry trends in federal and state laws and regulations, as well as emerging trends in private sector payment models, affect our clients' businesses and their need for technologies and services to support these challenges. These factors have various effects on our business, and on occasion have resulted in the slowing or cessation of the decision-making process by clients adopting our technologies and services. On the other hand, changes in macro-economic trends and the industry landscape have accelerated the need for our technologies and services from time-to-time, particularly as regulators introduce complex requirements with which our clients must comply.

        Shift to Fully Automated Data-Driven Intervention Platform Services.    We view the decreased proportion of revenue derived from partially automated data-driven intervention platform services as a positive reflection of our cloud-based interconnectivity and automation capabilities. The proportion of our revenue derived from pure cloud-based data analytics and fully automated data-driven intervention platform services revenue is expected to continue to expand over time as a percentage of total revenue as a result of our continued expansion of our cloud-based interconnectivity technologies and the continued expansion of interconnectivity within the healthcare landscape. In order to drive value for our clients and serve them irrespective of their level of connectivity, we continue to provide cloud-based partially automated data-driven intervention platform services, converting the performance of such services to cloud-based fully automated data-driven intervention platform services wherever possible. As the healthcare infrastructure becomes more interconnected and our integration and interconnectivity technologies continue to expand, we believe that we will be able to achieve more rapid implementation, and greater value impact, at more efficient costs.


Critical Accounting Policies

        Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with GAAP. In connection with the preparation of our consolidated financial statements, we are required to make assumptions and estimates about future events, and apply judgments that affect the reported amounts of assets and liabilities, the disclosures of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. We base our assumptions, estimates, and judgments on historical experience, current trends, and other factors we believe to be relevant at the time we prepare our consolidated financial statements. The accounting estimates used in the preparation of our consolidated financial statements will change as new events occur, as more experience is acquired, as additional information is obtained, and as our operating environment changes. On a regular basis, we review the accounting policies, assumptions, and evaluate and update our assumptions, estimates, and judgments to ensure that our consolidated financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material.

        Critical accounting policies are those policies that affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. For a more detailed discussion of our critical accounting policies, please refer to our Annual Report on Form 10-K for the fiscal year ended December 31, 2014, filed with the SEC on March 31, 2015.

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Components of Results of Operations

Revenue

        We earn revenue through the sale or subscription licensing of our cloud-based data analytics and data-driven intervention platform services.

        Our cloud-based data analytics services are performed either at the beginning of a data-driven intervention process, which typically aligns with regulatory submission deadlines, or on a monthly basis, depending on the particular client's needs. Cloud-based data analytics revenue is driven primarily by the number of identified gaps in care, quality, data integrity, and financial performance identified in a client's dataset, the number of unique patients in a client's dataset, a minimum data analytics processing fee, and a contractually negotiated transactional price for each identified gap or unique patient. Subscription licensing revenue is driven primarily by the number of clients, the number of unique patients in a client's population dataset, the number of analytical services contracted for by a client, and the contractually negotiated price of such services.

        Cloud-based data-driven intervention platform service revenue represents revenue that is generated from fully automated processes (i.e., those processes that require no material variable-based labor components) and partially automated processes (i.e., those processes that require a degree of variable-based labor components). The Company expects the expanding emphasis on data-driven analytics services, and therefore the increased share of Inovalon revenue from such services, to continue on a year-to-year basis. As many of our analytical capabilities are designed to identify gaps in care, quality, utilization, compliance, and/or other gaps that may impact our clients' achievement of greater healthcare quality and financial performance, our cloud-based data driven intervention platform services revenue is driven primarily by the results of our cloud-based data analytics processes and our clients' desire to utilize our cloud-based data-driven intervention platforms to resolve such identified gaps. Informed by our analytics, our cloud-based data-driven intervention platforms are designed to enable the resolution of specific gaps through the aggregation of specific data or achievement of specific impact. Revenue from our intervention platform utilization is generally driven by the quantity and type of completed interventions enabled by our platform, and a contractually negotiated transactional price for each such intervention.

Cost of Revenue

        Cost of revenue consists primarily of expenses for employees who provide direct contractual services to our clients, including salaries, benefits, discretionary incentive compensation, employment taxes, severance, and equity compensation costs. Cost of revenue also includes expenses associated with the integration, and verification of data and other service costs incurred to fulfill our revenue contracts. Cost of revenue does not include allocated amounts for occupancy expense and depreciation and amortization. Many of the elements of our cost of revenue are relatively variable and semi-variable, and can be reduced in the near-term to offset any decline in our revenue.

        Our business and operational models are designed to be highly scalable and leverage variable costs to support revenue generating activities. While we expect to grow our headcount over time to capitalize on our market opportunities, we believe our increased investment in automation, electronic health record integration capabilities, and economies of scale in our operating model, will position us to grow our revenue at a greater rate than our cost of revenue.

Sales and Marketing

        Sales and marketing expense consists primarily of employee-related expenses, including salaries, benefits, commissions, discretionary incentive compensation, employment taxes, severance, and equity compensation costs for our employees engaged in sales, sales support, business development, and

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marketing. Sales and marketing expense also includes operating expenses for marketing programs, research, trade shows and brand messages, and public relations costs. Our sales and marketing expense excludes any allocation of occupancy expense and depreciation and amortization.

        We expect our sales and marketing expenses to increase as we strategically invest to expand our business. We expect to hire additional sales personnel and related support personnel to capture an increasing amount of our market opportunity. As we scale our sales and marketing activities in the short to medium term, we expect these expenses to increase in both absolute dollars and as a percentage of revenue.

Research and Development

        Research and development expense (one component of our investment in innovation) consists primarily of employee-related expenses, including salaries, benefits, discretionary incentive compensation, employment taxes, severance, and equity compensation costs for our software developers, engineers, analysts, project managers, and other employees engaged in the development and enhancement of our service offerings. Research and development expense also includes certain third party consulting fees. Our research and development expense excludes any allocation of occupancy expense and depreciation and amortization. Research and development efforts that meet certain GAAP criteria are reclassified from expense to capital assets as internal-use software in support of our continuous investment in innovation and platform development.

        We expect to continue our focus on developing new data analytics and data-driven intervention platforms and enhancing our existing data analytics and data-driven intervention platforms. As a result, and exclusive of any capitalizable amounts attributable to our continuous investment in innovation, we expect our research and development expense to continue to increase in absolute dollars, although it may vary from period to period as a percentage of revenue.

General and Administrative

        Our general and administrative expense consists primarily of employee-related expenses including salaries, benefits, discretionary incentive compensation, employment taxes, severance, and equity compensation costs, for employees who are responsible for management information systems, administration, human resources, finance, legal, and executive management. General and administrative expense also includes occupancy expenses (including rent, utilities, communications, and facilities maintenance), professional fees, consulting fees, insurance, travel, and other expenses. Our general and administrative expense excludes depreciation and amortization.

        We expect our general and administrative expense to increase as we expand our business and incur incremental costs associated with being a public company. However, excluding certain increases as a result of being a public company, we expect our general and administrative expense to grow at a lower rate than revenue.

Depreciation and Amortization Expense

        Our depreciation and amortization expense consists primarily of depreciation of fixed assets, amortization of capitalized software development costs, and amortization of acquisition-related intangible assets.

Provision for Income Taxes

        Provision for income taxes consists of federal and state income taxes in the United States and foreign income taxes from the territory of Puerto Rico, including deferred income taxes reflecting the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.

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Results of Operations

        The following table set forth our consolidated statement of operations data for each of the periods presented (in thousands):

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2015   2014   2015   2014  

Revenue

  $ 117,618   $ 100,957   $ 211,251   $ 185,631  

Expenses:

                         

Cost of revenue(1)

    33,602     28,899     65,453     57,486  

Sales and marketing(1)

    2,377     1,612     4,227     2,945  

Research and development(1)

    5,504     5,144     10,915     11,192  

General and administrative(1)

    25,327     21,341     49,585     41,275  

Depreciation and amortization

    4,812     5,114     9,727     9,969  

Total operating expenses

    71,622     62,110     139,907     122,867  

Income from operations

    45,996     38,847     71,344     62,764  

Other income and (expenses):

                         

Interest income

    615     1     623     3  

Interest expense

    (1,105 )   (49 )   (2,208 )   (62 )

Income before taxes

    45,506     38,799     69,759     62,705  

Provision for income taxes

    19,370     15,169     29,864     24,518  

Net income

  $ 26,136   $ 23,630   $ 39,895   $ 38,187  

                                                 

                         

(1)    Includes stock-based compensation expense as follows:

                   

Cost of revenue

  $ 29   $   $ 57   $  

Sales and marketing

    41         56      

Research and development

    298         660      

General and administrative

    1,554     436     2,921     822  

Total stock-based compensation expense

  $ 1,922   $ 436   $ 3,694   $ 822  

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        The following table sets forth our consolidated statement of operations data for each of the periods presented as a percentage of revenue:

 
  Three Months
Ended June 30,
  Six Months
Ended June 30,
 
 
  2015   2014   2015   2014  

Revenue

    100 %   100 %   100 %   100 %

Expenses:

                         

Cost of revenue

    29     29     31     31  

Sales and marketing

    2     2     2     2  

Research and development

    5     5     5     6  

General and administrative

    21     21     23     22  

Depreciation and amortization

    4     5     5     5  

Total operating expenses

    61     62     66     66  

Income from operations

    39     38     34     34  

Other income and (expenses):

                         

Interest income

    1              

Interest expense

    (1 )       (1 )    

Income before taxes

    39     38     33     34  

Provision for income taxes

    16     15     14     13  

Net income

    23 %   23 %   19 %   21 %

Three and Six Months Ended June 30, 2015 and 2014

Revenue

 
  Three Months Ended
June 30,
  2014 to 2015
Change
  Six Months Ended
June 30,
  2014 to 2015
Change
 
 
  2015   2014   $   %   2015   2014   $   %  
 
  (dollars in thousands)
 

Total revenue

  $ 117,618   $ 100,957   $ 16,661     17 % $ 211,251   $ 185,631   $ 25,620     14 %

        Three and Six Months Ended June 30, 2015 compared with Three and Six Months Ended June 30, 2014.    Revenue during the three months ended June 30, 2015 increased by approximately $16.7 million, or 17%, compared with the three months ended June 30, 2014. The increase was primarily attributable to an increase in revenue from new clients of $9.4 million along with a net increase of $7.3 million from existing clients.

        Revenue during the six months ended June 30, 2015 increased by approximately $25.6 million, or 14%, compared with the six months ended June 30, 2014. The increase was primarily attributable to an increase in revenue from new clients of $14.6 million along with a net increase of $11.0 million from existing clients.

Cost of Revenue

 
  Three Months Ended
June 30,
  2014 to 2015
Change
  Six Months Ended
June 30,
  2014 to 2015
Change
 
 
  2015   2014   $   %   2015   2014   $   %  
 
  (dollars in thousands)
 

Cost of revenue

  $ 33,602   $ 28,899   $ 4,703     16 % $ 65,453   $ 57,486   $ 7,967     14 %

Cost of revenue as a percentage of revenue

    29 %   29 %               31 %   31 %            

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        Three and Six Months Ended June 30, 2015 compared with Three and Six Months Ended June 30, 2014.    During the three months ended June 30, 2015, cost of revenue increased by approximately $4.7 million, or 16%, compared with the three months ended June 30, 2014. The $4.7 million increase in cost of revenue was primarily due to the corresponding increase in revenue of $16.7 million, or 17%, and resulted from an increase in employee-related expenses, driven by an increase in providing a greater volume of partially-automated data-driven intervention services for our new and existing clients that leveraged insights enabled by our cloud-based data analytics during the three months ended June 30, 2015. Cost of revenue as a percentage of revenue was 29% for the three months ended June 30, 2015 and 2014.

        During the six months ended June 30, 2015, cost of revenue increased by approximately $8.0 million, or 14%, compared with the six months ended June 30, 2014. The increase in cost of revenue was directly proportional to the increase in revenue of $25.6 million, or 14%, during the six months ended June 30, 2015. The $8.0 million increase in cost of revenue was primarily due to an increase in employee-related expenses related to providing a greater volume of partially-automated data-driven intervention services for our new and existing clients that leveraged insights enabled by our cloud-based data analytics during the six months ended June 30, 2015. Cost of revenue as a percentage of revenue was 31% for the six months ended June 30, 2015 and 2014.

Sales and Marketing

 
  Three Months Ended
June 30,
  2014 to 2015
Change
  Six Months Ended
June 30,
  2014 to 2015
Change
 
 
  2015   2014   $   %   2015   2014   $   %  
 
  (dollars in thousands)
 

Sales and marketing

  $ 2,377   $ 1,612   $ 765     47 % $ 4,227   $ 2,945   $ 1,282     44 %

Sales and marketing as a percentage of revenue

    2 %   2 %               2 %   2 %            

        Three and Six Months Ended June 30, 2015 compared with Three and Six Months Ended June 30, 2014.    During the three months ended June 30, 2015, sales and marketing expenses increased by approximately $0.8 million, or 47%, compared with the three months ended June 30, 2014. The increase was primarily attributable to increased employee related expenses of $0.7 million, which was driven by our investment in additional sales personnel to focus on adding new clients and capturing an increased amount of our market opportunity, along with an increase of $0.1 million in marketing program spend.

        During the six months ended June 30, 2015, sales and marketing expenses increased by approximately $1.3 million, or 44%, compared with the six months ended June 30, 2014. The increase was primarily attributable to increased employee related expenses of $0.9 million, which was driven by our investment in additional sales personnel to focus on adding new clients and capturing an increased amount of our market opportunity, along with an increase of $0.4 million in marketing program spend.

Research and Development

 
  Three Months Ended
June 30,
  2014 to 2015
Change
  Six Months Ended
June 30,
  2014 to 2015
Change
 
 
  2015   2014   $   %   2015   2014   $   %  
 
  (dollars in thousands)
 

Research and development

  $ 5,504   $ 5,144   $ 360     7 % $ 10,915   $ 11,192   $ (277 )   (2 )%

Research and development as a percentage of revenue

    5 %   5 %               5 %   6 %            

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        Three and Six Months Ended June 30, 2015 compared with Three and Six Months Ended June 30, 2014.    During the three months ended June 30, 2015, research and development expense increased by approximately $0.4 million, or 7%, compared with the three months ended June 30, 2014. The increase of approximately $0.4 million was primarily attributable to an increase of $1.3 million in employee-related expenses and certain third-party consulting fees, which includes an increase of $0.3 million in stock based compensation expense, and was partially offset by growth in the capitalization of internal-use software development costs of $0.9 million compared to the prior period.

        During the six months ended June 30, 2015, research and development expense decreased by approximately $0.3 million, or 2%, compared with the six months ended June 30, 2014. The decrease of approximately $0.3 million was primarily attributable to growth in the capitalization of internal-use software development costs of $1.9 million compared to the prior period, which was partially offset by an increase of $1.6 million in employee-related expenses and certain third-party consulting fees, which includes an increase of $0.7 million in stock based compensation expense.

General and Administrative

 
  Three Months
Ended June 30,
  2014 to 2015
Change
  Six Months
Ended June 30,
  2014 to 2015
Change
 
 
  2015   2014   $   %   2015   2014   $   %  
 
  (dollars in thousands)
 

General and administrative

  $ 25,327   $ 21,341   $ 3,986     19 % $ 49,585   $ 41,275   $ 8,310     20 %

General and administrative as a percentage of revenue

    22 %   21 %               23 %   22 %            

        Three and Six Months Ended June 30, 2015 compared with Three and Six Months Ended June 30, 2014.    During the three months ended June 30, 2015, general and administrative expense increased by approximately $4.0 million, or 19%, compared with the three months ended June 30, 2014. Throughout the second half of 2014 and first half of 2015, we increased our investment in incremental personnel to support our growth and our transition from being a private to a public company. Our investment resulted in an increase in employee related costs of $3.9 million, which includes an increase of approximately $1.1 million related to stock-based compensation expense, for the three months ended June 30, 2015 compared to the prior year.

        During the six months ended June 30, 2015, general and administrative expense increased by approximately $8.3 million, or 20%, compared with the six months ended June 30, 2014. Throughout the second half of 2014 and first half of 2015, we increased our investment in incremental personnel to support our growth and our transition from being a private to a public company. Our investment resulted in an increase in employee related costs of $8.2 million, which includes an increase of approximately $2.1 million related to stock-based compensation expense, for the six months ended June 30, 2015 compared to the prior year.

Depreciation and Amortization

 
  Three Months
Ended June 30,
  2014 to 2015
Change
  Six Months
Ended June 30,
  2014 to 2015
Change
 
 
  2015   2014   $   %   2015   2014   $   %  
 
  (dollars in thousands)
 

Depreciation and amortization

  $ 4,812   $ 5,114   $ (302 )   (6 )% $ 9,727   $ 9,969   $ (242 )   (2 )%

Depreciation and amortization as a percentage of revenue

    4 %   5 %               5 %   5 %            

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        Three and Six Months Ended June 30, 2015 compared with Three and Six Months Ended June 30, 2014.    During the three months ended June 30, 2015, depreciation and amortization expense decreased by approximately $0.3 million, or 6%, compared with the three months ended June 30, 2014. Depreciation and amortization expense as a percentage of revenue, decreased to 4% of revenue for the three months ended June 30, 2015, as compared with 5% of revenue for the three months ended June 30, 2014. During the three months ended June 30, 2015 amortization of intangible assets decreased by approximately $1.2 million and was partially offset by increased amortization of capitalized software of $0.7 million and computer equipment of $0.1 million, as compared with the three months ended June 30, 2014.

        During the six months ended June 30, 2015, depreciation and amortization expense decreased by approximately $0.2 million, or 2%, compared with the six months ended June 30, 2014. Depreciation and amortization expense as a percentage of revenue for the six months ended June 30, 2015, was consistent with the six months ended June 30, 2014. During the six months ended June 30, 2015 amortization of intangible assets decreased by approximately $2.1 million and was partially offset by increased amortization of capitalized software of $1.6 million and computer equipment of $0.2 million, as compared with the six months ended June 30, 2014.

Interest Income

 
  Three Months
Ended June 30,
  2014 to 2015
Change
  Six Months
Ended June 30,
  2014 to 2015
Change
 
 
  2015   2014   $   %   2015   2014   $   %  
 
  (dollars in thousands)
 

Interest income

  $ 615   $ 1   $ 614            *% $ 623   $ 3   $ 620            *%

Interest income as a percentage of revenue

    1 %   * %               * %   * %            

*
not meaningful

        Three and Six Months Ended June 30, 2015 compared with Three and Six Months Ended June 30, 2014.    The interest income for the three and six months ended June 30, 2015 is attributable to the Company's available-for-sale, short-term investments, which the Company initiated its investment activities during the three months ended June 30, 2015.

Interest Expense

 
  Three Months
Ended June 30,
  2014 to 2015
Change
  Six Months
Ended June 30,
  2014 to 2015
Change
 
 
  2015   2014   $   %   2015   2014   $   %  
 
  (dollars in thousands)
 

Interest expense

  $ 1,105   $ 49   $ 1,056            *% $ 2,208   $ 62   $ 2,146            *%

Interest expense as a percentage of revenue

    1 %   * %               1 %   * %            

*
not meaningful

        Three and Six Months Ended June 30, 2015 compared with Three and Six Months Ended June 30, 2014.    The interest expense for the three and six months ended June 30, 2015 is attributable to the Term Loan Facility borrowed on September 19, 2014.

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Provision for Income Taxes

 
  Three Months
Ended June 30,
  2014 to 2015
Change
  Six Months
Ended June 30,
  2014 to 2015
Change
 
 
  2015   2014   $   %   2015   2014   $   %  
 
  (dollars in thousands)
 

Provision for income taxes

  $ 19,370   $ 15,169   $ 4,201     28 % $ 29,864   $ 24,518   $ 5,346     22 %

Effective tax rate

    43 %   39 %               43 %   39 %            

        Three and Six Months Ended June 30, 2015 compared with Three and Six Months Ended June 30, 2014.    During the three months ended June 30, 2015, provision for income taxes increased by approximately $4.2 million, or 28%, compared to the three months ended June 30, 2014. The growth of our operations resulted in a $2.6 million increase in income taxes for the three months ended June 30, 2015. In addition, expected state income taxes, net of federal income tax effect and related deferred tax adjustments increased approximately $1.5 million resulting primarily from New York City's change in revenue sourcing methodology which in turn increased the Company's effective state tax rate. New York City's revenue sourcing methodology change was passed into legislation in April 2015 and was retroactive to January 1, 2015. As a result of the statutory income tax rate change, the effective tax rate increased to 43% for the three months ended June 30, 2015 from 39% in the same period of the prior year.

        During the six months ended June 30, 2015, provision for income taxes increased by approximately $5.3 million, or 22%, compared to the six months ended June 30, 2014. The growth of our operations resulted in a $2.8 million increase in income taxes for the six months ended June 30, 2015. In addition, expected state income taxes, net of federal income tax effect and related deferred tax adjustments increased approximately $2.5 million resulting primarily from changes in revenue sourcing methodology passed into legislation by each of New York State and New York City, resulting in an increase in the Company's effective state tax rate. As a result of the statutory income tax rate change, the effective tax rate increased to 43% for the six months ended June 30, 2015 from 39% in the same period of the prior year.


Liquidity and Capital Resources

    Sources of Liquidity

        On February 18, 2015, we completed our IPO of 22,222,222 shares of Class A common stock and, upon the underwriters' exercise of their option to purchase additional shares, issued an additional 3,142,581 shares of Class A common stock for a total of 25,364,803 shares issued. All of the shares issued in the IPO were primary shares offered by us as none of our stockholders sold any shares in the IPO. The offering price of the shares sold in the IPO was $27.00 per share, resulting in net proceeds to us, after underwriters' discounts and commissions and other expenses payable by us, of approximately $639.1 million.

        Historically, our principal source of liquidity has been cash generated by operating activities. Our cash generated from operations has been sufficient to fund our growth, including our on-going investment in innovation and capital expenditures. In addition, during the first quarter of 2015, we received net proceeds from our IPO of $639.1 million. As of June 30, 2015, including proceeds received upon completion of our IPO, we had a combined balance of cash, cash equivalents and short-term investments of approximately $797.0 million.

        We believe our current cash and cash equivalent balance, our short-term investment balance, expected cash generated by operating activities and availability of cash under our Credit Facilities is sufficient to fund our operations, finance our strategic initiatives, and fund our investment in innovation and new service offerings, for the foreseeable future.

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    Debt

        As of June 30, 2015, we had outstanding indebtedness under our Credit Facilities and capital lease obligations of $290.0 million and $0.4 million, respectively, and had only capital lease obligations of $0.3 million as of June 30, 2014. As of June 30, 2015, we were in compliance with the covenants under the Credit Agreement.

Term Loan Facility

        As of June 30, 2015, the principal amount outstanding under the Term Loan Facility was $290.0 million. The Term Loan Facility has a five-year term. The Term Loan Facility is an amortizing facility with principal payments quarterly and interest payments monthly. Scheduled principal payments of $10.0 million and interest payments totaling $2.2 million were paid during the six months ended June 30, 2015.

Revolving Credit Facility

        Borrowings under the Revolving Credit Facility became available, subject to compliance with the terms and conditions set forth in the Credit Agreement, beginning (at our option) after the consummation of our IPO on February 18, 2015. No amounts were drawn against the Revolving Credit Facility during the six months ended June 30, 2015. The Revolving Credit Facility is scheduled to mature on March 31, 2020. The interest rate for the Revolving Credit Facility is LIBOR plus 1.25% per annum or the base rate plus 0.25% per annum (at our election).

    Cash Flows—Comparison of the Six Months Ended June 30, 2015 and 2014

    Operating Cash Flow Activities

        Net cash provided by operating activities during the six months ended June 30, 2015 was approximately $19.7 million, a decrease of approximately $12.5 million compared with the six months ended June 30, 2014. Cash provided by operating activities was driven by net income of approximately $39.9 million, as adjusted for the exclusion of non-cash expenses totaling approximately $11.1 million, which was partially offset by approximately $31.2 million related to the effect of changes in working capital and other balance sheet accounts, driven by payroll timing, customer payments and vendor payments.

    Investing Cash Flow Activities

        Net cash flows used in investing activities primarily relate to cash used to purchase short-term investments, net of maturities. We also use cash to invest in capital assets to support our growth and innovation. We make investments in innovation, including research and development expense, capital software development costs, and research and development infrastructure investments, on a recurring basis. We expect our investment in innovation to increase in the foreseeable future to support our continued growth and new service offerings.

        Net cash used in investing activities during the six months ended June 30, 2015 was approximately $617.3 million, an increase in cash outflow of approximately $606.5 million compared with the six months ended June 30, 2014. The increase in cash outflow was primarily resulted from $604.7 million in net purchases of short-term investments and investments in capitalized software and property and equipment of approximately $12.7 million.

    Financing Cash Flow Activities

        Cash provided by financing activities during the six months ended June 30, 2015 was approximately $629.5 million, an increase of approximately $641.4 million in cash inflow compared with the six months

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ended June 30, 2014. The cash provided by financing activities during the six months ended June 30, 2015 is primarily comprised of $639.1 million for the issuance of common stock in the IPO, and was partially offset by repayments of borrowings under our Credit Facilities of $10.0 million.

    Contractual Obligations

        The following table summarizes our future payments in cash, excluding the effects of time value, on contractual obligations by period as of June 30, 2015:

 
  Payments Due by Period  
 
  (in thousands)
 
 
  Total   Less than
1 year
  1 - 3 years   3 - 5 years   More than
5 years
 

Credit facilities(1)

  $ 290,000   $ 16,250   $ 60,000   $ 213,750   $  

Operating lease obligations

    21,413     3,248     12,441     5,724      

Total

  $ 311,413   $ 19,498   $ 72,441   $ 219,474   $  

(1)
We have cash interest requirements due on the Credit Facilities at variable rates which are not included in the above table.

        Our existing operating lease agreements may provide us with the option to renew. Our future operating lease obligations would change if we entered into additional operating lease agreements or if we exercised renewal options.

        Contractual obligations represent future cash commitments and liabilities under agreements with third parties, and exclude purchase orders for goods and services. Purchase orders are not included in the table above. Our purchase orders represent authorizations to purchase rather than legally binding agreements. The contractual commitment amounts in the table above are associated with agreements that are legally binding and enforceable, and that specify all significant terms, including fixed or minimum services to be used, fixed, minimum or variable price provisions and the approximate timing of the transaction.


Off-Balance Sheet Arrangements

        As of June 30, 2015, we did not have any off-balance sheet arrangements.


Non-GAAP Financial Measures

        We provide the measures Adjusted EBITDA, Adjusted EBITDA margin, and Non-GAAP net income as additional information for evaluating our operating results. These measures are not prepared in accordance with, or an alternative for, GAAP accounting and may be different from non-GAAP measures used by other companies.

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        Investors frequently have requested information from management regarding depreciation, amortization other non-cash charges, such as stock-based compensation, as well as the impact of non-comparable items and management believes, based on discussions with investors, that these non-GAAP measures enhance investors' ability to assess our historical and projected future financial performance. While we believe these non-GAAP financial measures provide useful supplemental information to investors, there are limitations associated with the use of non-GAAP financial measures. For example, one limitation of Adjusted EBITDA is that it excludes depreciation and amortization, which represents the periodic costs of certain capitalized tangible and intangible assets used in generating revenues in our business. We compensate for these limitations by using these non-GAAP financial measures as supplements to GAAP financial measures and by reconciling the non-GAAP financial measures to their most comparable GAAP financial measures. Investors are encouraged to review the reconciliations of these non-GAAP financial measures to the comparable GAAP measures that are provided below.

        These non-GAAP measures include financial information that is prepared in accordance with GAAP and presented in our consolidated financial statements and are used to evaluate our business, measure our performance, develop financial forecasts and make strategic decisions and as an important factor in determining variable compensation. Reconciliations of net income, the most directly comparable GAAP financial measure, to Adjusted EBITDA and Non-GAAP net income are presented below.

Adjusted EBITDA and Adjusted EBITDA Margin

        We define Adjusted EBITDA as net income calculated in accordance with GAAP, adjusted for the impact of depreciation and amortization, interest expense, interest income, provision for income taxes, stock-based compensation, other non-comparable income and expenses, and certain legal costs. We have provided below a reconciliation of net income, which is the most directly comparable GAAP financial measure, to Adjusted EBITDA.

        Adjusted EBITDA margin is our calculation of Adjusted EBITDA divided by revenue calculated in accordance with GAAP.

        We use Adjusted EBITDA and Adjusted EBITDA margin as supplemental measures of performance to gain insight into operating effectiveness. We use Adjusted EBITDA and Adjusted EBITDA margin as key metrics to assess our ability to increase revenues while controlling expense growth and the scalability of our business model. We believe that the exclusion of the expenses eliminated in calculating Adjusted EBITDA and Adjusted EBITDA margin provides management and investors a useful measure for period-to-period comparisons of our core business and operating results by excluding items that are not comparable across reporting periods or that do not otherwise relate to our ongoing operating results. Accordingly, we believe that Adjusted EBITDA and Adjusted EBITDA margin provide useful information to investors and others in understanding and evaluating our operating results. However, use of Adjusted EBITDA and Adjusted EBITDA margin as analytical tools has limitations, and you should not consider them in isolation or as substitutes for analysis of our financial results as reported under GAAP. In addition, other companies, including companies in our industry, might calculate Adjusted EBITDA and Adjusted EBITDA margin or similarly titled measures differently, which may reduce their usefulness as comparative measures.

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        The following table presents a reconciliation of net income to Adjusted EBITDA for each of the periods indicated (in thousands):

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2015   2014   2015   2014  

Reconciliation of Net Income to Adjusted EBITDA:

                         

Net income

  $ 26,136   $ 23,630   $ 39,895   $ 38,187  

Depreciation and amortization

    4,812     5,114     9,727     9,969  

Interest expense

    1,105     49     2,208     62  

Interest (income)

    (615 )   (1 )   (623 )   (3 )

Provision for income taxes

    19,370     15,169     29,864     24,518  

EBITDA

    50,808     43,961     81,071     72,733  

Stock-based compensation

    1,922     436     3,694     822  

Other non-comparable items(a)

                 

Professional service fees(b)

        592         846  

Adjusted EBITDA

  $ 52,730   $ 44,989   $ 84,765   $ 74,401  

(a)
Other "non-comparable items" include items that are not comparable across reporting periods or that do not otherwise relate to the Company's ongoing financial results. Non comparable items are excluded from Adjusted EBITDA in order to more effectively assess the Company's period over period and on-going operating performance.

(b)
Represents legal costs associated with the enforcement of a specific client contract. The legal process associated with this matter began in the first quarter of 2013 and concluded in the second quarter of 2014.

Non-GAAP net income

        We define Non-GAAP net income as net income adjusted to exclude tax-affected stock-based compensation expense, tax-affected amortization of acquired intangible assets, and tax-affected other non-comparable income and certain expenses.

        We use Non-GAAP net income as a supplemental measure of performance to gain insight into financial effectiveness. We use Non-GAAP net income as a key metric to assess our ability to increase revenues while controlling expense growth and the scalability of our business model. We believe that the exclusion of the expenses eliminated in calculating Non-GAAP net income provides management and investors a useful measure for period to period comparisons of our core business and financial results by excluding items that are not comparable across reporting periods or that do not otherwise relate to our ongoing financial results. Accordingly, we believe that Non-GAAP net income provides useful information to investors and others in understanding and evaluating our performance. However, use of Non-GAAP net income as an analytical tool has limitations, and you should not consider this measure in isolation or as a substitute for analysis of our financial results as reported under GAAP. In addition, other companies, including companies in our industry, might calculate Non-GAAP net income or similarly titled measures differently, which may reduce their usefulness as comparative measures.

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        The following table presents a reconciliation of net income to Non-GAAP net income for each of the periods indicated (in thousands):

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2015   2014   2015   2014  

Reconciliation of Net Income to Non-GAAP net income:

                         

Net income

  $ 26,136   $ 23,630   $ 39,895   $ 38,187  

Stock-based compensation

    1,922     436     3,694     822  

Amortization of acquired intangible assets

    261     1,433     803     2,966  

Other non-comparable items(a)

                 

Professional service fees(b)

        592         846  

Tax impact of add-back items(c)

    (929 )   (982 )   (1,930 )   (1,849 )

Non-GAAP net income

  $ 27,390   $ 25,109   $ 42,462   $ 40,972  

(a)
Other "non-comparable items" include items that are not comparable across reporting periods or that do not otherwise relate to the Company's ongoing financial results. Non comparable items are excluded from Non-GAAP net income in order to more effectively assess the Company's period over period and on-going operating performance.

(b)
Represents legal costs associated with the enforcement of a specific client contract. The legal process associated with this matter began in the first quarter of 2013 and concluded in the second quarter of 2014.

(c)
Assumes the tax rate applicable to the respective year.

Item 3.    Quantitative and Qualitative Disclosures About Market Risk

        Market risk includes risks that arise from changes in interest rates, equity prices and other market changes that affect market sensitive instruments.

        Our primary market risk exposure is related to changes in interest rates on our variable rate debt and marketable securities.

        Our variable rate debt includes our Term Loan Facility and our Revolving Credit Facility. As of June 30, 2015, we had $290.0 million outstanding under our Term Loan Facility at an effective interest rate of 1.4%. As a result, if market interest rates were to increase by 1.0%, or 100 basis points, interest expense would decrease future earnings and cash flows, net of estimated tax benefits, by approximately $1.7 million annually, assuming that we do not enter into contractual hedging arrangements. As of June 30, 2015 there was no balance outstanding on the Revolving Credit Facility.

        We had cash, cash equivalents and short-term investments totaling approximately $797.0 million as of June 30, 2015. This amount was invested primarily in marketable securities including corporate notes and bonds, U.S. agency obligations, commercial paper, U.S. treasury securities, certificates of deposit and money market funds. The cash and cash equivalents are held for working capital purposes. Our investments are made for capital preservation purposes. We do not enter into investments for trading or speculative purposes.

        Our cash equivalents and our short-term investments are subject to market risk due to changes in interest rates, which could affect our results of operations. Fixed rate securities may have their market value adversely affected due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fluctuate due to changes in interest rates or we may suffer losses in principal if we are forced to sell securities that decline in market value due to changes in interest rates. However because we classify

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our marketable securities as "available for sale," no gains or losses are recognized due to changes in interest rates unless such securities are sold prior to maturity or declines in fair value are determined to be other-than-temporary.

        An immediate increase of 100-basis points in interest rates would have resulted in an approximate $7.4 million market value reduction in our investment portfolio as of June 30, 2015. An immediate decrease of 100-basis points in interest rates would have increased the market value by approximately $10.7 million as of June 30, 2015. This estimate is based on a sensitivity model that measures market value changes when changes in interest rates occur. Fluctuations in the value of our investment securities caused by a change in interest rates (gains or losses on the carrying value) are recorded in accumulated other comprehensive income, and are realized only if we sell the underlying securities.

Item 4.    Controls and Procedures

Disclosure Controls and Procedures

        Our management, with the participation of our chief executive officer ("CEO") and chief financial officer ("CFO"), has evaluated the effectiveness of our disclosure controls and procedures, (as defined in Rules 13a- 15(e) and 15d- 15(e) under the Exchange Act), as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on such evaluation, our CEO and CFO have concluded that, as of June 30, 2015, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control

        There have been no changes in the our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during the three months ended June 30, 2015 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II—OTHER INFORMATION

Item 1.    Legal Proceedings

        From time to time, we may be involved in various legal proceedings and subject to claims that arise in the ordinary course of business. Although the results of litigation and claims are inherently unpredictable and uncertain, we are not currently a party to any legal proceedings the outcome of which, if determined adversely to us, are believed to, either individually or taken together, have a material adverse effect on our business, operating results, cash flows or financial condition. Regardless of the outcome, litigation has the potential to have an adverse impact on us because of defense and settlement costs, diversion of management resources, and other factors.

Item 1A.    Risk Factors

        For a discussion of potential risks and uncertainties related to our Company see the information in Part I, Item 1A ("Risk Factors") of our Annual Report on Form 10-K for the year ended December 31, 2014. There have been no material changes to the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2014.

Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds

    Unregistered Sales of Equity Securities

        None.

    Use of Proceeds from Registered Securities

        On February 18, 2015, we completed our IPO of 22,222,222 shares of Class A common stock and, upon the underwriters' exercise of their option to purchase additional shares, issued an additional 3,142,581 shares of Class A common stock for a total of 25,364,803 shares issued. All of the shares issued in the IPO were primary shares offered by us as none of our stockholders sold any shares in the IPO. The offering price of the shares sold in the IPO was $27.00 per share, resulting in net proceeds to us, after underwriters' discounts and commissions and other expenses payable by us, of $639.1 million. All of the shares were sold pursuant to our registration statement on Form S-1, as amended (File No. 333-201321), that was declared effective by the SEC on February 11, 2015. Our Class A common stock is listed on the NASDAQ Global Select Market under the symbol "INOV".

        The principal purposes of our IPO were to create a public market for our Class A common stock and thereby enable future access to the public equity markets by us and our stockholders, and obtain additional capital. We intend to use the net proceeds to us from our IPO for working capital and other general corporate purposes; however, we do not currently have any specific uses of the net proceeds. Additionally, we may use a portion of the proceeds for acquisitions of complementary businesses, technologies, or other assets, or to repay outstanding indebtedness.

    Issuer Purchases of Equity Securities

        None.

Item 3.    Defaults Upon Senior Securities

        Not applicable.

Item 4.    Mine Safety Disclosures

        Not applicable.

Item 5.    Other Information

        None.

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Item 6.    Exhibits

EXHIBIT INDEX

Exhibit
Number
  Description of Document
  31.1 * Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
        
  31.2 * Certification of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
        
  32.1 * Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
        
  32.2 * Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
        
  101.INS * XBRL Instance Document
        
  101.SCH * XBRL Taxonomy Extension Schema
        
  101.CAL * XBRL Taxonomy Extension Calculation Linkbase
        
  101.DEF * XBRL Taxonomy Extension Definition Linkbase
        
  101.LAB * XBRL Taxonomy Extension Label Linkbase
        
  101.PRE * XBRL Taxonomy Extension Presentation Linkbase

*
Filed herewith.

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SIGNATURES

        Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Date: August 6, 2015   INOVALON HOLDINGS, INC.

 

 

By:

 

/s/ KEITH R. DUNLEAVY, M.D.

Keith R. Dunleavy, M.D.
Chief Executive Officer and Chairman

 

 

By:

 

/s/ THOMAS R. KLOSTER

Thomas R. Kloster
Chief Financial Officer

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