UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
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(Mark One)
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | |
For the fiscal year ended December 31, 2019
or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | |
For the transition period from __________ to __________
Commission File Number 001-38253
(Exact name of registrant as specified in its charter)
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State or other jurisdiction of incorporation or organization | (I.R.S. Employer Identification No.) | |
(Address of principal executive offices, including zip code) | ||
(408 ) 213-3191
(Registrants telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class | Trading Symbol(s) | Name of each exchange on which registered |
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,”
and “emerging growth company” in Rule 12b-2 of the Exchange Act.
☒ | Accelerated filer | ☐ | ||
Non-accelerated filer | ☐ | Smaller reporting company | ||
Emerging growth company | ||||
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒
The aggregate market value of voting stock held by non-affiliates of the registrant on June 28, 2019 (the last business day of the registrant’s most recently completed second fiscal quarter), was approximately $1,492,156,938 based on the closing price of a share of the registrant’s common stock on that date as reported by The NASDAQ Global Market.
As of February 14, 2020, 48,404,973 shares of the registrant’s common stock, $0.001 par value, were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the information called for by Part III of this Annual Report on Form 10-K are hereby incorporated by reference where indicated from the definitive proxy statement for the registrant’s annual meeting of stockholders, which will be filed with the Securities and Exchange Commission not later than 120 days after the registrant’s fiscal year ended December 31, 2019.
FORESCOUT TECHNOLOGIES, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2019
TABLE OF CONTENTS
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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which statements involve substantial risks and uncertainties. Forward-looking statements generally relate to future events or our future financial or operating performance. In some cases, you can identify forward-looking statements because they contain words such as “may,” “will,” “should,” “would,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these words or other similar terms or expressions that concern our expectations, strategy, plans or intentions. Forward-looking statements contained in this Annual Report on Form 10-K include, but are not limited to, statements about:
• | the merger agreement and our proposed acquisition by entities affiliated with Advent International Corporation (“Advent”); |
• | the evolution of the cyberthreat landscape facing enterprises in the United States and other countries; |
• | developments and trends in the domestic and international markets for network security products and related services; |
• | our expectations regarding the size of our target market; |
• | our ability to educate prospective end-customers about our technical capabilities and the use and benefits of our products and to achieve increased market acceptance of our solution; |
• | our beliefs and objectives regarding our prospects and our future results of operations and financial condition; |
• | the effects of increased competition in our target markets and our ability to compete effectively; |
• | our business plan and our ability to manage our growth effectively; |
• | our investment in our sales force and our expectations concerning the productivity and efficiency of our expanding sales force as our sales representatives become more seasoned; |
• | our growth strategy to maintain and extend our technology leadership, expand and diversify our end-customer base, deepen our existing end-customer relationships, and attract and retain highly skilled security professionals; |
• | our ability to enhance our existing products and technologies and develop or acquire new products and technologies; |
• | our plans to attract new end-customers, retain existing end-customers, and increase our annual revenue; |
• | our expectations concerning renewal rates of Software Products subscription contracts, support and maintenance contracts, and software sold as a service (“SaaS”) contracts (collectively known as “term contracts”) with end-customers; |
• | our plans to expand our international operations; |
• | our expectations regarding future acquisitions of, or investments in, complementary companies, services, or technologies; |
• | our ability to continue to generate a significant portion of our revenue from public sector customers; |
• | the effects on our business of evolving information security and data privacy laws and regulations, government export or import controls and any failure to comply with the U.S. Foreign Corrupt Practices Act and similar laws; |
• | our ability to maintain, protect, and enhance our brand and intellectual property; |
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• | fluctuations in our results of operations and other operating measures; |
• | our expectations regarding changes in our cost of revenue, gross margins, and operating costs and expenses; |
• | our expectations regarding the portions of our revenue represented by license revenue, subscription revenue, and professional services revenue; |
• | our expectations concerning the impact on our results of operations of development of our distribution programs and sales through our channel partners; |
• | the impact on our revenue, gross margin, and profitability of future investments in the enhancement of Forescout eyeSight, Forescout eyeSegment Forescout eyeControl, Forescout eyeExtend, SilentDefense, and SilentDefense Command Center, and expansion of our sales and marketing programs; |
• | the impact of the Tax Cuts and Jobs Act on our business; |
• | our ability to successfully acquire and integrate companies and assets; |
• | sufficiency of our existing liquidity sources to meet our cash needs; and |
• | our potential use of foreign exchange forward contracts to hedge our foreign currency risk and our general use of our foreign currency. |
We caution you that the foregoing list may not contain all of the forward-looking statements made in this Annual Report on Form 10-K.
You should not rely upon forward-looking statements as predictions of future events. We have based the forward-looking statements contained in this Annual Report on Form 10-K primarily on our current expectations and projections about future events and trends that we believe may affect our business, financial condition, operating results, cash flows, or prospects. The outcome of the events described in these forward-looking statements is subject to risks, uncertainties, and other factors, including, but not limited to, those described in the section titled “Risk Factors” in Part I, Item 1A and elsewhere in this Annual Report on Form 10-K. Moreover, we operate in a very competitive and rapidly changing environment. New risks and uncertainties emerge from time to time and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements contained in this Annual Report on Form 10-K. We cannot assure you that the results, events, and circumstances reflected in the forward-looking statements will be achieved or occur, and actual results, events or circumstances could differ materially from those described in the forward-looking statements.
The forward-looking statements made in this Annual Report on Form 10-K relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statements made in this Annual Report on Form 10-K to reflect events or circumstances after the date of this Annual Report on Form 10-K or to reflect new information or the occurrence of unanticipated events, except as required by law. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements. You should not place undue reliance on our forward-looking statements. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures, or investments we may make.
You should read this Annual Report on Form 10-K and the documents that we reference in this Annual Report on Form 10-K and have filed with the Securities and Exchange Commission as exhibits to this Annual Report on Form 10-K with the understanding that our actual future results, levels of activity, performance, and events and circumstances may be materially different from what we expect.
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PART I
ITEM 1. BUSINESS
Overview
Forescout Technologies, Inc. (“Forescout”) is the leading provider of device visibility and control solutions. We have pioneered an agentless approach to device visibility and control that provides one of the most comprehensive, real-time identification, classification, assessment and continuous control over the devices, that collectively, comprise an organization’s network. This network extends across the campus information technology (“IT”) devices, the campus Internet of Things (“IoT”) devices, operational technology (“OT”) devices, the data center, and within the third-party cloud. The devices that comprise this vastly heterogeneous and flat (non-segmented) network are continuously monitored for purposes of taking real-time control action when those devices behave in a manner outside of established policies. Through continuous visibility and control over the devices, each of which is an entry point for malware to enter and for corporate and customer information to exit, we protect organizations against the emerging threats that exploit the billions of devices connected to organizations’ networks. Over 40 billion devices will be connected to the Internet by 2023, according to data published by ABI Research*, and a growing percentage of them will be used for business purposes through Enterprise IoT initiatives. In addition, in its Top Strategic IoT Trends and Technologies Through 2023 report (September 2018), Gartner, Inc. estimates that, by 2023, the average CIO will be responsible for more than three times the devices they managed in 2018.**
IoT devices often bring tremendous value to an organization and OT devices are fundamental to an organizations’ infrastructure and revenue generation. As such, the percentage of the network that is comprised of these devices will continue to increase, and, as evidenced by trends emerging in many of our end-customers’ organizations, will actually surpass, in quantity, the number of devices that are secured using the traditional approach of relying on a corporate-installed security software agent. Given that IoT devices, OT devices, and virtual devices within a third-party cloud provider cannot be adequately secured with the traditional approach of relying on a corporate-installed security software agent on those devices, organizations are faced with a major gap in device visibility and lack of control over a significant portion of their network. Also contributing to that gap are the wide varieties of platforms and operating systems on these devices that are something other than Microsoft Windows, UNIX or LINUX operating systems commonly found on traditional corporate-owned, IT managed devices.
The threat landscape is rapidly evolving, and attackers are now leveraging the gap in device visibility to gain access to organizations. New attacks are stealthy, targeted, and pervasive and can target known and unknown software vulnerabilities that can persist undetected inside a network for months. As organizations invest billions of dollars to protect their traditional devices, servers, network infrastructure, mobile systems, and personal computers, attackers are shifting their focus to the less secure IoT and OT devices, which have increased the attack surface within organizations. Attackers use these unsecured devices and a lack of IT control to enter a network and traverse through systems, gathering information before executing an attack. The response to such attacks is often both uncoordinated and manual because existing security systems operate in silos and security teams often lack the ability to share information and coordinate an attack response. Further compounding this issue is the continued trend of IT/OT network convergence, in which previously air-gapped OT networks are physically connected to traditional IT networks, exposing operational technologies and critical infrastructure to potential threats.
Organizations need a new approach to security that gives them the ability to see and control the devices connected to their extended networks. Over the past ten years, Forescout has developed proprietary agentless technology that discovers and classifies IP-based devices in real time as they connect to the network and continuously monitors and assesses their security posture. Our solution supports heterogeneous wired and wireless networks, typically without requiring network modification or upgrades, as well as both virtual and cloud infrastructures, while scaling to meet the needs of globally distributed organizations. We have built an extensive repository of policies that control how devices are expected to behave on the network. When a device deviates from a policy, we can immediately take action. Additionally, we offer integrations with third-party systems that expand upon our visibility and control capabilities and allow us to share contextual device data and deliver automatic policy enforcement between our system and the third-party systems. This is enforcement that neither our solution nor the third-party solution could do individually. Collectively, we refer to this as our orchestration capabilities.
Our solution is sold across two product groups: (i) products for visibility and control capabilities, and (ii) products for orchestration capabilities. Typically, end-customers initially deploy our solution in a portion of their campus IT and IoT network or in a portion of their OT network. Because our solution is agentless and supports heterogeneous network infrastructure, end-
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*ABI Research, Internet of Everything Market Tracker, QTR 1, 2019.
**Gartner, Inc., Top Strategic IoT Trends and Technologies Through 2023, Nick Jones, September 2018. The Gartner Report(s) described herein, (the "Gartner Report(s)") represent(s) research opinion or viewpoints published, as part of a syndicated subscription service, by Gartner, Inc. ("Gartner"), and are not representations of fact. Each Gartner Report speaks as of its original publication date (and not as of the date of the Filing and the opinions expressed in the Gartner Report(s) are subject to change without notice.
customers experience rapid deployment of the Forescout platform including compliance assessment of their devices within days. They then apply these detailed visibility insights to various access control policies. Anecdotally, an end-customer might begin in a specific region in their wired or wireless network within their campus IT and IoT network, for example - then expand their usage to cover additional regions and other portions of their network. After end-customers achieve enhanced visibility of and control over their devices, and before they have completed their wall-to-wall deployment in any specific portion of the network, they can deploy new use cases that often leverage our orchestration capabilities on that portion of the network.
We sell into organizations of all sizes, with a focus on those with a large footprint of devices. Our end-customers represent a broad range of industries, including financial services, government, healthcare, technology, manufacturing, services, energy, entertainment, and retail. We target the largest accounts in each industry first to establish reference accounts for that sector. As of December 31, 2019, we have sold to more than 3,700 end-customers in over 90 countries, including 25% of the Global 2000, since our inception, with nearly 80 million devices under management. We utilize a high-touch direct sales force with deep security expertise and strong industry relationships. We sell our products predominantly through a network of value added resellers and systems integrators that provide a broad reach into various segments of the market across geographies.
We have experienced rapid growth in recent periods. For the years ended December 31, 2019, 2018, and 2017, our revenue was $336.8 million, $297.7 million, and $224.4 million, respectively, representing year-over-year growth of 13% and 33%, respectively. For the years ended December 31, 2019, 2018, and 2017, our net loss was $118.5 million, $74.8 million, and $80.7 million, respectively.
Proposed Merger
On February 6, 2020, we entered into an Agreement and Plan of Merger (the ”Merger Agreement”) with Ferrari Group Holdings, L.P., a Delaware limited partnership (“Parent”), and Ferrari Merger Sub, Inc., a Delaware corporation and a wholly owned subsidiary of Parent (“Merger Sub”). Parent and Merger Sub are affiliates of Advent.
The Merger Agreement provides that, subject to the terms and conditions set forth in the Merger Agreement, Merger Sub will merge with and into Forescout (the “Merger”), with Forescout surviving the Merger and becoming a wholly-owned indirect subsidiary of Parent (the “Surviving Corporation”). Under the Merger Agreement, at the effective time of the Merger, each issued and outstanding share of our common stock (except for certain shares specified in the Merger Agreement) will be canceled and automatically converted into the right to receive cash in an amount equal to $33.00, without interest.
Consummation of the Merger is subject to the satisfaction or waiver of customary closing conditions, including (1) approval of the Merger Agreement by our stockholders; (2) the absence of any law or order restraining, enjoining or otherwise prohibiting the Merger; and (3) the expiration or termination of the waiting period under the United States Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and clearance under the antitrust laws of certain non-United States jurisdictions. The Merger is expected to close in the second fiscal quarter of 2020. Upon consummation of the Merger, our common stock will no longer be listed on any public market.
Our Growth Strategy
We intend to execute on the following growth strategies:
• | Expand within our existing end-customers as more devices enter the enterprise and as we expand to new parts of their network. We expect to grow within our end-customer base as more devices come online within the enterprise. Our license revenue and the SaaS portion of our subscription revenue, are directly tied to the number of licensed devices managed by our solution; therefore, we sell more product as more devices come online. End-customers often expand usage of our products as they realize the value and applicability to other areas within an organization. We expect to grow as our end-customers extend their use of our solution across campus IT and IoT portions of the network which are characterized as wired networks and wireless networks (remote and visitor devices), the operational technology portion of the network, the on-premise data center portion of the network, and the portion of their network that is now hosted by a third-party cloud provider. As of December 31, 2019, we had sold products with licenses covering nearly 80 million devices, 19% (or approximately 15 million) of those device licenses were purchased during the year ended December 31, 2019. |
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• | Grow global end-customer base. We have invested significantly, and plan to continue to invest, in our sales organization to drive new end-customer growth. During the year ended December 31, 2019, we added more than 400 new customers, of which approximately 80 are identified in the list of Global 2000. We now count six of the top 10 financial services companies, five of the top 10 manufacturing companies, numerous large healthcare companies and 12 of the 14 civilian cabinets within the United States federal government as customers that are standardizing with Forescout for device visibility and control. |
• | Increase sales of our eyeExtend family of products. We are seeing strong demand for our eyeExtend family of products as end-customers are realizing the value of the orchestration capabilities enabled with these integration modules. As of December 31, 2019, 31% of our end-customers have purchased at least one product in our eyeExtend family of products, up from 27% as of December 31, 2018. During the year ended December 31, 2019, nearly 40% of product deals included at least one product in our eyeExtend family of products, up from one-third of product deals during the year ended December 31, 2018. As of December 31, 2019, we had a portfolio of over 20 products in our eyeExtend family of products. We have also established an Alliance Partner program that allows us to productize these integrations and leverage joint go-to-market efforts. |
• | Expand our presence in the market by leveraging our ecosystem of channel partners. We will continue to broaden and invest in our value added and system integrator channel partner relationships to increase distribution of our products. We are focused on educating existing partners and investing in sales enablement to expand our market reach through our channel partner network, particularly into mid-market enterprises. |
Our Products
We offer our solution across two product groups: (i) products for visibility and control capabilities and (ii) products for orchestration capabilities.
• | Our products for visibility and control capabilities are comprised of eyeSight, eyeSegment, eyeControl, and SilentDefense. Our eyeSight, eyeSegment, and eyeControl products provide for visibility and control capabilities across the extended enterprise, from campus to data center to hybrid cloud to OT devices, while our SilentDefense product provides for visibility and control capabilities deeper within the OT portion of the network. Our agentless technology discovers, classifies, and assesses IP-based devices. It interrogates the network infrastructure to discover devices immediately as they attempt to connect to the network. Since it does not rely on agents, our end-customers have reported seeing up to 60% more devices on their networks than previously known. After discovering a device, our solution uses a combination of active and non-disruptive passive methods to classify the device based on its type and ownership. Based on its classification, our solution then assesses the device security posture and allows organizations to set policies that establish the specific behavior the device is allowed to have while connected to a network. The connected devices on these vastly heterogeneous and flat (non-segmented) networks are continuously monitored for purposes of taking real-time control action when those devices behave in a manner outside of established policies. Control actions vary, based on our customers’ preferences, and include blocking a device from accessing the network, establishing a Virtual Local Area Network (“VLAN”) that limits access on the network, and sending alerts of non-compliance. |
• | Our products for orchestration capabilities are comprised of our portfolio of eyeExtend products. Our eyeExtend products represent integrations with vendors across nine categories: advanced threat detection, client management tools, enterprise mobility management, endpoint protection, detection and response, IT Systems Management, next-generation firewall, privileged access management, security information and event management and vulnerability assessment. Additionally, end-customers can create their own integrations using our Open Integration Module or utilize our Advanced Compliance Module for security content automation protocol. |
• | Advanced Threat Detection (“ATD”): The combined solution automatically detects indicators of compromise (“IOCs”) and quarantines infected devices, thereby limiting malware propagation and breaking the cyber kill chain. |
• | Client Management Tools (“CMT”): The combined solution provides visibility and control of devices while they’re off the enterprise network. |
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• | Enterprise Mobility Management (“EMM”): The combined solution facilitates unified security policy management for mobile devices. |
• | Endpoint Protection, Detection and Response (“EPP/EDR”): The combined solution verifies device compliance for functional antivirus, up-to-date signatures, encryption and other endpoint policies and facilitates remediation actions. |
• | IT Service Management (“ITSM”): The combined solution provides up-to-date device properties, classification, configuration and network context to help true-up assets in a configuration management database (“CMDB”), improve asset compliance, and maintain a trusted single-source-of-truth repository for better decision-making. |
• | Next Generation Firewall (“NGFW”): The combined solution uses real-time situational awareness about devices to implement dynamic network segmentation, automate controls for secure access to critical resources and create context-aware security policies within industry-leading next-generation firewalls. |
• | Privileged Access Management (“PAM”): The combined solution provides real-time agentless visibility into undiscovered local privileged accounts and automated responses to threats based on holistic visibility into user activity, device security posture, incident severity, and overall threat exposure. |
• | Security Incidence and Event Management (“SIEM”): The combined solution improves situational awareness and mitigates risks using advanced analytics and comprehensive device information, including IoT classification and assessment context for correlation and incident prioritization. |
• | Vulnerability Assessment (“VA”): The combined solution ensures devices be added to the network for the first time or ones rejoining the network (such as mobile devices) meet defined vulnerability compliance thresholds. Additionally, the solution automates policy-based enforcement actions. |
• | Open Integration Module (“OIM”): Allows end-customers, systems integrators and technology vendors to integrate custom applications, security tools and management systems with our platform. |
• | Advanced Compliance Module for Security Content Automation Protocol (“SCAP”): Automates on-connect and continuous device configuration assessment to comply with standards-based security benchmarks and content published in the SCAP format. |
We offer our solution across two product types: software products and hardware products
• | Our software products include eyeSight, eyeSegment, eyeControl, eyeExtend, SilentDefense, and SilentDefense Command Center (“Software Products”). |
• | Our hardware products include hardware that is sold separately for use with our Software Products and appliances that are embedded with our software (“Hardware Products”). |
We offer our solution across license types and increments
• | Our products are sold with a perpetual license or a subscription license. |
• | End-customers can purchase in license increments of 100 devices, with hardware sold separately based on end-customer deployment requirements. End-customers can manage their deployments of our products in various options which are capable of scaling and managing deployments of up to 2,000,000 devices under a single console. End-customers can purchase our SilentDefense products in license increments that are on a per sensor basis. |
Our Technology
The key technologies underlying our platform have been built from the ground up to address the device visibility and control challenges of today. Our foundational technologies are: (i) agentless data collection, (ii) an adaptive abstraction layer, (iii) a real time and continuous policy engine, and (iv) distributed and scalable architecture. We have invested over ten years of research and development into our technology and believe it represents a significant competitive advantage for us.
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Agentless data collection. Our software uses a combination of both active and passive methods to discover, classify, and assess devices in an organization’s network. Utilizing active discovery methods, we can poll switches, VPN concentrators, and wireless controllers for a list of connected devices. Using NBT scans and NMAP, or via WMI for deeper inspection of corporate-managed devices, we can inspect workstations running Windows, Mac, or Linux, without the use of agents. We also deploy passive inspection methods that allow our appliances to receive SNMP traps from switches and wireless controllers, monitor a network SPAN port to see network traffic, and leverage information such as TCP window sizes, session information, HTTP traffic, and DHCP information banners as well as NetFlow traffic data. If 802.1x is implemented, our technology can authenticate 802.1x requests to a built-in or external RADIUS server, and authorize network access. In addition, our technology can import external MAC classification data or request LDAP data. Power over Ethernet (PoE) is an additional method available.
Adaptive abstraction layer. Our abstraction layer is able to ingest billions of packets of raw data across a wide array of heterogeneous network systems. We then consolidate this data into a single pane of glass showing our end-customers a real-time depiction of the devices on their networks by type. Our solution does not require vendor-specific network equipment, upgrades of existing infrastructure, or reconfiguration of each switch and switch port to support 802.1x. As organizations adopt virtual and cloud environments, our technology has the flexibility to integrate with hypervisor technologies and cloud platforms.
The abstraction layer adapts to the IT enterprise environment and continuously enriches its information as organizations make more data available. As an example, organizations can choose to consume only NetFlow data, which is only the metadata of the actual network traffic. With this information, our solutions expedite detection of new devices, collects device properties such as IP address and session protocols, and understands which devices are talking to each other. If organizations choose to give our technology full access to their network traffic through a SPAN port, we can build on this and provide very granular information such as MAC address, HTTP user agent, device type, applications in use, and the ability to identify malicious traffic.
Real-time and continuous policy engine. Our policy engine continuously checks devices against a set of policies that control how devices are expected to behave on the network. While other vendor technologies rely on periodic checks, or queries from an operator, our policy engine can do this continuously and in real-time for over two million devices. Our policies are triggered in real-time based on events occurring on a specific device. These can be network admission events, such as plugging into a switch port or change of IP address, authentication events like those received by RADIUS servers or detected by network traffic, changes in device attributes like user, opening/closing of ports, and specific traffic behavior such as how the device is communicating and what protocol it is using.
The policy engine leverages both infrastructure and host-based controls. At the network switch, our technology can change a Virtual Local Area Network (“VLAN”), add an Access Control List (“ACL”), or disable a switch port. At a wireless controller, we can blacklist a MAC address or change the role of a user. In addition, our technology can restrict remote VPN users. At the host, our technology can start and stop applications, update anti-virus security agents, disable peripheral devices, and request end-user acknowledgment. The policy engine applies these policies automatically regardless of a device’s location. As the device moves, the policy engine can follow it within the corporate network, cloud, or data center. We determine the type of infrastructure and, based on policy, apply the appropriate control actions.
Distributed, scalable architecture. Our console uses distributed computing algorithms to virtually consolidate the device information into a single pane of a glass view for the administrator. The algorithms allow the administrator to search for security related information such as users, processes, and services across the entire deployment in real time, and retrieve it in seconds.
Our Services
End-customers typically purchase maintenance and professional services when they purchase one or more of our products. Our support and maintenance contracts typically have a one-year or three-year term, but can be up to five years. We offer a portfolio of professional services and extended support contract options to assist with additional deployment and ongoing advanced technical support.
Maintenance and Support Services
We offer technical maintenance and support for our solution to our end-customers. We provide multiple levels of maintenance and support, including advanced-level support for coverage 24 hours a day, seven days a week on a global basis. Our end-customers receive post-sale support through online portals, email and telephone, managed by a single point of contact.
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Professional Services
We offer professional services to end-customers to help them design, plan, deploy, and optimize our solution. We also provide training on solution administration and emerging security best practices. Our certified channel partners also provide professional services for our products.
Our Customers
Since our inception, we have sold to more than 3,700 end-customers in over 90 countries, including 25% of the Global 2000, with nearly 80 million devices under management. We sell into all industries and into organizations of all sizes, including corporations and government agencies. Our end-customers generally purchase from distributors and/or VARs.
Sales and Marketing
Sales
We deploy a direct-touch channel-fulfilled strategy. Our customer acquisition sales cycle is typically nine to 24 months, depending on the industry and size and scope of deployment. Our expansion sales cycle is typically three to 12 months, as our customers buy more licenses to cover the additional devices that enter their network after their initial purchase and as we expand into other parts of their network, generally into their other campus environments or beyond campus and into OT, data center and cloud. We have a direct field sales team and a dedicated team focused on managing relationships with our channel partners and working with our channel partners to support our end-customers. We expect to continue to grow our sales headcount in areas of highest demand for our solution. Generally, our sales representatives become more productive the longer they are with us, with limited productivity in their first few quarters as they learn to sell our products and participate in field training, but with increasing productivity as they acquire accounts and as those accounts begin their expansion purchases for additional devices, additional parts of their network and orchestration capabilities. As of December 31, 2019, 38% of our sales representatives have been with us for more than two years, down from 50% as of December 31, 2018.
Our sales team is supported by sales engineers with deep technical expertise who are responsible for pre-sales technical support, solutions engineering for our end-customers, proof of concept work and technical training for our channel partners.
Marketing
Our marketing efforts are focused on building brand reputation and awareness to generate customer demand and build a strong sales pipeline, working in conjunction with our channel partners around the globe. Our team consists of corporate marketing, product marketing, partner marketing, field and digital marketing, account and lead development, operations, social media, public relations, and corporate communications. Marketing activities include demand generation, managing our corporate website and partner portal, trade shows and conferences, press, and analyst relations. Our sales development representatives also qualify sales leads and facilitate face-to-face meetings with potential customers. We actively drive thought leadership and tell our technology story by engaging industry analysts and top journalists at business and trade publications, as well as direct to customers via social media and other digital marketing channels.
Partner Ecosystem
We actively foster and develop our partner ecosystem to find and work with high quality partners who provide our solution to end-customers. Our sales force and strategic alliance group are responsible for cultivating these partnerships to establish new opportunities for delivering our solution to new and existing end-customers.
Channel Partners
We leverage the global breadth and reach of the channel ecosystem, including value-added resellers and distributors, to fulfill orders and sell to our mid-market end-customers. We dedicate significant resources to building in-depth relationships with our channel partners, including marketing, technical, and sales support to assist in jointly sourcing and closing sales opportunities.
Alliances Partners
We have established an Alliance Partner program that allows us to productize technical integrations with third-party security vendors and leverage joint go-to-market efforts.
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Research and Development
We invest substantial resources in research and development to consistently enhance features and capabilities of our solution. Our research and development teams are located in Tel Aviv, Israel; San Jose, California; Eindhoven, The Netherlands; and Dallas, Texas. We plan to continue to significantly invest in resources to conduct our research and development effort.
Competition
We operate in the intensely competitive security market that is characterized by constant change and innovation. The threat landscape is growing faster than the security market, drawing new providers and new functionality from existing providers to address dynamic threat vectors. We compete with security providers in the following categories:
• | the large networking vendors, Cisco and HP Enterprise Company; and |
• | independent security vendors that offer products that perform some of the functions of our solution. |
The principal competitive factors in our market include:
• | effectiveness; |
• | features and functionality; |
• | global support capabilities; |
• | scalability and overall performance; |
• | time to value; |
• | integration capabilities with heterogeneous network infrastructure and security tools; |
• | brand awareness and reputation; |
• | strength of sales and marketing efforts; |
• | size and scale of organization; |
• | price and total cost of ownership; and |
• | customer return on investment. |
We believe we compete favorably with our competitors on the basis of these factors as a result of the features and performance of our solution, the ease of integration of our products with network infrastructure, and the breadth of our capabilities. However, many of our competitors have substantially greater financial, technical and other resources, greater name recognition, larger sales and marketing budgets, deeper customer relationships, broader distribution, and larger and more mature intellectual property portfolios.
Manufacturing
We outsource the final assembly of the off-the-shelf-Dell-components that comprise the hardware that is sold separately along with our software, or which has our software embedded, to a single third-party contract manufacturer, Arrow Electronics, Inc. (“Arrow”). This approach allows us to reduce our costs by decreasing our manufacturing overhead and inventory and also allows us to adjust more quickly to changing end-customer demand. Arrow assembles our product using design specifications, quality assurance programs and standards that we establish, and it procures components and assembles our products based on our demand forecasts. These forecasts represent our estimates of future demand for our products based on historical trends and analysis from our sales and product management functions as adjusted for overall market conditions.
We have entered into a written agreement with Arrow pursuant to which Arrow provides its contract manufacturing services. This agreement continues in effect until either party terminates, with or without cause, by giving 90 days prior written notice.
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Seasonality and Backlog
We experience seasonality in our business, with sales generally stronger in our third and fourth fiscal quarters. For this reason, we do not believe that our product backlog at any particular time is meaningful because it is not necessarily indicative of future revenue in any given period as such orders may be rescheduled by our partners without penalty or delayed due to inventory constraints.
Intellectual Property
Our success depends in part upon our ability to protect our core technology and intellectual property. We rely on, among other things, patents, trademarks, copyrights, and trade secret laws, confidentiality safeguards and procedures, and employee non-disclosure and invention assignment agreements to protect our intellectual property rights. We have twelve U.S-issued patents, which expire between July 26, 2028 and December 26, 2037, 28 patent applications pending in the United States, and 21 pending foreign counterpart patent applications in a non-U.S. jurisdiction. We also have 24 issued foreign counterparts of these patents. We also license software from third parties for integration into our products, including open source software and other software available on commercially reasonable terms.
We control access to and use of our proprietary software, technology and other proprietary information through the use of internal and external controls, including contractual protections with employees, contractors, end-customers, and partners, and our software is protected by U.S. and international copyright, patent, and trade secret laws. In addition, we intend to expand our international operations and effective patent, copyright, trademark, and trade secret protection may not be available or may be limited in foreign countries.
See the section titled “Risk Factors—Failure to protect our proprietary technology and intellectual property rights could substantially harm our business and results of operations” for additional information.
Employees
As of December 31, 2019, we had 1,217 employees, including 1,206 full-time employees.
None of our employees are represented by a labor organization or are a party to any collective bargaining arrangement. None of our employees located in France, Spain, Germany and The Netherlands are currently covered by industry-wide collective bargaining agreements. We have never had a work stoppage, and we consider our relationship with our employees to be good.
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Corporate Information
We were incorporated in Delaware in April 2000. We completed our initial public offering (“IPO”) in October 2017 and our common stock is listed on The NASDAQ Global Market. Our principal executive offices are located at 190 West Tasman Drive, San Jose, California 95134. Our main telephone number is (408) 213-3191.
Several trademarks and trade names appear in this prospectus. “Forescout” and “CounterACT” are the exclusive properties of Forescout Technologies, Inc., are registered with the U.S. Patent and Trademark Office, and may be registered or pending registration in other countries. Other trademarks, service marks, or trade names appearing in this Annual Report on Form 10-K are the property of their respective owners.
Our website address is located at www.forescout.com, and our investor relations website is located at http://investors.forescout.com/investor-relations. Copies of our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, are available, free of charge, on our investor relations website as soon as reasonably practicable after we file such material electronically with or furnish it to the Securities and Exchange Commission (the “SEC”). The SEC also maintains a website that contains our SEC filings. The address of the site is www.sec.gov.
We also use our website and the investor relations page on our website as channels of distribution for important company information. Important information, including press releases, analyst presentations and financial information regarding us, as well as corporate governance information, is routinely posted and accessible on our investor relations website and social media. It is possible that the information that we post on social media could be deemed to be material information. Therefore, we encourage investors, the media and others interested in us to review the information we post on U.S. social media channels listed on the investor relations page on our website. Information contained on, or that can be accessed through, our website or social medial sites does not constitute part of this Annual Report on Form 10-K or any other report or document we file with the SEC, and any references to our website and social media sits are intended to be inactive textual references only.
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ITEM 1A. | RISK FACTORS |
You should carefully consider the following risks and uncertainties described below, together with all of the other information contained in this Annual Report on Form 10-K, including the sections titled “Special Note Regarding Forward-Looking Statements” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes. Any of the risks, if realized, could have a material adverse effect on our business, results of operations, prospects, and financial condition, and could cause the trading price of our common stock to decline, which would cause you to lose all or part of your investment. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or deemed to be material by us may impair our operations and performance.
Risks Related to the Merger
The announcement and pendency of our agreement to be acquired by Advent could adversely affect our business.
On February 6, 2020, we announced that we had entered into a definitive agreement to be acquired by entities affiliated with Advent. Uncertainty about the effect of the proposed Merger on our end-customers, employees, partners, and other parties may adversely affect our business. Our employees may experience uncertainty about their roles or seniority following the Merger. There can be no assurance that our employees, including key personnel, can be retained, or that we will be able to attract and retain employees to the same extent that we have previously been able to. Any loss or distraction of such employees could adversely affect our business and operations. In addition, we have diverted, and will continue to divert, significant management resources toward the completion of the Merger, which could adversely affect our business and operations. Parties with which we do business may experience uncertainty associated with the Merger, including with respect to current or future business relationships with us. Uncertainty may cause customers to refrain from doing business with us, which could adversely affect our business, results of operations and financial condition.
The failure to complete the Merger could adversely affect our business.
Consummation of the Merger is subject to several conditions beyond our control that may prevent, delay, or otherwise adversely affect its completion, including our need to obtain stockholder approval of the Merger. If any of these conditions are not satisfied or waived, it is possible that the Merger will not be consummated in the expected time frame (or at all) or that the definitive agreement may be terminated. If the proposed Merger is not completed, the share price of our common stock may decrease to the extent that the current market price of our common stock reflects an assumption that a transaction will be completed. In addition, under circumstances specified in the Merger Agreement, we may be required to pay a termination fee of $55.8 million to Advent. Further, a failed transaction may result in negative publicity and a negative impression of us in the investment community. Any disruption to our business resulting from the announcement and pendency of the transaction and from intensifying competition from our competitors, including any adverse changes in our relationships with our customers, employees, partners and other parties, could continue or accelerate in the event of a failed transaction. There can be no assurance that our business, relationships with other parties, liquidity or financial condition will not be adversely affected, as compared to the condition prior to the announcement of the Merger, if the Merger is not consummated.
While the Merger is pending, we are subject to business uncertainties and contractual restrictions that could harm our operations and the future of our business or result in a loss of employees.
Pursuant to the terms of the Merger Agreement with Advent, we are subject to certain restrictions on the conduct of our business. These restrictions generally require us to conduct our businesses in the ordinary course, consistent with past practice, and subject us to a variety of specified limitations, including the ability in certain cases to enter into material contracts, acquire or dispose of assets, incur indebtedness or incur capital expenditures, until the proposed Merger becomes effective or the Merger Agreement terminates. These restrictions, which are standard for a transaction of this type, may inhibit our ability to take actions outside of the ordinary course of our business that are inconsistent with our past practice but which we may consider advantageous and limit our ability to respond to future business opportunities and industry developments that may arise during such period. The pendency of the Merger may also divert management’s attention and our resources from ongoing business and operations. Our end-customers, employees, partners, and other parties may have uncertainties about the effects of the Merger. In connection
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with the Merger, it is possible that some customers and other persons with whom we have a business relationship may delay or defer certain business decisions or might decide to seek to terminate, change or renegotiate their relationship with us as a result of the Merger. If any of these effects were to occur, it could materially and adversely impact our business, cash flow, results of operations or financial condition, as well as the market price of our common stock and our perceived Merger value, regardless of whether the Merger is completed. In addition, whether or not the Merger is completed, while it is pending we will continue to incur costs, fees, expenses and charges related to the Merger, which may materially and adversely affect our financial condition.
The Merger Agreement limits our ability to pursue alternatives to the Merger.
The Merger Agreement contains provisions that make it more difficult for us to enter into alternative transactions. The Merger Agreement contains certain provisions that restrict our ability to, among other things, solicit, initiate or knowingly encourage or knowingly facilitate the submission of inquiries, proposals or offers relating to or that would reasonably be expected to lead to any acquisition proposal from a third party. The Merger Agreement also provides that our board of directors will not change its recommendation that our stockholders adopt the Merger Agreement and will not approve any agreement with respect to an acquisition proposal, subject to limited exceptions.
In addition, upon adoption of the Merger Agreement by our stockholders, our right to terminate the Merger Agreement in response to a superior proposal will be eliminated. While we believe these provisions are reasonable, customary and not preclusive of other offers, the provisions might discourage a third party that has an interest in acquiring all or a significant part of us from considering or proposing such acquisition, even if such party were prepared to pay consideration with a higher per-share value than the currently proposed merger consideration. Furthermore, the requirement to pay a termination fee under certain circumstances may result in a third party proposing to pay a lower per-share price to acquire us than it might otherwise have proposed to pay because of the added expense of the $55.8 million termination fee that may become payable by us in certain circumstances.
Litigation may arise in connection with the Merger, which could be costly, prevent consummation of the Merger, divert management’s attention and otherwise materially harm our business.
Regardless of the outcome of any future litigation related to the Merger, such litigation may be time-consuming and expensive and may distract our management from running the day-to-day operations of our business. The litigation costs and diversion of management’s attention and resources to address the claims and counterclaims in any litigation related to the Merger may materially adversely affect our business, results of operations, prospects, and financial condition. If the Merger is not consummated for any reason, litigation could be filed in connection with the failure to consummate the Merger. Any litigation related to the Merger may result in negative publicity or an unfavorable impression of us, which could adversely affect the price of our common stock, impair our ability to recruit or retain employees, damage our relationships with our end-customers, manufacturers and other third-party providers, or otherwise materially harm our operations and financial performance.
Risks Related to Our Business
As a result of recent changes in our market, sales organization, and go-to-market strategy, our ability to forecast our future results of operations and plan for and model future growth is limited and subject to a number of uncertainties.
Although we were founded in 2000 and launched CounterACT in 2006, much of our growth has occurred in recent periods. Our growth reflects a number of macro changes impacting the cyber security market, particularly through the growth of unsecured IoT devices within the campus and on-premise data center portions of organizations’ networks, the emerging awareness that the OT devices represent significant portions of many organizations’ networks that are unsecured and are connected to the IT part of the network and the shift of application payloads from on-premise data centers into third-party cloud providers thus extending the IT part of an organization’s network into a third-party network for which visibility and control over those virtual devices is very limited. To address this demand, we have made substantial investments in our sales force. As a result of these recent changes in our market, sales organization and go-to-market strategies, coupled with our limited operating history, our ability to forecast our future results of operations and plan for and model future growth is limited and subject to a number of uncertainties. We have encountered, and will continue to encounter, risks and uncertainties frequently encountered by rapidly growing companies in developing markets. If our assumptions regarding these risks and uncertainties are incorrect or change in response to developments in the security market, our results of operations and financial results could differ materially from our plans and forecasts. If we are unable to achieve our key objectives, our business and results of operations will be adversely affected and the fair market value of our common stock could decline.
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Our revenue growth rate in recent periods may not be indicative of our future performance.
Our revenue growth rate in recent periods should not be viewed as an indication of our future performance. For the years ended December 31, 2019, 2018, and 2017 our revenue was $336.8 million, $297.7 million, and $224.4 million, respectively, representing year-over-year growth of 13% and 33%, respectively. We may not achieve similar revenue growth rates in future periods. Factors that could impact our ability to increase our revenue include continued retention and sales to existing end-customers, extending the reach of our sales force footprint, and increasing the efficiency by which our sales force engages our end-customers. If we are unable to maintain consistent revenue or revenue growth, our stock price could experience volatility, and our ability to achieve and maintain profitability could be adversely affected.
In addition, beginning in 2019, we embarked on the first phases of a change in our go-to-market strategy by beginning to transition our business model from licensing our products on a perpetual basis toward term-based licensing and software-as-a-service offerings. Over time, we expect that we will transition further to a subscription license model. This transition may give rise to a number of risks, and if we do not successfully execute this transition, our business and future operating results could be adversely affected. In particular, we generally recognize perpetual license revenues upfront, while we recognize term-based and software-as-a-service offerings ratably over the term of the agreement. At the beginning of each period, we cannot predict the ratio of orders with revenues that will be recognized upfront and those with revenues that will be recognized ratably that we will enter into during the quarter, which makes it difficult for us to predict the amount of revenue we will be able to recognize in any quarter. Our operating margins, cash flows and other operating results and our business model could also be significantly impacted by shifts over time in the relative percentage of term-based licenses and software-as-a-service offerings and the duration of these types of agreements for our offerings. In addition, the size of our licenses and orders varies greatly. A single, large perpetual license order in a given period could distort our operating results, and a decline in larger orders in any given period could adversely affect our revenues and operating results. The timing and size of large orders are often hard to predict in any particular period.
We have a history of losses and may be unable to achieve or maintain profitability in the future.
We have incurred significant net losses in each year since our inception. We may not be able to sustain or increase our growth or achieve profitability in the future or on a consistent basis. We expect our operating expenses to increase over the next several years as we continue to expend substantial financial resources on, among other things, investments in research and development and sales and marketing, and the hiring of additional employees. The return on these investments, if any, will only be realized over time and may not result in increased revenue commensurate with increases in our expenses, or at all.
In addition, as a public company, we have incurred, and will continue to incur, significant accounting, legal, and other expenses that we did not incur as a private company. Achieving profitability will require us to increase revenue, manage our cost structure, and avoid significant liabilities. Revenue growth may slow, revenue may decline, or we may incur significant losses in the future for a number of reasons, including general macroeconomic conditions, increasing competition, a decrease in the growth of the markets in which we operate, the inability to expand our sales force and increase its productivity, or if we fail for any reason to continue to capitalize on growth opportunities. Additionally, we may encounter unforeseen operating expenses, difficulties, complications, delays, and other unknown factors that may result in losses in future periods. If these losses exceed our expectations or our revenue growth expectations are not met in future periods, our financial performance will be harmed and our stock price could decline.
If we are unable to increase sales of our solution to large organizations and government entities, while mitigating the risks associated with serving such end-customers, our business, financial position, and results of operations may suffer.
Our growth strategy is dependent, in part, upon increasing sales of our solution to large organizations and government entities. Sales to large organizations and government entities involve risks that may not be present (or that are present to a lesser extent) with sales to smaller entities. These risks include:
• | increased purchasing power and leverage held by large end-customers in negotiating contractual arrangements with us, including, in certain cases, clauses that provide preferred pricing of configurations with similar specifications; |
• | more stringent or costly requirements imposed upon us in our maintenance and support contracts with such end-customers, including stricter response times and penalties for any failure to meet maintenance and support requirements |
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(which penalties may include termination of our maintenance and support contracts with such end-customer, or refunds of amounts paid);
• | more complicated and costly implementation processes and network infrastructure; |
• | longer sales cycles and the associated risk that substantial time and resources may be spent on a potential end-customer that ultimately elects not to purchase our products or purchases fewer products than we anticipated; |
• | closer relationships with, and increased dependence upon, large technology companies who offer competitive products and have stronger brand recognition; and |
• | increased pressure for pricing discounts. In addition, because security breaches with respect to larger, high-profile organizations, or government entities are likely to be heavily publicized and because they are more likely to be targeted by cyberattackers, there is increased reputational risk associated with serving such end-customers. |
If we are unable to increase sales of our solution to large organizations and government entities while mitigating the risks associated with serving such end-customers, our business, results of operations, prospects, and financial condition may suffer.
Our business and operations have experienced rapid growth, and if we do not appropriately manage any future growth, or are unable to improve our systems and processes, our results of operations will be harmed.
We have experienced rapid growth over the last several years, which has placed, and will continue to place, significant demands on our management, administrative, operational, and financial infrastructure. As we have grown, we have had to manage an increasingly larger and more complex array of internal systems and processes to scale all aspects of our business in proportion to such rapid growth, including an expanded sales force, additional end-customer service personnel, and a new corporate headquarters, as well as more complex administrative systems related to managing increased headcount, particularly within our sales force. Our success will depend in part upon our ability to manage our growth effectively. To do so, we must continue to increase the productivity of our existing employees, particularly our sales force, and hire, train, and manage new employees as needed.
To manage the domestic and international growth of our operations and personnel, we will need to continue to improve our operational, financial, and management controls, as well as our reporting processes and procedures. In addition, we will need to implement more extensive and integrated financial and business information systems. These additional investments will increase our operating costs, which will make it more difficult for us to offset any future revenue shortfalls by reducing expenses in the short term. We may not be able to successfully acquire or implement these or other improvements to our systems and processes in an efficient or timely manner, or once implemented, we may discover deficiencies in their capabilities or effectiveness. We may experience difficulties in managing improvements to our systems and processes or in integrating with third-party technology. In addition, our systems and processes may fail to prevent or detect errors, omissions, or fraud. Our failure to improve our systems and processes, or their failure to operate effectively and in the intended manner, may result in the disruption of our current operations and end-customer relationships, our inability to manage the growth of our business, and our inability to accurately forecast and report our revenue, expenses and earnings, any of which may materially harm our business, results of operations, prospects, and financial condition.
If we are unable to increase market awareness of our company and our solution, or fail to successfully promote or protect our brand, our competitive market position and revenue may not continue to grow or may decline.
Market awareness of the value proposition of our solution will be essential to our continued growth and our success. If our marketing efforts are unsuccessful in creating market awareness of our company and our solution, then our business, results of operations, prospects, and financial condition will be adversely affected, and we will not be able to achieve sustained growth.
Moreover, due to the intensely competitive nature of our market, we believe that building and maintaining our brand and reputation is critical to our success and that the importance of positive brand recognition will increase as competition in our market further intensifies. While we believe that we are successfully building a well-established brand and have invested, and expect to continue to invest substantial resources to promote and maintain our brand, both domestically and internationally, there can be no assurances that our brand development strategies will enhance our reputation or brand recognition or lead to increased revenue.
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Furthermore, an increasing number of independent industry analysts and researchers, such as Gartner, Inc., International Data Corporation, and Forrester Research, Inc., regularly evaluate, compare, and publish reviews regarding the functionality of security products and services, including our solution. The market’s perception of our solution may be significantly influenced by these reviews. We do not have any control over the content of these independent industry analysts and researchers’ reports, and our reputation and brand could be harmed if they publish negative reviews of our solution or do not view us as a market leader. The strength of our brand may also be negatively impacted by the marketing efforts of our competitors, which may include incomplete, inaccurate, and misleading statements about us, or our products and services. If we are unable to maintain a strong brand and reputation, sales to new and existing end-customers could be adversely affected, and our financial performance could be harmed.
We operate in a highly competitive market, with certain competitors having greater resources than we do, and competitive pressures from existing and new companies may adversely impact our business, results of operations, prospects, and financial condition.
The market in which we compete is highly fragmented, intensely competitive, and evolving in response to changes in the threat landscape and corporate network security infrastructures. We expect competition to intensify in the future as existing competitors bundle new and more competitive offerings with their existing products and services, and as new market entrants introduce new products into the security market. This competition could result in increased pricing pressure, reduced profit margins, increased sales and marketing expenses, and our failure to increase, or the loss of, market share, any of which could seriously harm our business, results of operations, prospects, and financial condition. If we do not keep pace with product and technology advances and otherwise keep our products and services competitive, there could be a material and adverse effect on our competitive position, revenue, and prospects for growth.
Our competitors and potential competitors may emulate or integrate features similar to ours into their own products; independent network security vendors that offer products that claim to perform similar functions to our solution; and small and large companies that offer point solutions that compete with some of the features present in our solution. We may also face competition from highly specialized vendors as well as larger vendors that may continue to acquire or bundle their products more effectively as our market grows and IT budgets are increased or created to support next-generation threat protection.
Many of our current and potential competitors have longer operating histories, are substantially larger and have greater financial, technical, research and development, sales and marketing, manufacturing, distribution, and other resources, and greater name recognition. Such competitors also may have well-established relationships with our current and potential end-customers, extensive knowledge of our industry and the market in which we compete and intend to compete, and such competitors may emulate or integrate product features similar to ours into their own products. As a result, our competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the development, marketing, promotion, and sale of their products and services than we can with respect to our products and services. They also may make strategic acquisitions or establish cooperative relationships among themselves or with other providers, thereby increasing their ability to provide a broader suite of products and services, and potentially causing our end-customers to decrease purchases of, or defer purchasing decisions with respect to, our products and services. In addition, some of our larger competitors have substantially broader product offerings and may be able to leverage their relationships with distribution partners and customers based on other products or incorporate functionality into existing products to gain business in a manner that discourages potential end-customers from purchasing our products and services, including by selling at zero or negative margins, product bundling, or offering closed technology solutions. Potential end-customers may also prefer to purchase from their existing vendors rather than a new supplier regardless of product performance or features. Further, to the extent that one of our competitors acquires, or establishes or strengthens a cooperative relationship with, one or more of our channel partners, it could adversely affect our ability to compete. We may be required to make substantial additional investments in research and development and sales and marketing to respond to these competitive pressures, and we may not be able to compete successfully in the future. Any of the foregoing may limit our ability to compete effectively in the market and adversely affect our business, results of operations, prospects, and financial condition.
If we are unable to successfully expand our sales force while maintaining sales productivity, sales of our products, maintenance, and professional services and the growth of our business and financial performance could be harmed.
We continue to be substantially dependent on our sales force to obtain new end-customers and increase sales to existing end-customers, and we plan to continue to grow our sales force in the future. There is significant competition for sales personnel
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with the skills and technical knowledge that we require. Our ability to achieve significant revenue growth and profitability will depend, in large part, on our success in recruiting, training, and retaining a sufficient number of sales personnel to support our growth, particularly in international markets. New sales representative hires require significant training and may require a lengthy on-boarding process before they achieve adequate levels of productivity. Generally, our sales representatives become more productive the longer they are with us, with limited productivity in their first few quarters as they learn to sell our products and participate in field training.
Our recent hires and planned hires may not become productive as quickly as we expect, or at all, and we may be unable to hire or retain a sufficient number of qualified personnel in the markets where we do business or plan to do business. If we are unable to recruit, train, and retain a sufficient number of productive sales personnel, sales of our products, maintenance, and professional services and the growth of our business would be harmed. Additionally, if our efforts to expand our sales force do not result in increased revenue, our results of operations could be negatively impacted due to increased operating expenses associated with an expanded sales force.
Our end-customers’ purchasing cycles may cause fluctuations in our revenue.
Our business is affected by cyclical fluctuations in end-customer spending patterns, which result in some seasonal trends in the sale of our solution. Revenue in our third and fourth fiscal quarters, particularly in the last two weeks of the fourth quarter, is typically stronger due to the calendar year-end. Our U.S. public sector end-customers typically end their fiscal years during our third quarter, while many of our other end-customers end their fiscal years during our fourth quarter. Our first and second fiscal quarters typically experience lower sales, with aggregate revenue historically significantly lower in our first fiscal quarter when compared to our third and fourth fiscal quarters. Furthermore, our rapid growth rate over recent years may have made these fluctuations more difficult to detect. If our growth rate slows over time, cyclical variations in our operations may become more pronounced, and our business, results of operations, prospects, and financial condition may be adversely affected.
Failure to complete sales or deliver products at the end of the quarter could cause our revenue for the applicable period to fall below expected levels.
As a result of end-customer buying patterns and the efforts of our sales force and channel partners to meet or exceed their quarterly sales objectives, we have historically received a substantial portion of sales orders and generated a substantial portion of revenue during the last few weeks of each fiscal quarter. If recognition of expected revenue is delayed beyond the end of the quarter for any reason, our revenue for that quarter could fall below our expectations and the estimates of analysts, which could adversely impact our business, results of operations, prospects, and financial condition and cause a decline in the trading price of our common stock. The reasons our expected revenue may be delayed include:
• | the failure of anticipated purchase orders to materialize; |
• | our logistics partners’ inability to deliver products prior to fiscal quarter-end to fulfill purchase orders received near the end of the fiscal quarter; |
• | our failure to manage inventory to meet demand; |
• | our inability to release new products on schedule; |
• | any failure of our systems related to order review and processing; or |
• | any delays in shipments based on trade compliance requirements. |
We are dependent upon lead generation strategies to drive our sales and revenue. If these marketing strategies fail to continue to generate sales opportunities, our ability to grow our revenue will be adversely affected.
We are dependent upon lead generation strategies to generate sales opportunities, such as digital campaigns, sponsored events, tradeshows, webinars, product demonstrations and high-touch account-based marketing programs. These strategies may not be successful in continuing to generate sufficient sales opportunities necessary to increase our revenue. To the extent that targeted leads do not become, or we are unable to successfully attract, end-customers, we will not realize the intended benefits of these marketing strategies, and our ability to grow our revenue will be adversely affected. Additionally, our marketing strategies may become increasingly expensive and generating a meaningful return on these strategies may be difficult. Even if we
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successfully increase revenue as a result of our paid marketing efforts, it may not offset the additional marketing expenses we incur.
Our business depends substantially on our ability to retain end-customers and expand our offerings to them. A decline in our end-customer retention or in our ability to expand sales to existing end-customers could harm our future results of operations.
Many organizations seek security solutions that are among the best available in the industry. For us to maintain or improve our results of operations in an industry that is rapidly evolving and places a premium on market leading solutions, it is important that we retain existing end-customers and that our end-customers expand their use of our products and services. An increasing portion of our revenue is derived from additional sales to our end-customers for both the management of additional existing devices on their networks and the influx of new devices that are added to their networks each day. During the year ended December 31, 2019, the majority of our revenue came from existing end-customers, and it is important for us to increase sales into this base. Our end-customers also have no obligation to renew their maintenance and support contracts with us upon the expiration of the initial maintenance and support contract period, which is typically a one-year or three-year term, and even if end-customers do renew, they may not renew with a similar maintenance and support contract period, or they may renew on terms that are less economically beneficial to us.
Our end-customer retention rates may decline or fluctuate as a result of a number of factors, including the level of our end-customers’ satisfaction with our solution, services and support, our prices and the prices of competing solutions or products, mergers and acquisitions affecting our end-customer base, the effects of global economic conditions, new technologies, changes in our end-customers’ spending levels, and changes in how our end-customers perceive the security threats to their organizations and the importance of our offerings to the security of their organizations.
Our future success depends substantially on our ability to expand our sales to our existing end-customers with solutions we develop or acquire. If we are unable to expand our presence within our end-customer base by expanding the scope of their usage or adopting additional products, our business and revenue will be adversely affected.
If we are unable to attract new end-customers, our revenue growth and profitability will be adversely affected.
To increase our revenue and achieve and maintain profitability, we must consistently add new end-customers. Numerous factors, however, may impede our ability to add new end-customers, including our inability to convert prospective end-customers that have been referred to us by our existing network into end-customers, failure to attract and effectively train new sales and marketing personnel, failure to retain and motivate our current sales and marketing personnel, failure to develop relationships with resellers, or failure to ensure the effectiveness of our marketing programs. In addition, if prospective end-customers do not perceive our solution to be of superior value and quality, we will not be able to attract the number and types of new end-customers that we are seeking.
Our results of operations may fluctuate significantly, be difficult to predict, and may not meet investor expectations.
Our results of operations have varied significantly in the past and may vary significantly in the future, from period to period due to a number of factors, many of which are outside of our control, including macroeconomic factors. These factors limit our ability to accurately predict our results of operations and include factors discussed throughout this “Risk Factors” section, including the following:
• | macroeconomic conditions in our markets, both domestic and international, as well as the level of discretionary IT spending available to organizations; |
• | the timing, size, and mix of orders from, and shipments to, end-customers, including the timing of large orders, and timing of shipments; |
• | fluctuation in demand for our Software Products and Hardware Products; |
• | fluctuation in demand for our high-margin and low-margin Hardware Products; |
• | fluctuation in demand for our products, maintenance, and professional services; |
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• | shifts in our mix of perpetual and term-based or software-as-a-service licenses; |
• | evolving conditions in the markets in which we compete; |
• | variability and unpredictability in the rate of growth in the markets in which we compete; |
• | our ability to continue to acquire new end-customers and increase our market share; |
• | our sales cycles, which may lengthen as the complexity of products and competition in our markets increases and in response to macroeconomic conditions; |
• | the level of competition in our markets, including the effect of new entrants, price competition, consolidation, and technological innovation; |
• | market acceptance of our products, maintenance, and professional services; |
• | any disruption in our channel or termination of our relationship with important channel partners; |
• | product announcements, introductions, transitions, and enhancements by us or our competitors, which could result in deferrals of end-customer orders; |
• | technological changes in our markets; |
• | the quality and level of our execution of our business strategy and operating plan, and the effectiveness of our sales and marketing programs; |
• | the impact of future acquisitions or divestitures; |
• | the cost of potential and existing litigation, which could have a material adverse effect on our business; |
• | seasonality or cyclical fluctuations in our markets; |
• | the need to change our pricing model or make pricing concessions to large end-customers; |
• | changes in accounting rules and policies; and |
• | the need to recognize certain revenue ratably over a defined period or to defer recognition of revenue to a later period. |
Furthermore, a high percentage of our expenses, including those related to overhead, service and maintenance, research and development, sales and marketing, and general and administrative functions are generally fixed in the short term. As a result, if our revenue is less than forecasted, we may not be able to effectively reduce such expenses to compensate for the revenue shortfall and our results of operations will be adversely affected.
Within sales to our government customers, sales to U.S. federal, state, and local government agencies and other public sector entities are subject to a number of challenges and risks that may adversely impact our business.
We currently sell our solution to various government agencies and other public sector entities, and we may in the future increase sales to government agencies and other public sector entities. Sales to such government agencies and other public sector entities are subject to certain risks. Selling to government agencies and other public sector entities can be highly competitive, expensive, and time-consuming, and can require certification requirements, often requiring significant upfront time and expense without any assurance that these efforts will result in a sale. Additionally, public sector demand and payment for our products, maintenance, and professional services may be impacted by public sector budgetary cycles, government shutdowns, and/or funding authorizations. Funding reductions, budget constraints, or delays may adversely affect public sector demand for our products, maintenance, and professional services. For example, an extended government shutdown could prevent certain sales from being completed within the time anticipated. The vast majority of our sales to government agencies and other public sector entities are completed through our network of channel partners, and government agencies and other public sector entities may have statutory, contractual, or other legal rights to terminate contracts with our distributors and resellers for convenience or due to a default. The public sector routinely investigates and audits public sector contractors’ administrative processes, and any
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unfavorable audit could result in the public sector refusing to continue buying our products, maintenance, and professional services, a reduction of revenue, fines, or civil or criminal liability if the audit uncovers improper or illegal activities, which could adversely impact our results of operations.
Because we derive the majority of our revenue and cash flows from one product group, products for device visibility and control, the failure to achieve increased market acceptance would adversely affect our business, results of operations, prospects, and financial condition.
We derive and expect to continue to generate most of our revenue from our device visibility and control product group and related maintenance and professional services for the foreseeable future. As a result, the market acceptance of this product group is critical to our continued success. Demand for this product group is affected by a number of factors beyond our control, including continued market acceptance of this product group by referenceable accounts for existing and new use cases, the timing of development and release of new products by our competitors, technological change, and growth or contraction in our market. Our inability to expand our sales of this product group to existing end-customers or increase our sales of this product group to new end-customers would harm our business and results of operations more seriously than if we derived significant revenue from a variety of sources.
Real or perceived defects, errors or vulnerabilities in our products, the misconfiguration of our products, the failure of our products to detect or prevent a security breach, the failure of end-customers to take action on attacks identified by our products, or the failure of our products to detect newly developed devices could harm our reputation and adversely impact our business, results of operations, prospects, and financial condition.
Because our products are complex, they have contained, and may in the future contain, design or manufacturing defects or errors that are not detected before their deployment. Our products also provide our end-customers with the ability to customize a multitude of settings, and it is possible that an end-customer could misconfigure our products or otherwise fail to configure our products in an optimal manner. Such defects, errors, and misconfigurations of our products could cause our products to be vulnerable to security attacks, cause them to fail to secure networks and detect and block threats, or temporarily interrupt the networking traffic of our end-customers. In addition, because the devices and techniques used by computer hackers to access or sabotage networks change frequently and generally are not recognized until widely deployed, there is a risk that an advanced attack could emerge through a device that our products are unable to detect, particularly devices without IP addresses. Moreover, as our products are adopted by an increasing number of large organizations and government entities, it is possible that the individuals and organizations behind cyberattacks will begin to focus on finding ways to defeat our products. If this happens, our products could be targeted by attacks specifically designed to disrupt our business and undermine the perception that our products are capable of providing superior network security, which, in turn, could have a serious impact on our reputation. Any security vulnerability or perceived security vulnerability of our products could materially and adversely affect our business, results of operations, prospects, and financial condition.
If any of our end-customers become infected with malware after using our products, such end-customer could be dissatisfied with our products or perceive that our products failed to perform their intended purpose, regardless of whether our products mitigated the actual harm of malware, blocked the theft of any of such end-customer’s data, or would have blocked such theft if the product had been configured properly. If any of our end-customers experience a security breach, such end-customers and the general public may believe that our products failed even if the cause of the breach is unrelated to the performance of our products. Furthermore, if any organizations or government entities that are publicly known to use our products are the subject of a cyberattack that becomes publicized, our other current or potential end-customers may believe that our products failed and be inclined to purchase alternative solutions from our competitors. Real or perceived security breaches of our end-customers’ networks could cause disruption or damage to their networks or other negative consequences and could result in negative publicity about us, damage to our brand and reputation, decreased sales, increased expenses, and end-customer relations problems.
Furthermore, our existing products are designed to detect existing IP-based devices and may fail to detect newly developed IP-based devices or devices that operate on newly developed protocols for any number of reasons, including our failure to enhance and expand our products and services to reflect industry trends, the advancement of new and existing technologies and new operating environments, the complexity of our end-customers’ network and environment, and the sophistication of malware, viruses, and other threats. To the extent potential end-customers, industry analysts or testing firms believe that the failure of our products to detect certain networked devices indicates that our products or services do not provide significant value, our reputation
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and business could be harmed. Failure to keep pace with technological changes in the security industry and the threat landscape could adversely affect our ability to protect against security breaches and could cause us to lose end-customers.
Any real or perceived defects, errors, or vulnerabilities in our products, or any other failure of our products to detect devices that introduce threats to an end-customer’s network, could result in:
• | a loss of existing or potential end-customers or channel partners; |
• | delayed or lost revenue and harm to our financial condition and results of operations; |
• | a delay in attaining, or the failure to attain, market acceptance for new products; |
• | the expenditure of significant financial and product development resources in efforts to analyze, correct, eliminate, or work around errors or defects, to address and eliminate vulnerabilities, or to identify and ramp up production with alternative third-party manufacturers; |
• | an increase in warranty claims or an increase in the cost of servicing warranty claims, either of which would adversely affect our gross margins; |
• | harm to our reputation or brand; or |
• | litigation, regulatory inquiries, or investigations that may be costly and further harm our reputation. |
Because our products are subject to real or perceived defects, our business is subject to risks related to warranty claims, product returns and product liability.
We may incur significant costs in connection with a product recall and any related indemnification obligations, which could materially and adversely affect our results of operations. In addition, many of our products operate on our internally developed operating system, and any error in the operating system may affect those products. Because our products are complex, we have experienced in the past, and may continue to experience in the future, errors or quality problems in connection with new products and enhancements to existing products. We expect that errors or quality problems will be found from time to time in our products after commencement of commercial shipments, which could seriously harm our business.
Historically, the amount of warranty claims we have received has not been significant, but there is a risk that errors or problems with the quality of our products could result in material claims in the future. Because our end-customers install our appliances directly into their network infrastructures, any errors, defects, or other problems with our products could negatively impact their networks or other internet users, resulting in financial or other losses to our end-customers. While we typically seek by contract to limit our exposure to such damages, liability limitation provisions in our standard terms and conditions of sale, and those of our channel partners, may not be enforceable under some circumstances as a result of federal, state, or local laws or ordinances, or unfavorable judicial decisions in the United States or other countries or may not fully or effectively protect us from end-customer claims and related liabilities and costs, including indemnification obligations under our agreements with channel partners or end-customers. The sale and support of our products also entail the risk of product liability claims. We maintain insurance to protect against certain types of claims associated with the use of our products, but our insurance coverage may not adequately cover any such claims. In addition, even claims that ultimately are unsuccessful could require us to incur costs in connection with litigation, which could divert management’s time and other resources away from our business and could significantly harm the reputation of our business and products.
We rely upon subscription revenue, which may decline, and because we recognize revenue on these term contracts over the term of the relevant service period, downturns or upturns in sales of these services are not immediately reflected in full in our results of operations.
Sales of new or renewal term contracts may decline and fluctuate as a result of a number of factors, including our end-customers’ level of satisfaction with our term products, our maintenance and support services, the prices of our term products and services, and reductions in our end-customers’ spending levels. If our sales of new or renewal term contracts decline, our revenue and revenue growth may decline and our business will suffer. While we typically bill for term contracts upfront, we recognize revenue from term contracts ratably over the contractual service period, which is typically either one or three years, but can be up to five years. As a result, much of the subscription revenue from our term contracts that we report each fiscal
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quarter is the recognition of deferred revenue from term contracts entered into during previous fiscal quarters. Consequently, a decline in new or renewed term contracts in any one fiscal quarter will not be fully or immediately reflected in revenue in that fiscal quarter but will negatively affect our revenue in future fiscal quarters. Accordingly, the effect of significant downturns in new or renewed sales of our term contracts is not reflected in full in our results of operations until future periods. Also, it is difficult for us to rapidly increase our subscription revenue through additional sales of term contracts in any period, as revenue from new and renewal term contracts must be recognized over the applicable term of the contract. Furthermore, any increase in the average term of these contracts would result in revenue for such contracts being recognized over longer periods of time.
The security market is rapidly evolving and difficult to predict within the increasingly challenging cyberthreat landscape. If the security market does not continue to evolve as we anticipate or if our target end-customers do not adopt our solution, our sales will not grow as quickly as anticipated and our stock price could decline.
We are in a new, rapidly-evolving category within the security market that focuses on providing organizations with enhanced visibility and control over their networks through an agentless and continuous monitoring solution. As such, it is difficult to predict important market trends, including how large the security market will be or when and what products end-customers will adopt. For example, organizations that currently use traditional approaches may believe that these approaches already provide them with sufficient network security. Therefore, they may continue spending their network infrastructure budgets on these products and may not adopt our solution in addition to or in lieu of such traditional products.
The introduction of new products by others, market acceptance of products based on new or alternative technologies, or the emergence of new industry standards could render our existing products obsolete or make it easier for other products to compete with our products. Moreover, many of our end-customers operate in markets characterized by rapidly changing technologies and cyberthreats, which require them to add numerous devices and adopt increasingly complex network infrastructures, incorporating a variety of hardware devices, software applications, operating systems, and networking protocols. As their technologies and business plans grow more complex, we expect these end-customers to face new and increasingly sophisticated methods of cyberattack. We face significant challenges in ensuring that our solution effectively identifies and responds to these advanced and evolving attacks without disrupting our end-customers’ network performance. Changes in the nature of advanced cyberthreats could result in a shift in IT budgets away from solutions such as ours. In addition, any changes in government regulation, compliance standards, or audit requirements that deemphasize the types of visibility, controls, and monitoring that our solution provides would adversely impact demand for our offerings. If solutions such as ours are not viewed by organizations as necessary, or if end-customers do not recognize the benefit of our solution as a critical layer of an effective security strategy, then our revenue may not grow as quickly as expected, or may decline, and our business could suffer.
Our future success will depend in part upon our ability to:
• | develop, acquire, and/or maintain competitive products; |
• | enhance our products by adding innovative features that differentiate our products from those of our competitors; |
• | bring products to market on a timely basis at competitive prices; |
• | identify and respond to emerging technological trends in the market; and |
• | respond effectively to new technological changes or new product announcements by others. |
If the market for network security products does not evolve in the way we anticipate or if organizations do not recognize the benefits our solution offers in addition to or in place of existing network security products, and as a result we are unable to increase sales of our solution to end-customers, then our revenue may not grow as expected or may decline, which could adversely impact our stock price.
Our sales cycles can be long and unpredictable, and our sales efforts require considerable time and expense. As a result, our sales and the timing of our sales are difficult to predict and may vary substantially from period to period, which may cause our results of operations to fluctuate significantly.
The decision makers within our end-customers are primarily IT departments that are managing a growing set of user and compliance demands, which increases the complexity of end-customer requirements to be met in the sales cycle. The length of our customer acquisition sales cycle and our expansion sales cycles, from identification of an opportunity to delivery of and
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payment for our products, maintenance, and professional services, typically ranges from nine to 24 months and three to 12 months, respectively, but can be longer and may vary significantly from customer to customer, with sales to large organizations and government entities typically taking longer to complete. To the extent our competitors develop products that our prospective end-customers view as comparable to ours, our average sales cycle may increase. Additionally, a combination of legal, procurement, development, and IT departments are involved in testing, evaluating, and finally approving purchases, which can also make the sales cycle longer and less predictable. Moreover, sales to large organizations and government entities, which we target, will contribute to the growth of our revenue and involve challenges that could further increase the complexity and length of our sales cycle, such as complicated certification and bidding processes. As a result, large individual sales have, in some cases, occurred in quarters subsequent to those we anticipated or have not occurred at all. The loss or delay of one or more large transactions in a quarter could impact our results of operations for that quarter and any future quarters for which revenue from that transaction is delayed.
We may not be able to accurately predict or forecast the timing of sales, which could cause our results to vary significantly. In addition, we might devote substantial time and effort to a particular unsuccessful sales effort, and as a result we could lose other sales opportunities or incur expenses that are not offset by an increase in revenue, which could harm our business.
If our products do not successfully interoperate with our end-customers’ infrastructure, sales of our products, maintenance, and professional services could be negatively affected, which would harm our business.
Our products must interoperate with our end-customers’ existing or future infrastructures, which often have different specifications, utilize multiple protocol standards, deploy products from multiple vendors, and contain multiple generations of products that have been added over time. As a result, when problems occur in a network, it may be difficult to identify the sources of these problems. If we are unable to successfully manage and interpret new protocol standards and versions, or if we encounter problematic network configurations or settings, or if end-customer’s traffic is or becomes encrypted, or end-customer’s existing or future vendors threaten to disrupt the service level agreements they have with our shared customers based on a perceived potential disruption to their products are implemented, we may have to modify our software or hardware so that our products will interoperate with our end-customers’ infrastructures and can manage our end-customers’ traffic in the manner intended, which may divert substantial time and resources. If we find defects in the hardware installed with an end-customer, as we have in the past, we will replace the hardware as part of our normal warranty process. If we find errors or bugs in existing software that create problematic network configurations or settings, as we have in the past, we may have to issue software updates as part of our normal maintenance process. Any delays in identifying the sources of problems or in providing necessary modifications to our software or hardware could have a negative impact on our reputation and our end-customers’ satisfaction with our products, maintenance, and professional services and our ability to sell products and services could be adversely affected. In addition, government entities and other end-customers may require our products to comply with certain additional security or other certifications and standards. If our products are late in achieving or fail to achieve compliance with these certifications and standards, or our competitors achieve compliance with these certifications and standards, we may be disqualified from selling our products to such end-customers or at a competitive disadvantage, which would harm our business, results of operations, prospects, and financial condition.
Failure to protect our proprietary technology and intellectual property rights could substantially harm our business and results of operations.
The success of our business depends on our ability to protect and enforce our trade secrets, trademarks, copyrights, patents, and other intellectual property rights. We attempt to protect our intellectual property under patent, trademark, copyright, and trade secret laws, and through a combination of confidentiality procedures, contractual provisions, and other methods, all of which can offer only limited protection. We have a number of issued patents and pending patent applications in the United States and abroad, and we plan to file additional patent applications in the future. Valid patents may not issue from our pending applications, and the claims eventually allowed on any patents may not be sufficiently broad to prevent competitors from using technology similar to our patented technology.
Any issued patents may be challenged, invalidated, or circumvented, and any rights granted under these patents may not actually provide adequate defensive protection or competitive advantages to us. Patent applications in the United States are typically not published until 18 months after filing or, in some cases, not at all, and publications of discoveries in industry-related literature lag behind actual discoveries. At the time of filing a patent application, we cannot be certain that we were the first to make the inventions claimed in our pending patent applications or that we were the first to file for patent protection, which could
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prevent our patent applications from issuing as patents or invalidate our patents following issuance. Additionally, the process of obtaining patent protection is expensive and time-consuming, and we may not be able to prosecute all necessary or desirable patent applications or pursue patent protection in all countries and jurisdictions in which we do business at a reasonable cost or in a timely manner. In addition, recent changes to the patent laws in the United States may bring into question the validity of certain categories of software patents. As a result, we may not be able to obtain adequate patent protection for our software or effectively enforce any issued patents relating to software.
Many aspects of our business rely on our unpatented or unpatentable proprietary technology and trade secrets. Despite our efforts to protect our proprietary technology and trade secrets, unauthorized parties may attempt to misappropriate, reverse engineer, or otherwise obtain and use them. The contractual provisions that we enter into with employees, consultants, partners, vendors, and end-customers may not prevent unauthorized use or disclosure of our proprietary technology or intellectual property rights and may not provide an adequate remedy in the event of unauthorized use or disclosure of our proprietary technology or intellectual property rights, which may substantially harm our business. In addition, we cannot assure you that we have entered into such agreements with all parties who may have or have had access to our confidential information, that such agreements will be fully enforceable, or that the agreements we have entered into will not be breached by the counterparty. Some license provisions protecting against unauthorized use, copying, transfer, and disclosure of our technology may be unenforceable under the laws of certain jurisdictions and foreign countries. We cannot guarantee that any of the measures we have taken will prevent misappropriation of our technology. Because we, as a provider of network security solutions, may be an attractive target for computer hackers, we may have a greater risk of unauthorized access to, and misappropriation of, our proprietary information. Moreover, policing unauthorized use of our technologies, products and intellectual property is difficult, expensive and time-consuming, particularly in foreign countries where the laws may not be as protective of intellectual property rights as those in the United States and where mechanisms for enforcement of intellectual property rights may be weak. We may be unable to determine the extent of any unauthorized use or infringement of our products, technologies or intellectual property rights, and may not be able to take appropriate steps to mitigate harms resulting from any unauthorized use or infringement.
From time to time, we may need to bring legal action to enforce our patents, trademarks, and other intellectual property rights, to protect our trade secrets, to determine the validity and scope of the intellectual property rights of others, or to defend against claims of infringement or invalidity. Such litigation could result in substantial costs and diversion of resources and could negatively affect our business, results of operations, financial condition, and cash flows. If we are unable to protect our intellectual property rights, we may find ourselves at a competitive disadvantage to others who need not incur the additional expense, time, and effort required to create the innovative products that have enabled us to be successful to date.
Assertions by third parties of infringement or other violations by us of their intellectual property rights, or other lawsuits asserted against us, could result in significant costs and substantially harm our business and results of operations.
Patent and other intellectual property disputes are common in the security industry. Some companies in the security industry, including some of our competitors, own large numbers of patents, copyrights, trademarks, and trade secrets, which they may use to assert claims against us or to prevent us from developing certain technologies. Third parties may assert claims of infringement, misappropriation, or other violations of intellectual property rights against us. They may also assert such claims against our end-customers whom our standard license and other agreements obligate us to indemnify against claims that our products infringe, misappropriate, or otherwise violate the intellectual property rights of third parties. As the number of products and competitors in our market increase, the number of products with overlapping functionality may increase, which in turn may result in more claims of infringement, misappropriation, and other violations of intellectual property rights. Further, as we gain an increasingly high profile, the possibility of intellectual property rights claims against us grows. Any claim of infringement, misappropriation, or other violation of intellectual property rights by a third party, even those without merit, could cause us to incur substantial costs defending against the claim and could distract our management from our business.
While we expect to increase the size of our patent portfolio, the patent portfolios of our most significant competitors and potential competitors are larger than ours. This disparity between our patent portfolio and the patent portfolios of our most significant competitors may increase the risk that they may sue us for patent infringement and may limit our ability to counterclaim for patent infringement or settle through patent cross-licenses. In addition, future assertions of patent rights by third parties, and any resulting litigation, may involve other non-operating entities or other adverse patent owners who have no relevant license revenue and against whom our own patents may therefore provide little or no deterrence or protection. Given the competitive
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nature of the market in which we operate, there is a risk that we are infringing or otherwise violating third-party intellectual property rights.
An adverse outcome of a dispute may require us to:
• | pay substantial damages, including treble damages if we are found to have willfully infringed a third party’s patents or copyrights; |
• | cease making, licensing, or using solutions that are alleged to infringe or misappropriate the intellectual property of others; |
• | expend additional development resources to attempt to redesign our products or services or otherwise to develop non-infringing technology, which may not be successful; |
• | enter into potentially unfavorable royalty or license agreements to obtain the right to use necessary technologies or intellectual property rights; or |
• | indemnify our partners and other third parties. |
Any damages or royalty obligations we may become subject to and any third-party indemnity we may need to provide that result from an adverse outcome could harm our results of operations. Royalty or licensing agreements, if required or desirable, may be unavailable on terms acceptable to us or at all, and may require significant expense and expenditures. In addition, some licenses may be non-exclusive, and therefore our competitors may have access to the same technology licensed to us. Any of these events could seriously harm our business, results of operations, prospects, and financial condition.
We rely on technology that we license from third parties, including software that is integrated with our internally developed software and used with our products.
We rely on technology that we license from third parties, including third-party commercial software and open source software, which is used with certain of our products. We cannot be certain that our licensors are not infringing the intellectual property rights of third parties or that our licensors have sufficient rights to the licensed intellectual property in all jurisdictions in which we may sell our products. Some of our agreements with our licensors may be terminated for convenience by them. If we are unable to continue to license any of this software on commercially reasonable terms, we will face delays in releases of our software or we will be required to delete this functionality from our software until equivalent, non-infringing technology can be licensed or developed and integrated into our current products. This effort could take significant time (during which we would be unable to continue to offer our affected products or services) and expense and may ultimately not be successful. In addition, our inability to obtain certain licenses or other rights might require us to engage in litigation regarding these matters, which could have a material adverse effect on our business, results of operations, prospects, and financial condition.
Our use of open source software could negatively affect our ability to sell our solution, require us to reengineer our products and possibly subject us to litigation.
We use open source software in our products and our development environments and expect to continue to use open source software in the future. Open source software is typically provided without assurances of any kind. Some open source licenses contain requirements that we make available source code for modifications or derivative works we create based upon the type of open source software we use. If we combine our proprietary software with open source software in a certain manner that is not intended under our policies or monitoring practices, we could, under certain open source licenses, be required to release the source code of our proprietary software to the public. This would allow our competitors to create similar products quickly with lower development effort and ultimately could result in a loss of sales for us. This could also result in litigation, require us to purchase costly licenses, or require us to devote additional research and development resources to change our products or services, any of which would have a negative effect on our business and results of operations. In addition, if the license terms for the open source software we utilize change, we may be forced to reengineer our offerings or incur additional costs. Although we regulate the use and incorporation of open source software into our products, we cannot be certain that we have, in all cases, incorporated open source software in our products in a manner that is consistent with the applicable open source license terms.
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For our primary product, we are dependent on a single third-party for the final assembly of the off-the-shelf-Dell-components that comprise the hardware that is sold separately along with our software or which has our software embedded and a limited number of third-party logistics providers to fulfill orders for such hardware.
For our primary product, we depend on a single third-party manufacturer, Arrow Electronics, Inc., to perform the final assembly of the off-the-shelf-Dell-components that comprise the hardware that is sold separately with our software or which has our software embedded. Our reliance on this third-party reduces our control over the assembly process and exposes us to risks, including reduced control over quality assurance, product costs, and product supply and timing. This manufacturer typically fulfills our supply requirements on the basis of individual orders. We do not have a long-term contract with our third-party manufacturer that guarantees capacity, the continuation of particular pricing terms, or the extension of credit limits. Accordingly, it is not obligated to continue to fulfill our supply requirements, which could result in supply shortages, and the prices we are charged for their services could be increased on short notice. There are alternative providers that could provide components and assemble the hardware, as our agreements do not provide for exclusivity or minimum purchase quantities, but the transition and qualification from our single third-party provider to another could be lengthy, costly, and difficult, diverting substantial time and resources from our operations.
We also depend on third-party logistics providers to fulfill orders for our products. Our supply chain partners are not committed to the design or manufacture of our products, or to fulfill orders for our products, on a long-term basis in any specific quantity or at any specific price. From time to time, we may be required to add new supply chain partner relationships or new manufacturing or fulfillment sites to accommodate growth in orders or the addition of new products. It is time consuming and costly to qualify and implement new supply chain partner relationships and new manufacturing or fulfillment sites, and such additions increase the complexity of our supply chain management. Our ability to ship products to our end-customers could be delayed, and our business and results of operations could be adversely affected if:
• | we fail to effectively manage our supply chain partner relationships; |
• | our third-party assembly provider does not meet our schedules; |
• | our third-party assembly provider experiences delays, disruptions, or quality control problems in manufacturing our products; |
• | one or more of our third-party logistics providers experiences delays or disruptions or otherwise fails to meet our fulfillment schedules; or |
• | we are required to add or replace our third-party assembly provider, third-party logistics providers, or fulfillment sites. |
In addition, these supply chain partners have access to certain of our critical confidential information and could wrongly disclose or misuse such information or be subject to a breach or other compromise that introduces a vulnerability or other defect in the products manufactured by our supply chain partners, which risks cannot be fully mitigated. While we take precautions to ensure that the hardware obtained or manufactured by our supply chain partners is inspected, any espionage acts, malware attacks, theft of confidential information, or other malicious incidents perpetrated either directly or indirectly through our supply chain partners, may compromise our system infrastructure, expose us to litigation and associated expenses and lead to reputational harm that could result in a material adverse effect on our financial condition and results of operations. In addition, we are subject to risks resulting from the perception that certain jurisdictions do not comply with internationally recognized rights of freedom of expression and privacy and may permit labor practices that are deemed unacceptable under evolving standards of social responsibility. If assembly or logistics in these foreign countries is disrupted for any reason, including natural disasters, IT system failures, military, or government actions or economic, business, labor, environmental, public health, or political issues, or if the purchase or sale of products from such foreign countries is prohibited or disfavored, our business, results of operations, prospects, and financial condition could be adversely affected.
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We rely on third-party channel partners to sell our products, maintenance, and professional services. If our partners fail to perform, or if we fail to manage and retain such partners, our ability to sell our products, maintenance, and professional services would be limited, and if we fail to optimize our channel partner model going forward, our results of operations would be harmed.
We market and sell our products, maintenance, and professional services through a direct touch, channel fulfilled model. Our channel network includes channel partners, system integrators, value-added resellers, and distributors. If we lost any of our channel partners responsible for a significant portion of our business is unable to pay for our products, our results of operations could be harmed. Although we provide support to these channel partners through our direct sales and marketing activities, we depend upon these partners to generate sales opportunities and to independently manage the sales process for opportunities with which they are involved. In order to increase our revenue, we expect we will need to maintain our existing channel partners and continue to train and support them, as well as add new channel partners and effectively train, support, and integrate them with our sales process. Additionally, our entry into any new markets will require us to develop appropriate channel partners and to train them to effectively address these markets. If we are unsuccessful in these efforts, our ability to grow our business will be limited, and our business, results of operations, prospects, and financial condition will be adversely affected.
Our current system of channel distribution may not prove effective in maximizing sales of our products, maintenance, and professional services. Our products are complex and certain sales can require substantial effort and outlay of cost and resources, either by us or our channel partners. It is possible that our channel partners will be unable or unwilling to dedicate appropriate resources to support those sales. Furthermore, most of our channel partners do not have minimum purchase or resale requirements and may terminate our agreements with only a short notice period or otherwise cease selling our products at any time. If we are unable to develop and maintain effective sales incentive programs for our third-party channel partners, we may not be able to incentivize these partners to sell our products to end-customers and, in particular, to large organizations. They also may market, sell, and support products and services that are competitive with ours and may devote more resources to the marketing, sales, and support of those competitive products. There is no assurance that we will retain these channel partners or that we will be able to add additional or replacement channel partners in the future. The loss of one or more of our key channel partners in a given geographic area could harm our results of operations within that area, as new channel partners typically require extensive training and take several months to achieve acceptable productivity.
We also depend on some of our channel partners and our end-customers’ outsourced IT vendors to deliver professional services for our products. Once our products are deployed within our end-customers’ networks, many of our end-customers depend on the support of our channel partners and their outsourced IT vendors to resolve any issues relating to the implementation and maintenance of our solution. If our channel partners and our end-customers’ outsourced IT vendors do not effectively assist our end-customers in deploying our products, succeed in helping our end-customers quickly resolve post-deployment issues or provide effective ongoing support, our end-customer satisfaction and future sales of our products could be adversely affected.
While we require that our channel partners comply with applicable laws and regulations, they could engage in behavior or practices that expose us to legal or reputational risk.
Managing the supply of our products is complex. Insufficient supply and inventory may result in lost sales opportunities or delayed revenue, while excess inventory may harm our gross margins.
Our third-party manufacturer procures components and builds our products based on our forecasts, and we generally do not hold inventory. These forecasts are based on estimates of future demand for our products, which can be adjusted based on historical trends and analysis and for overall market conditions, and we cannot guarantee the accuracy of our forecasts. In order to reduce manufacturing lead times and plan for adequate component supply, from time to time we may issue forecasts for components and products that are non-cancelable and nonreturnable.
Our inventory management systems and related supply chain visibility tools may be inadequate to enable us to forecast accurately and effectively manage the supply of our products and product components. Supply management remains an increased area of focus as we balance the need to maintain supply levels that are sufficient to ensure competitive lead times against the risk of obsolescence because of rapidly changing technology and end-customer requirements. We accrue for manufacturing cost commitments in excess of our forecasted demand. If we ultimately determine that we have excess supply, we may have to record a reserve for excess manufacturing costs or reduce our prices and write-down inventory, either of which in turn could result in lower gross margins. Alternatively, insufficient supply levels may lead to shortages that result in delayed revenue or loss of sales opportunities altogether as potential end-customers turn to competitors’ products that are readily available. Additionally, any
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increases in the time required to manufacture our products or ship products could result in supply shortfalls. If we are unable to effectively manage our supply and inventory, our results of operations could be adversely affected.
Our failure to adequately protect personal information in compliance with evolving legal requirements could harm our business.
We are subject to a number of state, federal, and international laws and regulations relating to the collection, use, retention, protection, disclosure, transfer, and other processing of personal data. For instance, in order for our solution to detect devices on a network, our solution gathers and tracks IP addresses to monitor each device on our end-customer’s networks. We may have access to IP addresses and personal information from time to time in connection with our maintenance and professional services, as well as in connection with our cloud offerings. Data protection and privacy-related laws and regulations are evolving and may result in ever-increasing regulatory and public scrutiny and escalating levels of enforcement and sanctions. Our failure to comply with applicable laws and regulations, or to protect such data, could result in enforcement actions against us, including fines, imprisonment of company officials and public censure, claims for damages by end-customers and affected individuals, damage to our reputation and loss of goodwill (both in relation to existing end-customers and prospective end-customers), any of which could harm our operations, financial performance, and business. Evolving and changing definitions of personal data and personal information, within the European Union (the “EU”), the United States, and elsewhere, especially relating to classification of IP addresses, machine identification, location data, and other information, may limit or inhibit our ability to operate or expand our business, including limiting strategic partnerships that may involve the sharing of data. Even the perception of privacy concerns, whether or not valid, may harm our reputation and inhibit adoption of our products by current and future end-customers.
In addition, our appliances, when configured by our end-customers, may intercept and examine data in a manner that may subject the use of those appliances to privacy and data protection laws and regulations in those jurisdictions in which our end-customers operate. Any failure or perceived failure by us or by our products or services to comply with these laws and regulations may subject us to legal or regulatory actions, damage our reputation or adversely affect our ability to sell our products or services in the jurisdiction that has enacted the law or regulation. Moreover, if these laws and regulations change, or are interpreted and applied in a manner that is inconsistent with our data practices or the operation of our products and services, we may need to expend resources in order to change our business operations, data practices, or the manner in which our products or services operate. This could adversely affect our business, results of operations, prospects, and financial condition.
In addition, data protection regulation is an area of increased focus and changing requirements. The EU has adopted the General Data Protection Regulation 2016/679 (the “GDPR”), which took effect on May 25, 2018. The GDPR applies to companies established in the EU as well as to those outside the EU if they collect and use personal data in connection with the offering of goods or services to individuals in the EU or the monitoring of their behavior. The GDPR enhances data protection obligations for processors and controllers of personal data, including, for example, expanded disclosures about how personal information is to be used, limitations on retention of information, mandatory data breach notification requirements and new obligations on services providers. Non-compliance with the GDPR can trigger steep fines of up to €20 million or 4% of total worldwide annual turnover, whichever is higher. The GDPR imposes broad and significant data protection obligations, many aspects of which remain uncertain, necessitating substantial time and resources and a review of the technology and systems currently in use against the GDPR’s requirements. The United Kingdom also enacted a Data Protection Act that substantially implements the GDPR. It is unclear, however, how United Kingdom data protection laws or regulations will develop in the medium to longer term, and how data transfers to and from the United Kingdom will be regulated following the United Kingdom’s exit from the European Union on January 31, 2020, and a transition period that is scheduled to expire on December 31, 2020. We have made certain modifications to our practices in order to comply with the GDPR, the UK Data Protection Act, and other privacy and data protection requirements, and may be required to make additional modifications in order to comply with these or other requirements relating to privacy and data protection in the future, each of which may require us to incur significant costs and expenses.
Additionally, with regard to transfers of personal data from our European customers and employees to the U.S., we utilize the EU-U.S. Privacy Shield and a related program, the U.S.-Swiss Privacy Shield. The U.S.-EU Privacy Shield has been challenged in European courts, however, and may be suspended or invalidated. It is uncertain that the U.S.-EU or U.S.-Swiss Privacy Shield programs will remain intact and serve as appropriate means for us to meet European requirements for personal data transfers from the EEA or Switzerland to the United States. Developments in the legal landscape affecting the transfer of personal data from the EEA may cause us to find it necessary or desirable to modify our data handling practices, and may serve
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as a basis for our personal data handling practices, or those of our customers and vendors, to be challenged and may otherwise adversely impact our business, financial condition, and operating results. We may find it necessary to establish systems to maintain personal data originating from the EU or Switzerland in the EEA, which may involve substantial expense and may cause us to divert resources from other aspects of our business, all of which may adversely affect our business.
Further, California has enacted the California Consumer Privacy Act (the “CCPA”), which became operative on January 1, 2020. The CCPA requires covered companies to provide new disclosures to California consumers and provide such consumers new abilities to opt-out of certain sales of their personal information. Several aspects of the CCPA, including aspects addressed under proposed regulations issued by the California Attorney General, remain uncertain at this time. We cannot fully predict the impact of the CCPA on our business or operations, but it may require us to modify our data processing practices and policies and to incur substantial costs and expenses in an effort to comply.
Additionally, we cannot be certain that our insurance coverage will be adequate for data handling liabilities actually incurred, will cover any indemnification claims against us relating to any incident, that insurance will continue to be available to us on economically reasonable terms, or at all, or that any insurer will not deny coverage as to any future claim. The successful assertion of one or more large claims against us that exceed available insurance coverage, or the occurrence of changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could have a material adverse effect on our business, including our financial condition, operating results, and reputation.
If we or our third-party service providers experience a security breach or unauthorized parties otherwise obtain access to our customers' data, our data, or our solution, our offerings may be perceived as not being secure, our reputation may be harmed, demand for our offerings may be reduced, and we may incur significant liabilities.
Our solution and our related operations involve the storage, transmission and processing of data. Security breaches could result in the loss of this information, litigation, indemnity obligations and other liability. We may become the target of cyber-attacks by third parties seeking unauthorized access to our data or users' data or to disrupt our ability to provide service. While we have taken steps to protect the confidential information that we have access to, including confidential information we may obtain through our customer support services or customer usage of our solution, our security measures or those of our third-party service providers could be breached or we could suffer data loss. Computer malware, viruses, social engineering (predominantly spear phishing attacks), and general hacking have become more prevalent in our industry.
We also process, store and transmit our own data as part of our business and operations. This data may include personally identifiable, confidential or proprietary information. There can be no assurance that any security measures that we or our third-party service providers have implemented will be effective against current or future security threats. While we utilize certain measures in an effort to protect the integrity, confidentiality and security of our data, our security measures or those of our third-party service providers could fail and result in unauthorized access to or disclosure, modification, misuse, loss or destruction of such data.
Because there are many different security breach techniques and such techniques continue to evolve, we may be unable to anticipate attempted security breaches and implement adequate preventative measures. Third parties may also conduct attacks designed to disrupt or deny access to our solution. Any security breach or other security incident, or the perception that one has occurred, could result in a loss of customer confidence in the security of our solution and damage to our brand, reduce the demand for our offerings, disrupt normal business operations, require us to spend material resources to investigate or correct the breach, expose us to legal liabilities, including litigation, regulatory enforcement, and indemnity obligations, and adversely affect our revenues and operating results.
We use third-party technology and systems for a variety of reasons, including, without limitation, encryption and authentication technology, employee email, content delivery to customers, back-office support, credit card processing and other functions. Although we utilize measures designed to protect customer information and prevent data loss and other security breaches, such measures cannot provide absolute security.
If our security measures are, or are perceived to be, inadequate or breached as a result of third-party action, employee error or malfeasance, product defects, social engineering techniques, or otherwise, and this results in, or is believed to result in, the disruption of the confidentiality, integrity, or availability of our systems or networks or any data we process or maintain, or the loss, destruction, or corruption of such data, we could incur significant liability, we could face a loss of revenues, our business may suffer, and our reputation and competitive position may be damaged. Additionally, our service providers may suffer, or be
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perceived to suffer, data security breaches or other incidents that may compromise data stored or processed for us that may give rise to any of the foregoing. Any actual or perceived security breach or other incident may lead to the expenditure of significant financial and other resources in efforts to address and eliminate vulnerabilities, to remediate any breach or incident, and to prevent future security breaches or incidents.
Additionally, we cannot be certain that our insurance coverage will be adequate for data security liabilities actually incurred, will cover any indemnification claims against us relating to any incident, that insurance will continue to be available to us on economically reasonable terms, or at all, or that any insurer will not deny coverage as to any future claim. The successful assertion of one or more large claims against us that exceed available insurance coverage, or the occurrence of changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could have a material adverse effect on our business, including our financial condition, operating results, and reputation.
Reduced information technology and network infrastructure spending or adverse economic conditions may harm our business, results of operations, prospects, and financial condition.
Our business depends on the overall demand for information technology, network infrastructure, and network security products. In addition, the purchase of our products and services is often discretionary and may involve a significant commitment of capital and other resources. Currently, most organizations and public sector entities have not allocated a fixed portion of their budgets to protect against next-generation advanced cyberattacks. If we do not succeed in convincing end-customers that our products and services should be an integral part of their overall approach to network security and that a portion of their annual IT budgets should be allocated to our solution, general reductions in IT spending by our end-customers are likely to have a disproportionate impact on our business, results of operations, prospects, and financial condition.
Weak global economic conditions, or a reduction in information technology and network infrastructure spending even if economic conditions improve, could adversely impact our business, results of operations, prospects, and financial condition in a number of ways, including longer sales cycles, lower prices for our products and services, higher default rates among our distributors, reduced unit sales and lower or no growth. In addition, continued budgetary challenges in the United States and Europe and geopolitical turmoil in many parts of the world have and may continue to put pressure on global economic conditions and overall spending on network security products.
The average sales price of our products has decreased from time to time, and may decrease in the future, which may negatively impact our gross profits and results of operations.
From time to time, the average sales price of our products and services has decreased. In the future, it is possible that the average sales price of our products will decrease in response to competitive pricing pressures, increased sales discounts, new product introductions by us or our competitors, or other factors. Such pricing pressures may also be dependent upon the mix of products sold, the mix of revenue between products, maintenance, and professional services and the degree to which products, maintenance, and professional services are bundled and sold together for a package price. Therefore, to achieve and maintain profitability, we must develop and introduce new products and product enhancements on a timely basis and continually reduce our product costs. Our failure to do so would cause our revenue and gross profits to decline, which would harm our business and results of operations. Furthermore, currency fluctuations in certain countries and regions may negatively impact actual prices that partners and end-customers are willing to pay in those countries and regions. In addition, we may experience substantial period-to-period fluctuations in future results of operations in the event we experience an erosion of our average sales price.
We are dependent on the continued services and performance of our senior management and other key employees, and the loss of any of these key employees or any failure to hire and retain additional highly-skilled employees could adversely affect our business, results of operations, prospects, and financial condition.
Our future performance depends on the continued services and contributions of our senior management, including our Chief Executive Officer and President, Michael DeCesare, and other key employees to execute on our business plan, and to identify and pursue new opportunities and product innovations. The loss of services of senior management or other key employees could significantly delay or prevent the achievement of our development and strategic objectives and could harm our business and our customer relationships. We do not maintain key man life insurance with respect to any officer or other employee.
Our ability to continue to attract and retain highly skilled personnel will be critical to our future success. Competition for highly skilled personnel is frequently intense, especially in the San Francisco Bay Area, where we have a substantial presence
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and need for talent. We may not be successful in attracting, assimilating or retaining qualified personnel to fulfill our current or future needs. Also, to the extent we hire personnel from competitors, we may be subject to allegations that they have been improperly solicited or that they divulged proprietary or other confidential information.
In addition, we issue stock options and other equity awards as a key component of our overall compensation and recruiting and retention efforts. Our compensation arrangements, such as our equity award programs, may not always be successful in attracting new employees and retaining and motivating existing employees. We are also required under U.S. generally accepted accounting principles (“GAAP”) to recognize compensation expense in our results of operations for employee stock-based compensation under our equity grant programs, which may negatively impact our results of operations and may increase the pressure to limit stock-based compensation. Further, many of our employees have received, or may in the future receive, significant proceeds from the sale of our equity in the public markets, which may reduce their motivation to continue to work for us and lead to greater attrition.
We are dependent on various IT systems, and failures of, or interruptions to, those systems could harm our business.
Many of our business processes depend upon our IT systems, the systems and processes of third parties and on interfaces with the systems of third parties over which we do not have control. If those systems fail or are interrupted, or if our ability to connect to or interact with one or more networks is interrupted, our processes may function at a diminished level or not at all. This would harm our ability to maintain operations and to ship products, and our financial results would likely be harmed. In addition, reconfiguring our IT systems or other business processes in response to changing business needs may be time consuming and costly. To the extent any such reconfiguration were to impact our ability to react timely to specific market or business opportunities, our financial results would likely be harmed.
Governmental regulations affecting the manufacturing of products and that contain “conflict minerals” and the import or export of our products could negatively affect our revenue and may cause reputational harm.
We may be deemed to manufacture or contract to manufacture products that contain certain minerals that have been designated as “conflict minerals” under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). As a result, in future periods, we may be required to validate the origin of such minerals and disclose and report whether or not such minerals originated in the Democratic Republic of the Congo (“DRC”) or adjoining countries. For instance, the Dodd-Frank Act includes disclosure requirements regarding the use of certain minerals mined from the DRC and adjoining countries and procedures pertaining to a manufacturer’s efforts regarding the source of such minerals. SEC rules implementing these requirements and other international standards, such as the Organization for Economic Co-Operation and Development Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High Risk Areas, may have the effect of reducing the pool of suppliers who can supply DRC “conflict free” components and parts, and we may not be able to obtain DRC conflict free products or supplies in sufficient quantities for our products. In addition, we may incur additional costs to comply with the disclosure requirements, including costs related to determining the source of any of the relevant minerals and metals used in our products. We may also face reputational challenges with our end-customers, stockholders and other stakeholders if we are unable to verify the origins for the minerals used in our products.
In addition, the U.S. government and various foreign governments, including that of Israel, where we have significant research and development operations, have imposed controls, export license requirements, and restrictions on the import or export of some technologies, especially encryption technology. If we were to fail to comply with any of these controls or requirements, including U.S. export licensing requirements, U.S. customs regulations, U.S. economic sanctions, or other laws, we could be subject to substantial civil and criminal penalties, including fines, incarceration for responsible employees and managers, and the possible loss of export or import privileges. Obtaining the necessary export license or approval for a particular sale may be time-consuming and may result in the delay or loss of sales opportunities. Furthermore, U.S. export control laws and economic sanctions prohibit the shipment of certain products to U.S. embargoed or sanctioned countries, governments, and persons. Even though we take precautions to ensure that our channel partners, who we rely on to fulfill our product orders and deliver our products to our end-customers, comply with all relevant regulations, any failure by us or by our channel partners to comply with such regulations could have negative consequences, including reputational harm, government investigations, and penalties. In addition, from time to time, governmental agencies have proposed additional regulation of encryption technology, such as requiring the escrow and governmental recovery of private encryption keys. Governmental regulation of encryption technology and regulation of imports or exports, or our failure to obtain required import or export approval for our products,
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could harm our international and domestic sales and adversely affect our revenue. In addition, failure to comply with such regulations could result in penalties, costs and restrictions on export privileges, which would harm our results of operations.
Parts of our research and development activities are located in Israel and, therefore, our results of operations may be adversely affected by political, economic, and military instability in Israel.
Parts of our research and development facilities are located in Israel. Accordingly, political, economic, and military conditions in Israel may directly affect our business. Since the establishment of the State of Israel in 1948, a number of armed conflicts have taken place between Israel and its neighboring countries. In recent years, these have included hostilities between Israel and Hezbollah in Lebanon and Hamas in the Gaza strip, both of which resulted in rockets being fired into Israel causing casualties and disruption of economic activities. In addition, Israel faces threats from more distant neighbors, in particular, Iran. Our commercial insurance does not cover losses that may occur as a result of an event associated with the security situation in the Middle East. Although the Israeli government is currently committed to covering the reinstatement value of direct damages that are caused by terrorist attacks or acts of war, we cannot assure you that this government coverage will be maintained or, if maintained, will be sufficient to compensate us fully for damages incurred. Any losses or damages incurred by us could have a material adverse effect on our business. Any armed conflict involving Israel could adversely affect our operations and results of operations.
Further, our operations could be disrupted by the obligations of personnel to perform military service. We have a number of employees based in Israel, certain of which may be called upon to perform up to 54 days in each three year period (and in the case of non-officers depending on their specific military commanders or officers, up to 70 or 84 days, respectively, in each three year period) of military reserve duty until they reach the age of 40 (and in some cases, up to 49 years of age) and, in certain emergency circumstances, may be called to immediate and unlimited active duty. Our operations could be disrupted by the absence of a significant number of employees related to military service, which could materially adversely affect our business and results of operations.
Several countries, principally in the Middle East, restrict doing business with Israel and Israeli companies, and additional countries may impose restrictions on doing business with Israel and Israeli companies whether as a result of hostilities in the region or otherwise. In addition, there have been increased efforts by activists to cause companies and consumers to boycott Israeli goods based on Israeli government policies. Such actions, particularly if they become more widespread, may adversely impact our ability to sell our products.
Our international operations expose us to a variety of risks.
We currently have operations in a number of foreign countries and make sales to end-customers throughout the world. The majority of our sales are into the Americas; however, we anticipate that our sales in markets outside of the Americas will increase as we grow and expand our international operations and sales force. In addition, we currently perform certain of our research and development and other operations in Israel and in other geographically dispersed locations outside of the United States. Our international operations and sales into international markets require significant management attention and financial resources, and subject us to certain inherent risks, including:
• | technical difficulties and costs associated with product localization; |
• | challenges associated with coordinating product development efforts among geographically dispersed areas; |
• | potential loss of proprietary information due to piracy, misappropriation, or laws that may inadequately protect our intellectual property rights; |
• | greater difficulty in establishing, utilizing, and enforcing our intellectual property rights; |
• | our limited experience in establishing a sales and marketing presence, and research and development operations, together with the appropriate internal systems, processes, and controls, in certain geographic markets; |
• | political unrest or economic instability, regulatory changes, war, or terrorism, and other unpredictable and potentially long-term events in the countries or regions where we or our end-customers do business, which could result in delayed or lost sales or interruption in our business operations; |
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• | longer payment cycles for sales in certain foreign countries; |
• | seasonal reductions in business activity in the summer months in Europe and at other times in various countries; |
• | the significant presence of some of our competitors in some international markets; |
• | potentially adverse tax consequences or changes in applicable tax laws; |
• | import and export restrictions, trade disputes, tariffs and other trade protection initiatives; |
• | potential failures of our foreign employees and channel partners to comply with both U.S. and foreign laws and regulations, including antitrust laws, trade regulations, and anti-bribery and corruption laws, including the U.S. Foreign Corrupt Practices Act (“FCPA”); |
• | compliance with foreign laws, regulations, and other government controls, such as those affecting trade, privacy and data protection, the environment, corporations, and employment; |
• | management, staffing, legal, and other costs of operating a distributed enterprise spread over various countries; |
• | currency exchange restrictions or costs and fluctuations in foreign exchange rates, which we currently do not hedge against; and |
• | natural disasters, restrictions on travel or health risks that may adversely affect our ability to sell our products and services or support our operations or may result in disruption of our supply chain. . |
To the extent we are unable to effectively manage our international operations and these risks, our international sales or operations may be adversely affected, we may incur additional and unanticipated costs, and we may be subject to litigation or regulatory action. As a consequence, our business, results of operations, prospects, and financial condition could be seriously harmed.
Due to the global nature of our business, we could be adversely affected by violations of the U.S. FCPA or similar anti-bribery laws in other jurisdictions in which we operate and various international trade and export laws.
The global nature of our business creates various domestic and local regulatory challenges. The FCPA and similar anti-bribery laws in other jurisdictions generally prohibit U.S.-based companies and their intermediaries from making improper payments for the purpose of obtaining or retaining business to non-U.S. officials. In addition, U.S.-based companies are required to maintain records that accurately and fairly represent their transactions and have an adequate system of internal accounting controls. We operate in areas of the world that experience corruption by government officials to some degree and, in certain circumstances, compliance with anti-bribery laws may conflict with local customs and practices. Our global operations require us to import and export to and from several countries, which increases our compliance obligations. In addition, changes in such laws could result in increased regulatory requirements and compliance costs which could adversely affect our business, financial condition and results of operations. We cannot assure you that our employees or other software agents will not engage in prohibited conduct and render us responsible under the FCPA. If we are found to be in violation of the FCPA or other anti-bribery laws (either due to acts or inadvertence of our employees or due to the acts or inadvertence of others), we could suffer criminal or civil penalties or other sanctions, which could have a material adverse effect on our business.
Third parties may bring legal actions against us.
In the past, third parties have brought legal actions against us and we may, from time to time, be a party to other lawsuits in the normal course of our business. We have incurred costs to defend those lawsuits and related legal proceedings. It is likely that in the future other parties may bring legal actions against us. Such actions, even if without merit, could harm our business. Litigation in general, and intellectual property and securities litigation in particular, can be expensive, lengthy, and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. An unfavorable resolution of any lawsuit could adversely affect our business, results of operations, prospects, or financial condition. Any material litigation or arbitration inevitably results in the diversion of the attention of our management and other relevant personnel. To the extent uninsured, such claims further require us to incur defense costs for us and for parties to whom we may have indemnification obligations. For example, we indemnify our channel partners in response to requests they receive from our end-
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customers to be indemnified for patent or other intellectual property litigation brought by third parties against our end-customers with regard to our end-customers’ use of products or services sold by our channel partners, including our own products. We also may be required to pay material amounts in settlement costs or damages. Furthermore, if the matter relates to infringement of a third party’s intellectual property, we may be required to enter into royalty or licensing agreements or to develop non-infringing technology, and injunctive relief could be entered against us. End-customer concerns with respect to material litigation can result in delayed or lost sales and reputational damage. Any of the foregoing could seriously harm our business and have a material adverse effect on our business, financial condition and results of operations.
Our operations could be significantly hindered by the occurrence of a natural disaster, terrorist attack, health epidemic, or other catastrophic event.
Our business operations are susceptible to outages due to fire, floods, power loss, telecommunications failures, terrorist attacks, military or political conflicts, and other events beyond our control, including health epidemics, and our sales opportunities may also be affected by such events. In addition, a substantial portion of our facilities, including our headquarters, are located in Northern California, an area susceptible to earthquakes. We do not carry earthquake insurance for earthquake-related losses. Despite our implementation of network security measures, our servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with our computer systems. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any of these events. In addition, acts of terrorism, other geo-political unrest, travel restrictions, or health epidemics could cause disruptions in our business or the business of our supply chain, manufacturers, logistics providers, partners, or end-customers or the economy as a whole. Any disruption in the business of our supply chain, manufacturers, logistics providers, partners, or end-customers that impacts sales at the end of a fiscal quarter could have a significant adverse impact on our financial results. To the extent that such events disrupt our business or the business of our current or prospective end-customers, or adversely impact our reputation, such events could adversely affect our business, results of operations, prospects, and financial condition.
If we fail to comply with environmental requirements, our business, results of operations, prospects, financial condition, and reputation could be adversely affected.
Our operations and the sale of our products are subject to various federal, state, local, and foreign environmental and safety regulations, including laws adopted by the EU, such as the Waste Electrical and Electronic Equipment Directive (the “WEEE Directive”) and the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment Directive, (the “EU RoHS Directive”) of certain metals from global hot spots. The WEEE Directive requires electronic goods producers to be responsible for marking, collection, recycling, and treatment of such products. Changes in the WEEE Directive of the interpretation thereof may cause us to incur additional costs or meet additional regulatory requirements, which could be material.
The EU RoHS Directive and similar laws of other jurisdictions limit the content of certain hazardous materials such as lead, mercury, and cadmium in the manufacture of electrical equipment, including our products. Currently, our products comply with the EU RoHS Directive requirements. However, if there are changes to this or other laws, or to their interpretation, or if new similar laws are passed in other jurisdictions, we may be required to reengineer our products or to use different components to comply with these regulations. This reengineering or component substitution could result in substantial costs to us or disrupt our operations or logistics.
We are also subject to environmental laws and regulations governing the management of hazardous materials, which we use in small quantities in our engineering labs. Our failure to comply with past, present, and future environmental and safety laws could result in increased costs, reduced sales of our products, substantial product inventory write-offs, reputational damage, penalties, third-party property damage, remediation costs, and other sanctions, any of which could harm our business and financial condition. To date, our expenditures for environmental compliance have not had a material impact on our results of operations or cash flows, and although we cannot predict the future impact of such laws or regulations, they will likely result in additional costs and may increase penalties associated with violations or require us to change the content of our products or how they are manufactured, which could have a material adverse effect on our business, results of operations, prospects, and financial condition. We also expect that our business will be affected by new environmental laws and regulations on an ongoing basis, which may be more stringent, imposing greater compliance costs and increasing risks and penalties associated with violations which could harm our business.
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Our gross margin is affected by a number of factors, and we may not be able to sustain it at present levels.
Our gross margin has been and will continue to be affected by a variety of factors, including:
• | market acceptance of our solution and fluctuations in demand for our solution and services; |
• | fluctuation in demand mix between our Software Products and Hardware Products; |
• | fluctuation in demand mix among the portfolio of products that comprise our Hardware Products; |
• | fluctuation in demand for our products, maintenance, and professional services; |
• | varying discounting rates among end-customers; |
• | our ability to increase sales to and retain existing end-customers and to sell to new end-customers; |
• | increased price competition and changes in product pricing; |
• | actions taken by our competitors; |
• | new product innovations and enhancements; |
• | increased costs incurred from third-party providers related to our new product innovations and enhancements; |
• | manufacturing and component costs; |
• | availability of sufficient inventory to meet demand; |
• | purchase of inventory in excess of demand; |
• | our execution of our strategy and operating plans; |
• | geographies in which sales are made; and |
• | revenue recognition rules. |
Macroeconomic factors and competitive pressures may also require us to lower prices or increase spending, and our business and results of operations may suffer. Even if we achieve our net revenue and operating expense objectives, our net income or loss and results of operations may be below our expectations and the expectations of investors if our gross margin is below expectations.
Our investments in new or enhanced products and services may not yield the benefits we anticipate.
The success of our business is predicated on our ability to develop new products and technologies and to anticipate future market requirements and applicable industry standards. We intend to continue to invest in enhancing our products by adding personnel and other resources to our research and development function. We will likely recognize costs associated with these investments earlier than the anticipated benefits. If we do not achieve the anticipated benefits from these investments, or if the achievement of these benefits is delayed, our business, results of operations, prospects, and financial condition may be adversely affected.
The process of developing new technologies is time consuming, complex, and uncertain, and requires the commitment of significant resources well in advance of being able to fully determine market requirements and industry standards. Furthermore, we may not be able to timely execute new product or technical initiatives because of errors in product planning or timing, technical difficulties that we cannot timely resolve, or a lack of appropriate resources. This could result in competitors bringing products to market before we do and a consequent decrease in our market share and net revenue. Our inability to timely and cost-effectively introduce new products and product enhancements, or the failure of these new products or enhancements to achieve market acceptance and comply with industry standards, could seriously harm our business, results of operations, prospects, and financial condition. Additionally, products and technologies developed by others, and our own introduction of
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new products and product enhancements, could result in the obsolescence and write-off of previously purchased or committed inventory, which would reduce our net income or increase our net loss.
We have acquired and may in the future acquire or invest in companies, which may divert our management’s attention and result in additional dilution to our stockholders. We may be unable to integrate acquired businesses and technologies successfully or achieve the expected benefits of such acquisitions.
Our success will depend, in part, on our ability to grow our business in response to changing technologies, end-customer demands, and competitive pressures. In some circumstances, we may choose to do so through the acquisition of complementary businesses and technologies rather than through internal development. The risks we face in connection with acquisitions include:
• | encountering difficulties or unforeseen expenditures in integrating the business, technologies, products, personnel, or operations of a company that we acquire, particularly if key personnel of the acquired company decide not to work for us; |
• | failure to achieve the expected benefits of the acquisition or investment; |
• | difficulties maintaining relationships with the customers and suppliers of the acquired company; |
• | unforeseen liabilities that were not identified or accounted for in due diligence; |
• | disruptions of our ongoing business, divert resources, increase our expenses, and distract our management; |
• | ineffective or inadequate controls, procedures or policies at the acquired company; |
• | differing regulatory or tax regimes applicable to the acquired company; |
• | the tax and accounting effects of the acquisition, which may adversely impact our financial results; |
• | our use of cash to pay for acquisitions, which would limit other potential uses for our cash; |
• | if we incur debt to fund an acquisition, such debt may subject us to material restrictions on our ability to conduct our business; and |
• | if we issue a significant amount of equity securities in connection with acquisitions, existing stockholders may be diluted and earnings per share may decrease. |
In addition, the identification of suitable acquisition candidates can be difficult, time-consuming, and costly, and we may not be able to complete successfully identified acquisitions. The occurrence of any of these risks could have an adverse effect on our business, results of operations, prospects, and financial condition.
We face increased exposure to foreign currency exchange rate fluctuations.
Our sales contracts are primarily denominated in U.S. Dollars, and therefore, the majority of our revenue is not currently subject to foreign currency risk. However, a strengthening of the U.S. Dollar could increase the real cost of our products to our end-customers outside of the United States, which could adversely affect our financial condition and results of operations. In addition, increased international sales in the future, including through our channel partners and other partnerships, may result in greater foreign currency denominated sales, increasing our foreign currency risk. Moreover, an increasing portion of our operating expenses is incurred outside the United States, is denominated in foreign currencies, and is subject to fluctuations due to changes in foreign currency exchange rates. If we are not able to successfully hedge against the risks associated with currency fluctuations, our financial condition and results of operations could be adversely affected.
We do not currently maintain a program to hedge transactional exposures in foreign currencies. However, in the future, we may use derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging activities may not offset any or more than a portion of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. Moreover, the use of hedging instruments may introduce additional risks if we are unable to structure effective hedges with such instruments.
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If we fail to maintain an effective system of disclosure controls and internal control over financial reporting, our ability to produce timely and accurate financial statements or comply with applicable regulations could be impaired.
As a public company, we are required to maintain internal control over financial reporting and to report any material weaknesses in such internal controls. Section 404 of the Sarbanes-Oxley Act of 2002, as amended (the “Sarbanes-Oxley Act”), requires that we evaluate and determine the effectiveness of our internal control over financial reporting and, beginning with our Annual Report on Form 10-K for our fiscal year 2018, provide a management report on internal control over financial reporting. We are also required to have our independent registered public accounting firm issue an opinion on the effectiveness of our internal control over financial reporting on an annual basis.
Any failure to develop or maintain effective controls, or any difficulties encountered in their implementation or improvement, could harm our results of operations, cause us to fail to meet our reporting obligations, result in a restatement of our consolidated financial statements for prior periods, or adversely affect the results of management evaluations and independent registered public accounting firm audits of our internal control over financial reporting that we are required to include in our periodic reports that we file with the SEC. Ineffective disclosure controls and procedures and internal controls over financial reporting could also cause investors to lose confidence in our reported financial and other information, which would likely have a negative effect on the trading price of our common stock.
If we are unable to assert that our internal control over financial reporting is effective or when required in the future, if our independent registered public accounting firm issues an adverse opinion on the effectiveness of our internal control over financial reporting, investors may lose confidence in the accuracy and completeness of our financial reports, the market price of our common stock could be adversely affected and we could become subject to investigations by the stock exchange on which our securities are listed, the SEC, or other regulatory authorities, which could require additional financial and management resources.
If we cannot maintain our corporate culture as we grow, we could lose the innovation, teamwork, passion, and focus on execution that we believe contribute to our success, and our business may be harmed.
We believe that our corporate culture has been a critical component to our success. We have invested substantial time and resources in building our team. As we grow and mature as a public company, we may find it difficult to maintain our corporate culture. Any failure to preserve or evolve our culture could negatively affect our future success, including our ability to recruit and retain personnel and effectively focus on and pursue our business strategy.
Forecasting our estimated annual effective tax rate is complex and subject to uncertainty, and there may be material differences between our forecasted and actual tax rates.
We are currently generating operating losses and have minimal tax rate uncertainty. When we begin generating operating profit, and fully utilize our net operating losses (“NOLs”), forecasts of our effective tax rate will become more complex. As a multinational corporation we conduct our business in many countries and are subject to different taxation in many jurisdictions. The taxation of our business is subject to the application of multiple and conflicting tax laws and regulations as well as multinational tax conventions. Our effective tax rate will be highly dependent upon the geographic distribution of our worldwide earnings or losses, the tax regulations in each geographic region, changes in or new legislation relating to tax, the availability of tax credits and carryforwards, and the effectiveness of our tax planning strategies.
In addition, we are subject to examination of our income tax returns by the Internal Revenue Service and other tax authorities. If tax authorities challenge the relative mix of our U.S. and international income, our future effective income tax rates could be adversely affected. While we regularly assess the likelihood of adverse outcomes from such examinations and the adequacy of our provision for income taxes, there can be no assurance that such provision is sufficient and that a determination by a tax authority will not have an adverse effect on our business, results of operations, prospects, and financial condition.
Changes in U.S. tax laws could have a material adverse effect on our business, cash flow, results of operations or financial condition.
Recent changes to U.S. tax laws, as well as changes to U.S. tax laws that may be enacted in the future, could materially impact our deferred tax assets and tax liabilities. On December 22, 2017, the President of the United States signed the Tax Cuts and Jobs Act (the “Tax Act”) into law, which significantly changes the taxation of U.S.-based multinational corporations, by, among other things, changes to U.S. federal tax rates and the taxation of foreign earnings. The legislation is unclear in some
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respects and requires interpretations and implementing regulations by the Internal Revenue Service, as well as state tax authorities, and the legislation could be subject to potential amendments and technical corrections, any of which could lessen or increase certain impacts of the legislation. We will continue to assess the effects of the legislation. The current and future impact of the Tax Act and other changes to U.S. tax laws, and regulations or interpretations thereof, could materially impact our deferred tax assets and tax liabilities, which could adversely affect our business, cash flow, results of operations or financial condition.
Our ability to use our net operating loss carry-forwards and certain other tax attributes may be limited.
We have federal and state NOLs available. Subject to the following discussion, such NOLs are generally available to be carried forward to offset our future taxable income, if any, until such NOLs are used or expire.
In general, under Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), a corporation that undergoes an “ownership change” (generally defined as a greater than 50-percentage point cumulative change (by value) in the equity ownership of certain stockholders over a rolling three-year period) is subject to limitations on its ability to utilize its pre-change NOLs to offset post-change taxable income. Similar rules may apply under state tax laws. Based upon an analysis of the period from inception through November 30, 2015, we believe we may have undergone an ownership change and that a portion of our current NOLs may be subject to limitations under Section 382. Future changes in our stock ownership, some of which are outside of our control, could result in an ownership change under Section 382 of the Code. Furthermore, our ability to utilize NOLs of companies that we have acquired or may acquire in the future may be subject to limitations. There is also a risk that due to regulatory changes, such as suspensions on the use of NOLs, or other unforeseen reasons, our existing NOLs could expire or otherwise be unavailable to offset future income tax liabilities. For these reasons, we may not be able to realize a tax benefit from the use of our NOLs, whether or not we attain profitability.
Risks Related to Owning Our Common Stock
Provisions of our corporate governance documents could make an acquisition of our company more difficult and may prevent attempts by our stockholders to replace or remove our current management, even if beneficial to our stockholders.
Our amended and restated certificate of incorporation and amended and restated bylaws and the Delaware General Corporation Law (the “DGCL”) contain provisions that could make it more difficult for a third party to acquire us, even if doing so might be beneficial to our stockholders.
These provisions include:
• | the division of our board of directors into three classes and the election of each class for three-year terms; |
• | advance notice requirements for stockholder proposals and director nominations; |
• | the ability of the board of directors to fill a vacancy created by the expansion of the board of directors; |
• | the ability of our board of directors to issue new series of, and designate the terms of, preferred stock, without stockholder approval, which could be used to, among other things, institute a rights plan that would have the effect of significantly diluting the stock ownership of a potential hostile acquirer, likely preventing acquisitions that have not been approved by our board of directors; |
• | limitations on the ability of stockholders to call special meetings and to take action by written consent; and |
• | the required approval of holders of at least 66-2/3% of the voting power of the outstanding shares of our capital stock to adopt, amend, or repeal certain provisions of our amended and restated certificate of incorporation and amended and restated bylaws or remove directors for cause. |
In addition, Section 203 of the DGCL may affect the ability of an “interested stockholder” to engage in certain business combinations, for a period of three years following the time that the stockholder becomes an “interested stockholder.”
These provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board. Because our board of directors is responsible for appointing the members of our management team, these provisions could in turn affect any attempt to replace current members of our management team.
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Our amended and restated bylaws designate courts in the State of Delaware and in the county of Santa Clara, California as the sole and exclusive forums for certain types of actions and proceedings that may be initiated by our stockholders, which could limit our stockholders’ ability to obtain a favorable judicial forum for disputes with us or our directors, officers, or employees.
Our amended and restated bylaws provide that, subject to limited exceptions, a state or federal court located within the State of Delaware or a state or federal court located within the county of Santa Clara, California will be the sole and exclusive forums for:
• | any derivative action or proceeding brought on our behalf; |
• | any action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, or other employees to us or our stockholders; |
• | any action asserting a claim against us arising pursuant to any provision of the DGCL, our amended and restated certificate of incorporation, or our amended and restated bylaws; or |
• | any other action asserting a claim against us or our directors, officers, or employees that is governed by the internal affairs doctrine. |
Any person or entity purchasing or otherwise acquiring any interest in shares of our capital stock shall be deemed to have notice of and to have consented to these provisions. These provisions may limit a stockholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with us or our directors, officers, or other employees, which may discourage such lawsuits against us and our directors, officers, and employees. Alternatively, if a court were to find these provisions of our amended and restated bylaws inapplicable to, or unenforceable in respect of, one or more of the specified types of actions or proceedings, we may incur additional costs associated with resolving such matters in other jurisdictions, which could adversely affect our business and financial condition.
Market volatility may affect the price of our common stock.
The market price and trading volume of our common stock has been and may continue to be highly volatile, and the holders of our common stock may experience a decrease in the value of their shares, including decreases unrelated to our operating performance or prospects. The trading price of our common stock may continue to fluctuate significantly in response to a number of factors, most of which we cannot predict or control and may not be related to our operating performance, including:
• | actual or anticipated changes or fluctuations in our results of operations and whether our results of operations meet the expectations of securities analysts or investors; |
• | actual or anticipated changes in securities analysts’ estimates and expectations of our financial performance; |
• | announcements of new products and solutions, services or technologies, commercial relationships, acquisitions, or other events by us or our competitors; |
• | general market conditions, including volatility in the market price and trading volume of technology companies in general and of companies in the network security industry in particular; |
• | changes in how current and potential end-customers perceive the effectiveness of our solution in protecting against advanced cyberattacks or other reputational harm; |
• | sales of large blocks of our common stock, including sales by our executive officers, directors, and significant stockholders and significant settlements of RSUs; |
• | announced departures of any of our key personnel; |
• | lawsuits threatened or filed against us or involving our industry, or both; |
• | changing legal or regulatory developments in the United States and other countries; |
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• | general economic conditions and trends; and |
• | other events or factors, including those resulting from major catastrophic events, war, acts of terrorism, or responses to these events. |
In addition, the stock markets have experienced extreme price and volume fluctuations that have affected and continue to affect the market prices of equity securities of many technology companies. Stock prices of many technology companies have fluctuated in a manner unrelated or disproportionate to the operating performance of those companies. In the past, stockholders have instituted securities class action litigation following periods of market volatility. If we were to become involved in securities litigation, it could subject us to substantial costs, divert resources and the attention of management from our business and adversely affect our business, results of operations, prospects, and financial condition.
As a public company, we are subject to additional laws, regulations, and stock exchange listing standards, which impose additional costs on us and may strain our resources and divert our management’s attention.
We are subject to the reporting requirements of the Exchange Act, the Sarbanes-Oxley Act, the Dodd-Frank Act, the listing requirements of The NASDAQ Global Market, and other applicable securities laws and regulations. Compliance with these laws and regulations increases our legal and financial compliance costs and make some activities more difficult, time-consuming, or costly. For example, the Exchange Act requires us, among other things, to file annual, quarterly, and current reports with respect to our business and results of operations and maintain effective disclosure controls and procedures and internal control over financial reporting. Also, as a public company, it is more expensive for us to obtain director and officer liability insurance than it was before we became a public company, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. Although we have already hired additional employees to comply with these requirements, we may need to hire even more employees in the future, which will increase our costs and expenses. These factors may therefore strain our resources, divert management’s attention, and affect our ability to attract and retain qualified board members.
Since we have no current plans to pay regular cash dividends on our common stock, you may not receive any return on investment unless you sell your common stock for a price greater than that which you paid for it.
We do not anticipate paying any regular cash dividends on our common stock in the foreseeable future. Any decision to declare and pay dividends in the future will be made at the discretion of our board of directors and will depend on, among other things, our results of operations, financial condition, cash requirements, contractual restrictions, and other factors that our board may deem relevant. In addition, our ability to pay dividends is, and may be, limited by covenants of existing and any future outstanding indebtedness we or our subsidiaries incur. Therefore, any return on investment in our common stock is solely dependent upon the appreciation of the price of our common stock on the open market, which may not occur.
If securities or industry analysts do not publish research or reports about our business, if they adversely change their recommendations regarding our shares or if our results of operations do not meet their expectations, our share price and trading volume could decline.
The trading market for our shares will be influenced by the research and reports that industry or securities analysts publish about us or our business. We do not have any control over these analysts. If one or more of these analysts cease coverage of our company or fails to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our share price or trading volume to decline. Moreover, if one or more of the analysts who cover our company downgrade our stock or if our results of operations do not meet their expectations, our share price could decline.
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ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2. PROPERTIES
Our corporate headquarters is located in San Jose, California in a facility consisting of approximately 95,950 square feet of office space under a lease that expires in 2026. We maintain additional offices throughout the United States and various international locations, including Australia, Canada, China, Germany, Hong Kong, Israel, Japan, the Netherlands, the United Arab Emirates, the United Kingdom, Brazil, and France. We lease all of our facilities and do not own any real property. We intend to procure additional space as we add employees and expand geographically. We believe our facilities are adequate and suitable for our current needs and that suitable additional or alternative space will be available to accommodate the expansion of our operations if needed.
ITEM 3. LEGAL PROCEEDINGS
The information set forth under the “Litigation” subheading in Note 8, of Notes to Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K is incorporated herein by reference.
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ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
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PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITITIES
Market Information for Common Stock
Our common stock is traded on The NASDAQ Global Market under the symbol “FSCT”.
Holders of Record
As of December 31, 2019, there were 68 holders of record of our common stock. Because many of our shares of common stock are held by brokers and other institutions on behalf of beneficial owners of our stock, we are unable to estimate the total number of stockholders.
Dividend Policy
We have never declared or paid cash dividends on our common stock. We currently intend to retain any future earnings to fund business development and growth, and we do not expect to pay any dividends in the foreseeable future. Any future determination to declare cash dividends will be made at the discretion of our board of directors, subject to applicable laws, and will depend on a number of factors, including our financial condition, results of operations, capital requirements, contractual restrictions, general business conditions, and other factors that our board of directors may deem relevant.
Recent Sales of Unregistered Securities and Use of Proceeds
Recent Sales of Unregistered Securities
None.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
None.
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Performance Graph
This performance graph shall not be deemed “filed” for purposes of Section 18 of the Exchange Act, or incorporated by reference into any filing of Forescout under the Securities Act of 1933, as amended (the “Securities Act”), or the Exchange Act, except as shall be expressly set forth by specific reference in such filing.
The following graph compares the cumulative total return for our common stock, the NASDAQ Composite Index and the NASDAQ Computer Index. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in our common stock and in each index on October 27, 2017, the date our common stock began trading on the NASDAQ, and its relative performance is tracked through December 31, 2019, the last trading date of our 2019 fiscal year end. The returns shown are based on historical results and are not intended to suggest future performance.
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ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
The selected consolidated financial data below should be read in conjunction with the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Part II, Item 7 of this Annual Report on Form 10-K, and our consolidated financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K. The selected consolidated statements of operations data for the years ended December 31, 2019, 2018, and 2017, and the consolidated balance sheet data as of December 31, 2019 and 2018 are derived from our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. The selected consolidated statement of operations data for the years ended December 31, 2016 and 2015, and the consolidated balance sheet data as of December 31, 2017, 2016 and 2015 are derived from audited consolidated financial statements which are not included in this Annual Report on Form 10-K. Our historical results are not necessarily indicative of our future results. The selected consolidated financial data in this section are not intended to replace our consolidated financial statements and the related notes, and are qualified in their entirety by the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.
As described in Note 6 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K, we adopted Accounting Standard Update 2016-02, Leases, Accounting Standard Update 2018-10, Codification Improvements to Topic 842, Leases, and Accounting Standard Update 2018-11, Targeted Improvements (collectively, “Topic 842”) effective January 1, 2019 using the transition method which had a material impact on our opening balances in certain asset and liability accounts as of January 1, 2019. Financial data of prior years were not adjusted as a result of the adoption.
Financial data for the year ended December 31, 2015 has not been adjusted to reflect the adoption of Accounting Standard Update 2014-09, Revenue from Contracts with Customers (“Topic 606”).
Prior to the first quarter of fiscal 2019, we presented revenue and cost of revenue on our consolidated statements of operations as (i) product and (ii) maintenance and professional services. Under the new presentation of revenue and cost of revenue included in our consolidated statements of operations beginning in the first quarter of fiscal 2019, product has been retitled as license revenue, and maintenance and professional services is now presented as two separate line items on our consolidated statements of operations as (i) subscription and (ii) professional services. The related prior period financial data were adjusted to reflect the new presentation of our revenue and cost of revenue. There is no impact on total revenue and total cost of revenue.
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Year Ended December 31, | |||||||||||||||||||
2019 | 2018 | 2017 | 2016 | 2015 | |||||||||||||||
(In thousands, except per share data) | |||||||||||||||||||
Consolidated Statements of Operations Data: | |||||||||||||||||||
Revenue: | |||||||||||||||||||
License | $ | 175,115 | $ | 162,667 | $ | 125,348 | $ | 97,994 | $ | 71,264 | |||||||||
Subscription | 142,777 | 118,572 | 86,691 | 60,374 | 46,438 | ||||||||||||||
Professional services | 18,909 | 16,412 | 12,365 | 9,178 | 8,257 | ||||||||||||||
Total revenue | 336,801 | 297,651 | 224,404 | 167,546 | 125,959 | ||||||||||||||
Cost of revenue: | |||||||||||||||||||
License (1) | 31,301 | 27,854 | 23,841 | 21,832 | 16,161 | ||||||||||||||
Subscription (1) | 21,977 | 16,215 | 13,912 | 9,896 | 5,317 | ||||||||||||||
Professional services (1) | 25,900 | 23,813 | 20,859 | 16,675 | 11,644 | ||||||||||||||
Total cost of revenue | 79,178 | 67,882 | 58,612 | 48,403 | 33,122 | ||||||||||||||
Total gross profit | 257,623 | 229,769 | 165,792 | 119,143 | 92,837 | ||||||||||||||
Operating expenses: | |||||||||||||||||||
Research and development (1) | 82,795 | 61,713 | 47,435 | 31,490 | 17,772 | ||||||||||||||
Sales and marketing (1) | 213,046 | 183,880 | 144,398 | 119,071 | 70,269 | ||||||||||||||
General and administrative (1) | 63,018 | 57,721 | 51,206 | 30,731 | 22,874 | ||||||||||||||
Total operating expenses | 358,859 | 303,314 | 243,039 | 181,292 | 110,915 | ||||||||||||||
Loss from operations | (101,236 | ) | (73,545 | ) | (77,247 | ) | (62,149 | ) | (18,078 | ) | |||||||||
Interest expense | (496 | ) | (913 | ) | (1,223 | ) | (2,577 | ) | (2,745 | ) | |||||||||
Other income (expense), net | 1,918 | 2,567 | 316 | (607 | ) | (488 | ) | ||||||||||||
Revaluation of warrant liabilities | — | — | (727 | ) | 1,104 | (5,621 | ) | ||||||||||||
Loss before income taxes | (99,814 | ) | (71,891 | ) | (78,881 | ) | (64,229 | ) | (26,932 | ) | |||||||||
Income tax provision | 18,721 | 2,945 | 1,839 | 1,250 | 328 | ||||||||||||||
Net loss | $ | (118,535 | ) | $ | (74,836 | ) | $ | (80,720 | ) | $ | (65,479 | ) | $ | (27,260 | ) | ||||
Deemed dividend on the conversion of Series G redeemable convertible preferred stock | — | — | 12,810 | — | — | ||||||||||||||
Net loss attributable to common stockholders | $ | (118,535 | ) | $ | (74,836 | ) | $ | (93,530 | ) | $ | (65,479 | ) | $ | (27,260 | ) | ||||
Net loss per share attributable to common stockholders, basic and diluted (2) | $ | (2.58 | ) | $ | (1.83 | ) | $ | (8.20 | ) | $ | (11.67 | ) | $ | (6.61 | ) | ||||
Weighted-average shares used to compute net loss per share attributable to common stockholders, basic and diluted (2) | 45,957 | 40,980 | 11,405 | 5,609 | 4,122 | ||||||||||||||
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_____________________
(1) | Includes stock-based compensation expense as follows: |
Year Ended December 31, | |||||||||||||||||||
2019 | 2018 | 2017 | 2016 | 2015 | |||||||||||||||
(In thousands) | |||||||||||||||||||
Cost of revenue: | |||||||||||||||||||
License | $ | 346 | $ | 253 | $ | 103 | $ | 30 | $ | 16 | |||||||||
Subscription | 1,851 | 1,517 | 1,089 | 300 | 82 | ||||||||||||||
Professional services | 1,730 | 1,498 | 1,202 | 823 | 309 | ||||||||||||||
Research and development | 12,303 | 10,161 | 6,213 | 2,311 | 1,101 | ||||||||||||||
Sales and marketing | 25,698 | 24,999 | 14,451 | 8,084 | 2,245 | ||||||||||||||
General and administrative | 13,522 | 15,069 | 19,538 | 5,286 | 4,959 | ||||||||||||||
Total | $ | 55,450 | $ | 53,497 | $ | 42,596 | $ | 16,834 | $ | 8,712 | |||||||||
(2) | See Note 12 in the Notes to our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for a description of how we calculate net loss per share, basic and diluted. |
December 31, | |||||||||||||||||||
2019 | 2018 | 2017 | 2016 | 2015 | |||||||||||||||
(In thousands) | |||||||||||||||||||
Consolidated Balance Sheet Data: | |||||||||||||||||||
Cash and cash equivalents | $ | 69,030 | $ | 66,895 | $ | 63,009 | $ | 79,665 | $ | 126,846 | |||||||||
Marketable securities | $ | 29,181 | $ | 47,632 | $ | 123,384 | $ | — | $ | — | |||||||||
Working capital, excluding deferred revenue | $ | 137,552 | $ | 154,523 | $ | 223,927 | $ | 98,821 | $ | 111,521 | |||||||||
Total assets | $ | 416,227 | $ | 388,478 | $ | 328,718 | $ | 194,272 | $ | 170,870 | |||||||||
Total deferred revenue | $ | 187,598 | $ | 171,518 | $ | 134,859 | $ | 85,290 | $ | 83,459 | |||||||||
Notes payable - non-current | $ | — | $ | 8,248 | $ | 15,579 | $ | 22,824 | $ | — | |||||||||
Warrant liabilities | $ | — | $ | — | $ | — | $ | 4,874 | $ | 5,978 | |||||||||
Operating lease liabilities - non-current | $ | 32,125 | $ | — | $ | — | $ | — | $ | — | |||||||||
Other liabilities | $ | 23,893 | $ | 14,335 | $ | 11,807 | $ | 12,277 | $ | 5,865 | |||||||||
Redeemable convertible preferred stock | $ | — | $ | — | $ | — | $ | 283,854 | $ | 279,913 | |||||||||
Total stockholders’ equity (deficit) | $ | 97,545 | $ | 127,721 | $ | 115,491 | $ | (258,127 | ) | $ | (252,802 | ) | |||||||
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the section titled “Selected Consolidated Financial Data” and our consolidated financial statements and related notes included elsewhere within this Annual Report on Form 10-K. This discussion contains forward-looking statements based upon current plans, expectations and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and in other parts of this Annual Report on Form 10-K. Our fiscal year end is December 31.
As described in Note 6 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K, we adopted Accounting Standard Update 2016-02, Leases, Accounting Standard Update 2018-10, Codification Improvements to Topic 842, Leases, and Accounting Standard Update 2018-11, Targeted Improvements (collectively, “Topic 842”) effective January 1, 2019 using the transition method which had a material impact on our opening balances in certain asset and liability accounts as of January 1, 2019. Financial data of prior years were not adjusted as a result of the adoption.
Financial data for the year ended December 31, 2015 has not been adjusted to reflect the adoption of Topic 606.
Prior to the first quarter of fiscal 2019, we presented revenue and cost of revenue on our consolidated statements of operations as (i) product and (ii) maintenance and professional services. Under the new presentation of revenue and cost of revenue included in our consolidated statements of operations beginning in the first quarter of fiscal 2019, product has been retitled as license revenue, and maintenance and professional services is now presented as two separate line items on our consolidated statements of operations as (i) subscription and (ii) professional services. The related prior period financial data were adjusted to reflect the new presentation of our revenue and cost of revenue. There is no impact on total revenue and total cost of revenue.
Overview
We generate revenue from sales of our products and associated maintenance and professional services.
We offer our solution across two product groups: (i) products for visibility and control capabilities, and (ii) products for orchestration capabilities. Our products for visibility and control capabilities consist of eyeSight, eyeSegment (introduced on November 6, 2019), eyeControl, and SilentDefense. Our eyeSight, eyeSegment, and eyeControl products provide for visibility and control capabilities across the extended enterprise, from campus to data center to hybrid cloud to OT devices, while our SilentDefense product provides for visibility and control capabilities deeper within the OT portion of the network. Our products for orchestration capabilities are comprised of our portfolio of our eyeExtend family of products.
We offer our solution across two product types: (i) software products and (ii) hardware products. Our software products include eyeSight, eyeSegment, eyeControl, eyeExtend, SilentDefense, and SilentDefense Command Center (“Software Products”). Our hardware products include hardware that is sold separately for use with our Software Products and appliances that are embedded with our software (“Hardware Products”).
We also offer our solution across license types and increments. Our Software Products are sold with a perpetual license or a subscription license. Customers can purchase in license increments of 100 devices, with hardware sold separately based on customer deployment requirements. Customers can manage their own deployments of our products in varying options capable of scaling and managing deployments of up to 2,000,000 devices under a single console. Customers can purchase our SilentDefense products in license increments that are on a per sensor basis.
Since our inception through December 31, 2019, we have sold to more than 3,700 end-customers in over 90 countries, including 25% of the Global 2000, since our inception. For the years ended December 31, 2019, 2018, and 2017 we sold to 18%, 14%, and 13% of the Global 2000, respectively. Our end-customers represent a broad range of industries, including government, financial services, healthcare, technology, manufacturing, energy, services, retail, entertainment, and education.
We have experienced rapid growth in recent periods. For the years ended December 31, 2019, 2018, and 2017, our revenue was $336.8 million, $297.7 million, and $224.4 million, respectively, representing year-over-year increase of 13% for 2019 and 33% for 2018.
Proposed Merger
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On February 6, 2020, we entered into an Agreement and Plan of Merger with Ferrari Group Holdings, L.P., a Delaware limited partnership, and Ferrari Merger Sub, Inc., a Delaware corporation and a wholly owned subsidiary of Parent. Parent and Merger Sub are affiliates of Advent.
The Merger Agreement provides that, subject to the terms and conditions set forth in the Merger Agreement, Merger Sub will merge with and into Forescout, with Forescout surviving the Merger and becoming a wholly-owned indirect subsidiary of Parent. Under the Merger Agreement, at the effective time of the Merger, each issued and outstanding share of our common stock (except for certain shares specified in the Merger Agreement) will be canceled and automatically converted into the right to receive cash in an amount equal to $33.00, without interest.
Consummation of the Merger is subject to the satisfaction or waiver of customary closing conditions, including (1) approval of the Merger Agreement by our stockholders; (2) the absence of any law or order restraining, enjoining or otherwise prohibiting the Merger; and (3) the expiration or termination of the waiting period under the United States Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and clearance under the antitrust laws of certain non-United States jurisdictions. The Merger is expected to close in the second fiscal quarter of 2020. Upon consummation of the Merger, our common stock will no longer be listed on any public market.
Factors Affecting Our Performance
We believe that the growth of our business and our future success are dependent upon many factors, including our ability to continue to increase the efficiency by which our sales force engages our end-customers, to extend the reach of our sales force footprint to engage more end-customers, to retain and increase sales to existing end-customers, to grow our global end-customer base, and to increase the deal size of sales to our end-customers. While each of these areas presents significant opportunities for us, they also pose significant risks and challenges that we must successfully address in order to sustain the growth of our business and improve our results of operations.
Increasing the Efficiency by which Our Sales Force Engages Our End-Customers
We are focused on increasing the efficiency of our sales force. Over the last few years, we have increased hiring in sales enablement and marketing, enhanced sales training activities, and implemented company-wide standards for product positioning in order to instill a culture of success and discipline in our sales organization. Our sales strategy depends on attracting top talent from security organizations, expanding our sales coverage, increasing our pipeline of business, and enhancing productivity. We focus on productivity per quota-carrying sales representative across different levels within the sales organization, and the time it takes our sales representatives to reach productivity. We manage our pipeline on a quarterly basis by sales representative to ensure sufficient coverage of our bookings targets. Our ability to manage our sales productivity and pipeline are important factors to the success of our business.
We deploy a direct-touch channel-fulfilled strategy. Our customer acquisition sales cycle is typically nine to 24 months, depending on the industry, size and scope of deployment. Our expansion sales cycle is typically shorter, as customers buy more licenses to cover the additional devices that enter their network after their initial purchase and as we expand into other parts of their network - generally into their other campus environments or beyond campus and into OT, data center and cloud. We have a direct field sales team and a dedicated team focused on managing relationships with our channel partners and working with our channel partners to support our end-customers. We expect to continue to grow our sales headcount in areas of highest demand for our solution. Generally, our sales representatives become more productive the longer they are with us, with limited productivity in their first few quarters as they learn to sell our products and participate in field training, but with increasing productivity as they acquire accounts and as those accounts begin their expansion purchases for additional devices, additional parts of their network, and orchestration capabilities. We focus our sales management efforts on helping our sales representatives increase productivity as they become more seasoned. As of December 31, 2019, 38% of our sales representatives have been with us for more than two years.
Extending the Reach of Our Sales Force Footprint
We have made substantial investments in our sales force in recent periods in order to address the significant opportunity created primarily by the increase in the attack surface within organizations driven by the influx of IoT in the campus and data centers, the digital transformation from data centers to third party hosted cloud providers, and the emergence of the critical need to secure OT networks. We expect to continue to make investments in our sales force to capitalize on the market opportunity for device visibility and control.
Continued Retention and Sales to Existing End-Customers
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Reflecting the strategic nature of our visibility, control and orchestration capabilities 84% of our revenue for the year ended December 31, 2019 came from our existing end-customers as they expanded their deployment of our solution within their large heterogeneous networks well beyond their initial deployment phase and associated purchases. The chart below illustrates, most profoundly in the most recent years, the annual value of end-customers, as measured as a calendar-year-class-cohort, as they expand the use of our solutions, beyond their initial deployment. The chart shows revenue generated from our end-customers beginning from fiscal year 2007, the initial year of purchase for the 2007 end-customer cohort, along with the annual revenue derived from those same end-customers in each year through fiscal 2019. Each colored segment represents a new cohort of end-customers beginning in their initial year of purchase.
For context, we have served several of our top 20 end-customers for over 10 years. Our largest end-customer has spent more than $81 million with us life-to-date and our 20th largest end-customer has spent more than $10 million with us life-to-date. We have one end-customer, acquired in 2015 that has spent approximately $45 million with us life-to-date. The number of annual end-customer deals over $1 million and the collective value of those deals continues to increase. For the years ended December 31, 2019, 2018, and 2017, we had 69, 49, and 48 deals valued at over $1 million. We define an annual end-customer deal as the aggregate billings to an end-customer during a calendar year.
We believe the net-recurring revenue retention rate over the trailing 12 month period on our subscription revenue and on the annualized value of our subscription license revenue is an important metric to measure our ability to retain and increase sales to our existing end-customers. We calculate the net-recurring revenue retention rate using the following formula:
X = (A + B + C)/(B + D)
where:
X = net-recurring revenue retention rate
A = annualized value of term contracts renewed over the trailing 12 month period
B = trailing 12 month annualized value of term contracts not subject to renewal because the scheduled expiration date of the multi-year contract falls outside of the 12 month period under measurement
C = trailing 12 month annualized value of new term contracts from end-customers that have been end-customers for more than one year
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D =12 months annualized value of term contracts scheduled to terminate or renew during the 12 month period under measurement
We believe this metric is an indication of the continuing value we provide to our end-customers because it shows the renewal rate of their support and maintenance contracts and Software Products subscription contracts. Our net-recurring revenue retention rate as of December 31, 2019, 2018, and 2017 were 122%, 117%, and 126%, respectively. A net retention rate over 100% indicates that our products are expanding within our end-customer base, whereas a rate less than 100% indicates that our products are constricting within our end-customer base. Additionally, this calculation includes all changes to the annualized value of the recurring revenue from term contracts used in the calculation, which includes scheduled expiration periods, stub periods, changes in pricing, additional products purchased, lost end-customers, early renewals, and decreases in the number of devices licensed to be managed by our license under contract. This metric does not take into account perpetual license revenue or professional services revenue. The annualized value of our contracts is a legal and contractual determination made by assessing the contractual terms with our end-customers. The annualized value of our term contracts is not determined by reference to historical revenue, deferred revenue, or any other U.S. generally accepted accounting principles (“GAAP”) financial measure over any period.
Recurring Revenue Rate
We are focused on providing our customers with more licensing and delivery options from which to purchase our products. In the last 24 months, we introduced centralized licensing options as an alternative to our legacy options of licensing by individual units of physical and virtual appliances. We introduced Software Products subscription contracts in the first quarter of 2019 and began deriving revenue from these Software Products subscription contracts in the second quarter of 2019. In the future, we intend to offer our Software Products, in addition to our current on-premise offerings, in a form that also includes critical functionality being delivered from our cloud hosted facilities.
Included in our license revenue is the value allocated to license within our Software Products subscription contracts, which is recognized at the time of transfer of control, which is generally upon delivery of access to software downloads or shipment, provided that all other revenue recognition criteria have been met or upon commencement of a renewed term contract.
Included in our subscription revenue is the value allocated to support and maintenance within our Software Products subscription contracts and revenue derived from support and maintenance contracts. Subscription revenue is recognized ratably over the term of the contract.
We introduced recurring revenue rate as a key metric in the second quarter of 2019 since we believe it is an important metric in understanding the impact of customer buying preferences for the varying Software Products options upon our reported revenue. We calculate the recurring revenue rate as subscription revenue plus the portion of license revenue that is derived from the value allocated to license within our Software Products subscription contracts, collectively, as a percent of total revenue, as measured over the trailing 12 month period. We calculate the recurring revenue rate using the following formula:
X = (A + B)/C
where:
X = recurring revenue rate
A = subscription revenue over the trailing 12 month period
B = value allocated to license revenue within our Software Products subscription contracts over the trailing 12 month period
C = total revenue
Our recurring revenue rate as of December 31, 2019, 2018, and 2017 was 49%, 40%, and 39%, respectively. The numerator does not take into account perpetual license revenue or professional services revenue. The numerator does include the value allocated to license within our Software Products subscription contracts for all contract durations. Those contract durations that are greater than 12 months will raise the recurring revenue rate for the first 12 months of the contract duration and will lower the recurring revenue rate for the balance of the contract duration after the first 12 months relative to the annualized value of such Software Products subscription contracts.
Grow Global End-Customer Base
We have invested significantly, and plan to continue to invest, in our sales organization to drive new end-customer growth. During the year ended December 31, 2019, we added more than 400 new end-customers, of which approximately 80 are identified in the list of Global 2000. We now count six of the top 10 financial services companies, five of the top 10 manufacturing companies,
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12 of the 14 civilian cabinets with the US federal government, and numerous large healthcare companies as our customers that are standardizing with us for device visibility and control.
Increasing Deal Size of Sales to Our End-Customers
The value realized from our products has led to increased adoption and larger scale deployments. We define an annual end-customer deal as the aggregate billings to an end-customer during a calendar year. For the year ended December 31, 2019, our average deal size was approximately $192,000, a decrease of 5% from the average annual deal size for the year ended December 31, 2018, reflecting the lower quantity of deals that are over $10 million. We define the average deal size as the aggregate sales to end-customers during a calendar year divided by the number of end-customers purchasing in that year, excluding any end-customer for which the total value of their purchases in that year were less than five thousand dollars and excluding support and maintenance renewals, as we determined that the majority of this population was comprised of transactions not fundamental to our end-customer group and go-to-market strategy.
Key Financial Metrics
Non-GAAP Operating Loss and Free Cash Flow
In addition to our results determined in accordance with GAAP, we monitor the non-GAAP financial metrics described below to evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and measure and assess operational efficiencies.
We define non-GAAP operating loss as loss from operations excluding stock-based compensation expense, acquisition-related expenses, and amortization of acquired intangible assets. Acquisition-related expenses include transaction costs such as accounting and legal fees, and other employee retention expenses arising from business acquisitions. We consider non-GAAP operating loss to be a useful metric for investors and other users of our financial information in evaluating our operating performance because it excludes the impact of stock-based compensation, a non-cash charge that can vary from period to period for reasons that are unrelated to our core operating performance and non-recurring and non-operating amortization of acquired intangible assets, and acquisition-related expenses. This metric also provides investors and other users of our financial information with an additional tool to compare business performance across companies and periods, while eliminating the effects of items that may vary for different companies for reasons unrelated to core operating performance.
We define free cash flow as net cash (used in) provided by operating activities less purchases of property and equipment. We consider free cash flow to be an important metric because it measures the amount of cash we use or generate and reflects changes in working capital.
A reconciliation of non-GAAP operating loss to loss from operations, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:
Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
(In thousands) | |||||||||||
Non-GAAP operating loss: | |||||||||||
Loss from operations | $ | (101,236 | ) | $ | (73,545 | ) | $ | (77,247 | ) | ||
Add: | |||||||||||
Stock-based compensation expense | 55,450 | 53,497 | 42,596 | ||||||||
Acquisition-related expenses | 4,673 | 3,497 | — | ||||||||
Amortization of acquired intangible assets | 3,334 | 463 | — | ||||||||
Non-GAAP operating loss | $ | (37,779 | ) | $ | (16,088 | ) | $ | (34,651 | ) | ||
A reconciliation of free cash flow to net cash (used in) provided by operating activities, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:
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Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
(In thousands) | |||||||||||
Free cash flow (non-GAAP): | |||||||||||
Net cash (used in) provided by operating activities | $ | (22,524 | ) | $ | 13,489 | $ | (2,735 | ) | |||
Less: purchases of property and equipment | (7,760 | ) | (7,628 | ) | (4,517 | ) | |||||
Free cash flow (non-GAAP) | $ | (30,284 | ) | $ | 5,861 | $ | (7,252 | ) | |||
Net cash provided by (used in) investing activities | $ | 745 | $ | (36,950 | ) | $ | (127,549 | ) | |||
Net cash provided by financing activities | $ | 24,362 | $ | 25,123 | $ | 113,764 | |||||
It is important to note that other companies, including companies in our industry, may not use non-GAAP operating loss or free cash flow, may calculate these metrics differently, or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of these non-GAAP metrics as comparative measures.
As a result, our non-GAAP operating loss and free cash flow should be considered in addition to, not as substitutes for or in isolation from, measures prepared in accordance with GAAP.
We compensate for these limitations by providing investors and other users of our financial information, reconciliations of non-GAAP operating loss to the corresponding GAAP financial measure, operating loss, and reconciliations of free cash flow to the corresponding GAAP financial measure, cash flow (used in) provided by operating activities. We encourage investors and others to review our financial information in its entirety, not to rely on any single financial measure, and to view non-GAAP operating loss and free cash flow in conjunction with the corresponding GAAP financial measure.
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Results of Operations
The following tables summarize our consolidated statement of operations data and such data as a percentage of our total revenue. The period-to-period comparison of results is not necessarily indicative of results for future periods.
Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
(In thousands) | |||||||||||
Revenue: | |||||||||||
License | $ | 175,115 | $ | 162,667 | $ | 125,348 | |||||
Subscription | 142,777 | 118,572 | 86,691 | ||||||||
Professional services | 18,909 | 16,412 | 12,365 | ||||||||
Total revenue | 336,801 | 297,651 | 224,404 | ||||||||
Cost of revenue: | |||||||||||
License (1) | 31,301 | 27,854 | 23,841 | ||||||||
Subscription (1) | 21,977 | 16,215 | 13,912 | ||||||||
Professional services (1) | 25,900 | 23,813 | 20,859 | ||||||||
Total cost of revenue | 79,178 | 67,882 | 58,612 | ||||||||
Total gross profit | 257,623 | 229,769 | 165,792 | ||||||||
Operating expenses: | |||||||||||
Research and development (1) | 82,795 | 61,713 | 47,435 | ||||||||
Sales and marketing (1) | 213,046 | 183,880 | 144,398 | ||||||||
General and administrative (1) | 63,018 | 57,721 | 51,206 | ||||||||
Total operating expenses | 358,859 | 303,314 | 243,039 | ||||||||
Loss from operations | (101,236 | ) | (73,545 | ) | (77,247 | ) | |||||
Interest expense | (496 | ) | (913 | ) | (1,223 | ) | |||||
Other income, net | 1,918 | 2,567 | 316 | ||||||||
Revaluation of warrant liabilities | — | — | (727 | ) | |||||||
Loss before income taxes | (99,814 | ) | (71,891 | ) | (78,881 | ) | |||||
Income tax provision | 18,721 | 2,945 | 1,839 | ||||||||
Net loss | $ | (118,535 | ) | $ | (74,836 | ) | $ | (80,720 | ) | ||
Deemed dividend on the conversion of Series G redeemable convertible preferred stock | — | — | 12,810 | ||||||||
Net loss attributable to common stockholders | $ | (118,535 | ) | $ | (74,836 | ) | $ | (93,530 | ) | ||
_____________________
(1) | Includes stock-based compensation expense as follows: |
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Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
(In thousands) | |||||||||||
Cost of revenue: | |||||||||||
License | $ | 346 | $ | 253 | $ | 103 | |||||
Subscription | 1,851 | 1,517 | 1,089 | ||||||||
Professional services | 1,730 | 1,498 | 1,202 | ||||||||
Research and development | 12,303 | 10,161 | 6,213 | ||||||||
Sales and marketing | 25,698 | 24,999 | 14,451 | ||||||||
General and administrative | 13,522 | 15,069 | 19,538 | ||||||||
Total | $ | 55,450 | $ | 53,497 | $ | 42,596 | |||||
Year Ended December 31, | ||||||||
2019 | 2018 | 2017 | ||||||
(As a percentage of total revenue) | ||||||||
Revenue: | ||||||||
License | 52 | % | 55 | % | 56 | % | ||
Subscription | 42 | 40 | 39 | |||||
Professional services | 6 | 5 | 5 | |||||
Total revenue | 100 | 100 | 100 | |||||
Cost of revenue: | ||||||||
License | 9 | 10 | 11 | |||||
Subscription | 7 | 5 | 6 | |||||
Professional services | 8 | 8 | 9 | |||||
Total cost of revenue | 24 | 23 | 26 | |||||
Total gross profit | 76 | 77 | 74 | |||||
Operating expenses: | ||||||||
Research and development | 25 | 21 | 21 | |||||
Sales and marketing | 63 | 62 | 64 | |||||
General and administrative | 19 | 19 | 23 | |||||
Total operating expenses | 107 | 102 | 108 | |||||
Loss from operations | (31 | ) | (25 | ) | (34 | ) | ||
Interest expense | — | — | (1 | ) | ||||
Other income, net | 1 | 1 | — | |||||
Revaluation of warrant liabilities | — | — | — | |||||
Loss before income taxes | (30 | ) | (24 | ) | (35 | ) | ||
Income tax provision | 5 | 1 | 1 | |||||
Net loss | (35 | )% | (25 | )% | (36 | )% | ||
Deemed dividend on the conversion of Series G redeemable convertible preferred stock | — | % | — | % | 6 | % | ||
Net loss attributable to common stockholders | (35 | )% | (25 | )% | (42 | )% | ||
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Comparison of the Years Ended December 31, 2019, 2018, and 2017
Revenue
Our revenue is comprised of license revenue, subscription revenue, and professional services revenue. License revenue is derived from sales of Software Products and Hardware Products, which includes the value allocated to license within our Software Products subscription contracts. Subscription revenue is derived from term contracts with terms that are generally either one or three years, but can be up to five years. Professional services revenue is generally recognized over time as the services are rendered. As a percentage of total revenue, we expect our license revenue, subscription revenue, and professional services revenue to vary from quarter to quarter based on seasonal and cyclical factors.
Year Ended December 31, | 2019 to 2018 | 2018 to 2017 | |||||||||||||||||||||||
2019 | 2018 | 2017 | Change | Change | |||||||||||||||||||||
Amount | Amount | Amount | Amount | % | Amount | % | |||||||||||||||||||
(In thousands) | |||||||||||||||||||||||||
Revenue: | |||||||||||||||||||||||||
License | $ | 175,115 | $ | 162,667 | $ | 125,348 | $ | 12,448 | 8 | % | $ | 37,319 | 30 | % | |||||||||||
Subscription | 142,777 | 118,572 | 86,691 | 24,205 | 20 | % | 31,881 | 37 | % | ||||||||||||||||
Professional services | 18,909 | 16,412 | 12,365 | 2,497 | 15 | % | 4,047 | 33 | % | ||||||||||||||||
Total revenue | $ | 336,801 | $ | 297,651 | $ | 224,404 | $ | 39,150 | 13 | % | $ | 73,247 | 33 | % | |||||||||||
License revenue increased for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to an increase of $21.0 million, or 20%, in Software Product revenue, which was partially offset by a decrease of $8.6 million, or 15%, in Hardware Product revenue. The increase in Software Product revenue included a $30.6 million increase in the sale of eyeSight, eyeControl, and SilentDefense, which was partially offset by a $9.6 million decrease in the sale of eyeExtend.
Subscription revenue increased for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to a $15.3 million increase attributed to support and maintenance contracts associated with initial product sales and a $8.9 million increase attributed to support and maintenance contracts that were renewals.
Professional services revenue increased for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to an increase in sale of optional installation and training services.
License revenue increased for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to an increase of $57.6 million, or 117%, in Software Product revenue, which was partially offset by a decrease of $20.3 million, or 27%, in Hardware Product revenue. The increase in Software Product revenue included a $29.7 million increase in the sale of eyeSight, eyeControl and SilentDefense, and a $27.9 million increase in the sale of eyeExtend. The decrease in Hardware Product revenue was primarily due to a $35.2 million decrease in the sale of appliances embedded with our software, which was partially offset by a $14.8 million increase in the sale of hardware sold separately for use with our Software Products.
Subscription revenue increased for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to a $16.1 million increase attributed to support and maintenance contracts associated with initial product sales and a $15.8 million increase attributed to support and maintenance contracts that were renewals.
Professional services revenue increased for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to an increase in sale of optional installation and training services.
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Cost of Revenue
Our cost of revenue is comprised of cost of license revenue, cost of subscription revenue, and cost of professional services revenue.
Cost of license revenue primarily consists of costs paid to our third-party contract manufacturer for our Hardware Products. Our cost of license revenue also includes allocated costs, shipping costs and personnel costs associated with logistics for our Hardware Products, and amortization of acquired developed technology. We expect our cost of license revenue to fluctuate from quarter to quarter based on product mix between Software Products and Hardware Products; however, over time, we expect our cost of license revenue to decline as a percentage of license revenue reflecting the continuing shift towards Software Products in our product mix.
Cost of subscription revenue consists of personnel costs for our global customer support organization and warranty-related hardware support costs. We expect our cost of subscription revenue to increase in absolute dollars over time as we grow our customer support organization to accommodate our anticipated subscription revenue growth rate. In addition, we also expect the cost of subscription revenue to increase in absolute dollars as costs associated with supporting the infrastructure for our nascent SaaS products increase.
Cost of professional services revenue consists of personnel costs for our global professional services organization and costs paid to third-party contractors that deliver some of our services. We expect our cost of professional services revenue to decline over time as a percentage of our professional services revenue as we expect to scale our professional services organization at a lower growth rate than our anticipated professional services revenue growth rate.
Year Ended December 31, | 2019 to 2018 | 2018 to 2017 | |||||||||||||||||||||||
2019 | 2018 | 2017 | Change | Change | |||||||||||||||||||||
Amount | Amount | Amount | Amount | % | Amount | % | |||||||||||||||||||
(In thousands) | |||||||||||||||||||||||||
Cost of revenue: | |||||||||||||||||||||||||
License | $ | 31,301 | $ | 27,854 | $ | 23,841 | $ | 3,447 | 12 | % | $ | 4,013 | 17 | % | |||||||||||
Subscription | 21,977 | 16,215 | 13,912 | 5,762 | 36 | % | 2,303 | 17 | % | ||||||||||||||||
Professional services | 25,900 | 23,813 | 20,859 | 2,087 | 9 | % | 2,954 | 14 | % | ||||||||||||||||
Total cost of revenue | $ | 79,178 | $ | 67,882 | $ | 58,612 | $ | 11,296 | 17 | % | $ | 9,270 | 16 | % | |||||||||||
Cost of license revenue increased for the year ended December 31, 2019 compared to the year ended December 31, 2018, primarily due to a $1.9 million in amortization expense associated with acquired developed technology and a $5.1 million increase due to higher quantities of hardware sold separately for use with our Software Products, partially offset by a $3.6 million decrease due to lower quantities of appliances sold that are embedded with our software.
Cost of subscription revenue increased for the year ended December 31, 2019 compared to the year ended December 31, 2018, primarily due to an increase in personnel costs related to a 20% increase in headcount in our customer support organization.
Cost of professional services revenue increased for the year ended December 31, 2019 compared to the year ended December 31, 2018 due to an increase in personnel costs related to a 16% increase in headcount in our professional services organization.
Cost of license revenue increased for the year ended December 31, 2018 compared to the year ended December 31, 2017, primarily due to a $11.5 million increase due to higher quantities of hardware sold separately for use with our Software Products, partially offset by an $8.2 million decrease due to lower quantities of appliances sold that are embedded with our software.
Cost of subscription revenue increased for the year ended December 31, 2018 compared to the year ended December 31, 2017, primarily due to an increase in personnel costs related to a 54% increase in headcount in our customer support organization.
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Cost of professional services revenue increased for the year ended December 31, 2018 compared to the year ended December 31, 2017 due to an increase in personnel costs related to a 4% increase in headcount in our professional services organization.
Gross Profit and Gross Margin
Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including the mix of products sold between Software Products and Hardware Products; the mix between high-margin and low-margin Hardware Products; the mix of revenue between license, subscription, and professional services; the average sales price of our Software Products, Hardware Products, support and maintenance contracts, and professional services; amortization of acquired developed technology; and manufacturing costs.
Margin on our Software Products was approximately 99% for the years ended December 31, 2019, 2018, and 2017. Margin on our Hardware Products varies. The average margin on hardware sold separately for use with our Software Products was approximately 26% and 24% for the years ended December 31, 2019 and 2018, respectively. We began selling hardware sold separately for use with our Software Products in 2017. Margin on appliances, which are the hardware appliances that are embedded with our software, varies. The average margin on our high-end appliances was approximately 76%, 80%, and 83%, and the average margin on our low-end appliances was approximately 39%, 53%, and 58% for the years ended December 31, 2019, 2018, and 2017, respectively.
We expect our margins to fluctuate from quarter to quarter based on product mix; however, over time, we expect our margins to increase as a percentage of license revenue primarily due to a shift in product mix towards increased sales of Software Products.
Year Ended December 31, | 2019 to 2018 | 2018 to 2017 | ||||||||||||||||||||||||||||||||
2019 | 2018 | 2017 | Change | Change | ||||||||||||||||||||||||||||||
Gross Profit | Gross Margin | Gross Profit | Gross Margin | Gross Profit | Gross Margin | Gross Profit | Gross Margin % | Gross Profit | Gross Margin % | |||||||||||||||||||||||||
(In thousands) | ||||||||||||||||||||||||||||||||||
Gross profit: | ||||||||||||||||||||||||||||||||||
License | $ | 143,814 | 82 | % | $ | 134,813 | 83 | % | $ | 101,507 | 81 | % | $ | 9,001 | (1 | )% | $ | 33,306 | 2 | % | ||||||||||||||
Subscription | 120,800 | 85 | % | 102,357 | 86 | % | 72,779 | 84 | % | 18,443 | (1 | )% | 29,578 | 2 | % | |||||||||||||||||||
Professional services | (6,991 | ) | (37 | )% | (7,401 | ) | (45 | )% | (8,494 | ) | (69 | )% | 410 | 8 | % | 1,093 | 24 | % | ||||||||||||||||
Total gross profit | $ | 257,623 | 76 | % | $ | 229,769 | 77 | % | $ | 165,792 | 74 | % | $ | 27,854 | (1 | )% | $ | 63,977 | 3 | % | ||||||||||||||
Gross profit increased for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase is consistent with the changes in our revenue and cost of revenue.
Gross margin decreased for the year ended December 31, 2019 compared to the year ended December 31, 2018. The decrease was driven by decreases in margin on our license and subscription revenue, partially offset by an increase in margin on our professional services revenue.
The decrease in margin on our license revenue was primarily driven by a shift in product mix within Hardware Products revenue due to a lower concentration of high-end appliances revenue for the year ended December 31, 2019 compared to the year ended December 31, 2018. This decrease was partially offset by a higher concentration of revenue generated from Software Products. The mix between Software Products revenue and Hardware Products revenue shifted to 73:27 for the year ended December 31, 2019, from 66:34 for the year ended December 31, 2018. Within Hardware Products revenue, the mix among hardware sold separately for use with our Software Products, low-end appliances that are embedded with our software, and high-end appliances that are embedded with our software shifted to 58:20:22 for the year ended December 31, 2019, from 35:31:34 for the year ended December 31, 2018.
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The decrease in margin on our subscription revenue was due to higher personnel costs related to an investment in headcount in our support organization, as compared to our subscription revenue growth.
The increase in margin on our professional services revenue was primarily driven by improvements made within professional services as we scale our professional services organizations at a lower growth rate than our anticipated professional services revenue growth rate.
Gross profit increased for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase is consistent with the changes in our revenue and cost of revenue.
Gross margin increased for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was driven by increases in margin on license revenue, increases in margin on subscription revenue, and increases in margin on professional services margin.
The increase in margin on our license revenue was primarily due to a higher concentration of Software Products revenue compared to Hardware Products revenue, which was principally driven by a shift in product mix towards increased sales of eyeExtend and customers deploying eyeSight and eyeControl in virtual environments that does not require any hardware being provided by the Company. The mix between Software Products revenue and Hardware Products revenue shifted to 66:34 for the year ended December 31, 2018, from 39:61 for the year ended December 31, 2017. Within Hardware Products revenue, the mix among hardware sold separately for use with our Software Products, low-end appliances that are embedded with our software, and high-end appliances that are embedded with our software shifted to 35:31:34 for the year ended December 31, 2018, from 6:39:55 for the year ended December 31, 2017.
The increase in margin on our subscription revenue was due to growing efficiencies in our customer support organization.
The increase in margin on our professional services revenue was primarily driven by improvements made within professional services as we scale our professional services organizations at a lower growth rate than our anticipated professional services revenue growth rate.
Operating Expenses
Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, stock-based compensation, and with regard to sales and marketing expense, sales commissions.
Research and development expense consists primarily of personnel costs. Research and development expense also includes consulting expense, amortization of acquired developed technology, and allocated costs including facilities and information technology related costs. Sales and marketing expense consists primarily of personnel costs. Sales and marketing expense also includes sales commissions, costs for market development programs, promotional and other marketing costs, travel costs, professional services, amortization of acquired customer relationships, and allocated costs including facilities and information technology related costs. Incremental commissions incurred to acquire customer contracts are deferred and recognized as we recognize the associated revenue or over the estimated customer life. General and administrative expense consists of personnel costs, professional services, and allocated costs including facilities and information technology related costs. General and administrative personnel include our executive, finance, human resources, and legal organizations. Professional services consist primarily of legal, auditing, accounting, and other consulting costs. We expect operating expenses to increase in absolute dollars as we continue to invest in our future products and services; however, we expect our operating expenses to decline as a percentage of total revenue in the long term as we scale the business.
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Year Ended December 31, | 2019 to 2018 | 2018 to 2017 | |||||||||||||||||||||||
2019 | 2018 | 2017 | Change | Change | |||||||||||||||||||||
Amount | Amount | Amount | Amount | % | Amount | % | |||||||||||||||||||
(In thousands) | |||||||||||||||||||||||||
Operating expenses: | |||||||||||||||||||||||||
Research and development | $ | 82,795 | $ | 61,713 | $ | 47,435 | $ | 21,082 | 34 | % | $ | 14,278 | 30 | % | |||||||||||
Sales and marketing | 213,046 | 183,880 | 144,398 | 29,166 | 16 | % | 39,482 | 27 | % | ||||||||||||||||
General and administrative | 63,018 | 57,721 | 51,206 | 5,297 | 9 | % | 6,515 | 13 | % | ||||||||||||||||
Total operating expenses | $ | 358,859 | $ | 303,314 | $ | 243,039 | $ | 55,545 | 18 | % | $ | 60,275 | 25 | % | |||||||||||
Research and development expense increased for the year ended December 31, 2019 compared to the year ended December 31, 2018, due to an increase in personnel costs of $14.2 million related to an increase of 26% in headcount, which includes headcount from our recent acquisitions over the last two years and an increase in stock-based compensation costs of $2.0 million. The increase was further driven by an increase in allocated IT and facilities costs of $2.7 million and increase in professional fees of $1.6 million.
Sales and marketing expense increased for the year ended December 31, 2019 compared to the year ended December 31, 2018, due to an increase in personnel costs of $28.3 million and includes an increase in commissions expense of $5.7 million. The increase was further driven by an increase in other marketing activities costs of $2.2 million, which includes increase in amortization of acquired intangible assets of $1.0 million.
General and administrative expense increased for the year ended December 31, 2019 compared to the year ended December 31, 2018, due to an increase in personnel cost of $7.3 million related to an increase of 2% in headcount and post combination compensation expense relating to the acquisition of SecurityMatters B.V. (“SecurityMatters” or “Forescout Technologies, B.V.”).
Research and development expense increased for the year ended December 31, 2018 compared to the year ended December 31, 2017, due to an increase in personnel costs of $11.6 million related to an increase of 43% in headcount, and includes an increase in stock-based compensation costs of $3.9 million. The increase was further driven by an increase in allocated IT and facilities costs of $1.5 million.
Sales and marketing expense increased for the year ended December 31, 2018 compared to the year ended December 31, 2017, due to an increase in personnel costs of $31.8 million related to an increase of 40% in headcount, and include an increase in stock-based compensation expense of $10.4 million and an increase in commissions expense of $7.0 million. The increase was further driven by an increase in other marketing activities costs of $2.5 million, an increase in allocated IT and facilities cost of $2.4 million, and an increase in travel and entertainment cost of $2.1 million.
General and administrative expense increased for the year ended December 31, 2018 compared to the year ended December 31, 2017, due to an increase in personnel cost, excluding stock-based compensation expenses, of $5.1 million related to an increase of 26% in headcount, partially offset by a decrease in stock-based compensation expense of $4.3 million impacted by the modification of our CEO’s equity awards in the year ended December 31, 2017 but no similar transactions occurred during the year ended December 31, 2018. This increase was further driven by an increase in professional fees of $3.8 million which includes acquisition-related expenses.
Interest Expense
Interest expense consists of interest on our outstanding indebtedness.
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Year Ended December 31, | 2019 to 2018 | 2018 to 2017 | |||||||||||||||||||||||
2019 | 2018 | 2017 | Change | Change | |||||||||||||||||||||
Amount | Amount | Amount | Amount | % | Amount | % | |||||||||||||||||||
(In thousands) | |||||||||||||||||||||||||
Interest expense | $ | (496 | ) | $ | (913 | ) | $ | (1,223 | ) | $ | 417 | (46 | )% | $ | 310 | (25 | )% | ||||||||
Interest expense decreased for the year ended December 31, 2019 compared to the year ended December 31, 2018 and the year ended December 31, 2018 compared to the year ended December 31, 2017, primarily due to the decreasing notes payable balance associated with our amended and restated loan and security agreement entered into on December 22, 2016.
Other Income, Net
Other income, net consists primarily of interest income earned on our cash, cash equivalents, and marketable securities, sublease income, and foreign currency exchange gains (losses) related to transactions denominated in currencies other than the U.S. Dollar.
Year Ended December 31, | 2019 to 2018 | 2018 to 2017 | |||||||||||||||||||||||
2019 | 2018 | 2017 | Change | Change | |||||||||||||||||||||
Amount | Amount | Amount | Amount | % | Amount | % | |||||||||||||||||||
(In thousands) | |||||||||||||||||||||||||
Other income, net | $ | 1,918 | $ | 2,567 | $ | 316 | $ | (649 | ) | (25 | )% | $ | 2,251 | 712 | % | ||||||||||
Other income, net decreased for the year ended December 31, 2019 compared to the year ended December 31, 2018, primarily due to a decrease in interest income from marketable securities.
Other income, net increased for the year ended December 31, 2018 compared to the year ended December 31, 2017, primarily due to an increase in interest income from marketable securities.
Revaluation of Warrant Liabilities
Revaluation of warrant liabilities includes adjustments to the estimated fair value of the redeemable convertible preferred stock warrants outstanding offset by any gain realized from the exercise of outstanding warrants when the fair value of the warrants exercised is greater than the fair value of the redeemable convertible preferred stock. We mark-to-market our warrant liabilities on a quarterly basis. All of these warrants were exercised as of December 31, 2017.
Year Ended December 31, | 2019 to 2018 | 2018 to 2017 | |||||||||||||||||||||||
2019 | 2018 | 2017 | Change | Change | |||||||||||||||||||||
Amount | Amount | Amount | Amount | % | Amount | % | |||||||||||||||||||
(In thousands) | |||||||||||||||||||||||||
Revaluation of warrant liabilities | $ | — | $ | — | $ | (727 | ) | $ | — | — | % | $ | 727 | (100 | )% | ||||||||||
Change in revaluation of warrant liabilities decreased for the year ended December 31, 2018 compared to the year ended December 31, 2017 as there were no preferred stock warrants outstanding during the year ended December 31, 2018.
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Provision for Income Taxes
Provision for income taxes consists primarily of foreign income taxes, unrecognized tax benefits, withholding taxes, and U.S. state income taxes. We maintain a full valuation allowance for domestic net deferred tax assets. Our foreign deferred tax assets are immaterial.
Year Ended December 31, | 2019 to 2018 | 2018 to 2017 | |||||||||||||||||||||||
2019 | 2018 | 2017 | Change | Change | |||||||||||||||||||||
Amount | Amount | Amount | Amount | % | Amount | % | |||||||||||||||||||
(In thousands) | |||||||||||||||||||||||||
Provision for income taxes | $ | 18,721 | $ | 2,945 | $ | 1,839 | $ | 15,776 | 536 | % | $ | 1,106 | 60 | % | |||||||||||
Effective tax rate | (18.8 | )% | (4.1 | )% | (2.3 | )% | |||||||||||||||||||
We recorded an income tax provision for the year ended December 31, 2019 due to foreign income taxes, income tax reserves, and U.S. state minimum taxes. The increase in the provision for the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to an increase in income tax expense related to the completion of an intra-group transfer of certain intellectual property rights (the “IP”). The loss was primarily generated in the United States and does not impact the provision for income taxes as it was offset by a full valuation allowance. The effective tax rate decreased primarily due to an increase in the provision for income taxes associated with the intra-group transfer of the IP.
We recorded an income tax provision for the year ended December 31, 2018 due to foreign income taxes, unrecognized tax benefits and U.S. state minimum taxes. The increase in the provision for the year ended December 31, 2018 compared to the year ended December 31, 2017 was primarily due to an increase in pre-tax income of our international operations mainly due to our decision for stock based compensation to be included within our Israeli entity’s transfer pricing reimbursement arrangements. The effective tax rate decreased primarily due to a decrease in worldwide loss before income taxes, which was largely generated in the United States and offset by a full valuation allowance.
See Note 11 of our Notes to Consolidated Financial Statements, included in Part II Item 8 of this Annual Report on Form 10-K, for details on income tax reserves related to uncertain tax provisions.
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Liquidity and Capital Resources
The following data should be read in conjunction with our consolidated statements of cash flows.
December 31, | |||||||
2019 | 2018 | ||||||
(In thousands) | |||||||
Working capital | $ | 25,320 | $ | 52,623 | |||
Cash, cash equivalents, and marketable securities: | |||||||
Cash and cash equivalents | $ | 69,030 | $ | 66,895 | |||
Marketable securities | 29,181 | 47,632 | |||||
Total cash, cash equivalents, and marketable securities | $ | 98,211 | $ | 114,527 | |||
Total notes payable | 8,248 | 15,579 | |||||
Net cash, cash equivalents, and marketable securities | $ | 89,963 | $ | 98,948 | |||
Our liquidity and capital resources are derived from cash received from our IPO and our follow-on offering, and cash flows from operations. Our cash equivalents are comprised of cash and money market accounts. Our marketable securities are comprised of commercial paper, corporate-debt securities, and U.S. government securities. We believe our existing cash, cash equivalents, and marketable securities will be sufficient to meet our projected operating requirements for at least the next 12 months. Our future capital requirements will depend on many factors including our growth rate, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the introduction of new and enhanced products and services offerings, and the continuing market acceptance of our products.
At December 31, 2019, our cash, cash equivalents, and marketable securities of $98.2 million were held for general corporate purposes, of which approximately $35.1 million was held outside the United States. As discussed further in Note 11 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K, we will continue to reinvest our foreign cash outside of the United States. If we were to repatriate these earnings to the United States, any associated withholding tax would not be material.
The significant components of our working capital are cash and cash equivalents, marketable securities, accounts receivable, current deferred commissions, and prepaid expenses and other current assets, reduced by accounts payable, accrued compensation, accrued expenses, current deferred revenue, current notes payable, and current operating lease liabilities. Working capital decreased by $27.3 million during the year ended December 31, 2019, primarily due to a decrease in marketable securities, an increase in current deferred revenue, an increase in current operating lease liabilities, an increase in accrued expenses, an increase in accrued compensation, and a decrease in inventory, partially offset by an increase in accounts receivable, an increase in prepaid expenses and other current assets, an increase in cash and cash equivalents, and a decrease in accounts payable. The following table summarizes our cash flows for the years ended December 31, 2017, 2018, and 2019:
Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
(In thousands) | |||||||||||
Net cash (used in) provided by operating activities | $ | (22,524 | ) | $ | 13,489 | $ | (2,735 | ) | |||
Net cash provided by (used in) investing activities | 745 | (36,950 | ) | (127,549 | ) | ||||||
Net cash provided by financing activities | 24,362 | 25,123 | 113,764 | ||||||||
Effect of exchange rate changes on cash, cash equivalents, and restricted cash | (4 | ) | (7 | ) | — | ||||||
Net change in cash, cash equivalents, and restricted cash for period | $ | 2,579 | $ | 1,655 | $ | (16,520 | ) | ||||
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On October 31, 2017, we completed our IPO, in which we issued and sold 6,072,000 shares of common stock inclusive of the underwriters’ option to purchase additional shares that were exercised in full. We received aggregate proceeds of $124.2 million from the IPO, net of underwriters’ discounts and commissions.
On March 23, 2018, we completed our follow-on offering (the “Offering”), in which we issued and sold 500,000 shares of our common stock. Further, an additional 4,572,650 shares of our common stock were sold by certain stockholders in the Offering, inclusive of the underwriters’ option to purchase additional shares from certain of the selling stockholders. The price to the public was $29.00 per share. We received aggregate proceeds of $16.4 million from the Offering, net of underwriters’ discounts and commissions of $0.7 million and inclusive of approximately $2.6 million received by us in connection with the exercise by certain selling stockholders of options to purchase an aggregate of 425,436 shares of common stock that were sold in the Offering. The Company incurred offering costs of approximately $1.2 million. We did not receive any proceeds from the sale of shares by the selling stockholders in the Offering.
On April 25, 2018 (the “Settlement Date”), an aggregate of 892,996 shares underlying the RSUs held by our directors and then-current employees vested and settled. Substantially all of the RSUs vest upon the satisfaction of both a service-based vesting condition and a performance-based vesting condition. The performance-based vesting condition became probable on October 26, 2017, which was the effective date of the registration statement for our IPO, and was satisfied on the Settlement Date. For our executive officers, 227,044 of the vested shares were withheld to satisfy the tax obligations due for the RSUs that settled on the Settlement Date. The closing price of our common stock on the Settlement Date was $32.76 per share, resulting in tax obligations of $7.4 million in the aggregate. For RSUs held by our non-executive employees, subject to tax withholding obligations, 55,904 shares were sold on the Settlement Date to cover tax obligations of $1.8 million in the aggregate.
Loan Agreements
In December 2016, we amended our amended and restated loan and security agreement, which we originally entered into in May 2009, or the Amended and Restated 2009 Loan and Security Agreement, to increase the maximum amount of credit available for borrowing under the revolving line of credit to 80% of qualified accounts receivable up to $40.0 million. In addition, the Amended and Restated 2009 Loan and Security Agreement provides that the combined outstanding balances of the revolving line of credit and the term loan cannot exceed $40.0 million. Additionally, we borrowed $30.0 million under the Amended and Restated 2009 Loan and Security Agreement, which carries a maturity date of December 2020. The agreement is subject to us maintaining an adjusted quick ratio of 1.25. The Amended and Restated 2009 Loan and Security Agreement requires us to pay equal monthly installments of principal of $625,000 and monthly interest payments at a fixed interest rate per annum of 3.25%. Concurrent with the final monthly installment payment on the maturity date, we will be required to pay an additional payment of $825,000.
On April 4, 2019, we entered into a Second Amended and Restated Loan and Security Agreement to extend the maturity period of the revolving line of credit by two years to March 31, 2021 and amend the borrowing base and interest of the revolving line of credit.
Our Amended and Restated 2009 Loan and Security Agreement contains customary affirmative covenants and certain financial and negative covenants, including restrictions on disposing of assets, entering into change of control transactions, mergers or acquisitions, incurring additional indebtedness, granting liens on certain of our assets and paying dividends. We have pledged substantially all of our assets other than intellectual property as collateral under our Amended and Restated 2009 Loan and Security Agreement and granted the lender a negative pledge on our intellectual property.
We were in compliance with respect to all financial-related covenants under our loan agreements as of December 31, 2019 and December 31, 2018.
Operating Activities
Our operating activities have consisted of net loss adjusted for certain non-cash items and changes in assets and liabilities.
Cash (used in) provided by operating activities was $(22.5) million, $13.5 million, and $(2.7) million for the years ended December 31, 2019, 2018, and 2017, respectively, representing a change of $(36.0) million and $16.2 million year over year for the year ended December 31, 2019 and 2018, respectively, as compared to the prior year periods. The decrease in generation of cash during the year ended December 31, 2019 was due primarily to lower billings and higher operating expenses as we
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continue to invest in the long-term growth of our business, partially offset by proceeds from collections. The increase in generation of cash during the year ended December 31, 2018 was due primarily to higher billings and collections, partially offset by higher operating expenses as we continue to invest in the long-term growth of our business.
Investing Activities
Our investing activities have consisted of financial instrument purchases and capital expenditures. We expect to continue such activities as our business grows.
Cash provided by investing activities during the year ended December 31, 2019 was $0.7 million, primarily resulting from proceeds from maturities of marketable securities of $82.3 million, partially offset by $63.6 million in purchases of marketable securities, $10.3 million due to acquisition of certain assets of Bullguard Israel Ltd., and capital expenditures to purchase property and equipment of $7.8 million related to the continuing growth of our business.
Cash used in investing activities during the year ended December 31, 2018 was $37.0 million, primarily due to the business acquisition of SecurityMatters, net of cash acquired, of $105.4 million, $54.5 million in purchases of marketable securities, and capital expenditure to purchase property and equipment of $7.6 million related to the continuing growth of our business, partially offset by proceeds from maturities of marketable securities of $130.6 million.
Cash used in investing activities for the year ended December 31, 2017 was $127.5 million, primarily resulting from an increase of $123.0 million in purchases of marketable securities from our net IPO proceeds received in October 2017. Additionally, there was a $4.5 million increase from capital expenditures to purchase property and equipment.
Financing Activities
Our financing activities have consisted of proceeds from the issuance of common stock, issuance of shares through our employee equity incentive plans, partially offset by repayments of notes payable.
Cash provided by financing activities for the year ended December 31, 2019 was $24.4 million, primarily due to proceeds from sale of shares through employee equity incentive plans of $36.4 million, partially offset by $7.5 million in repayment of notes payable and $4.5 million in payments related to shares withheld for taxes on vesting of restricted stock units.
Cash provided by financing activities for the year ended December 31, 2018 was $25.1 million, primarily due to proceeds from sale of shares through employee equity incentive plans of $31.8 million, proceeds from the follow-on offering in March 2018 of $13.8 million, partially offset by $11.4 million in payments related to shares withheld for taxes on vesting of restricted stock units, $7.5 million in repayment of notes payable, and $1.5 million in payments of deferred offering costs.
Cash provided by financing activities for the year ended December 31, 2017 was $113.8 million, primarily due to proceeds of $124.2 million received from our IPO, and proceeds of $1.6 million from the exercise of stock options, offset by $7.5 million in repayment of notes payable, and $4.2 million in payments of deferred offering costs.
Contractual Obligations and Commitments
The following summarizes our contractual obligations and commitments as of December 31, 2019:
Payments Due by Period | |||||||||||||||||||
Total | Less Than 1 Year | 1 - 3 Years | 3- 5 Years | More Than 5 Years | |||||||||||||||
(In thousands) | |||||||||||||||||||
Notes payable | $ | 8,325 | $ | 8,325 | $ | — | $ | — | $ | — | |||||||||
Operating lease obligations (1) | 47,169 | 8,791 | 15,353 | 14,699 | 8,326 | ||||||||||||||
Purchase obligations (2) | 4,611 | 2,385 | 2,226 | — | — | ||||||||||||||
Contract manufacturer commitments (3) | 7,019 | 7,019 | — | — | — | ||||||||||||||
Total (4) | $ | 67,124 | $ | 26,520 | $ | 17,579 | $ | 14,699 | $ | 8,326 | |||||||||
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_____________________
(1) | Consists of contractual obligations from our non-cancelable operating leases, including short-term leases. |
(2) | Consists primarily of non-cancelable license obligations for software licenses expiring at various dates through March 2022. |
(3) | Consists of minimum purchase commitments of products and components with our independent contract manufacturer. Obligations under contracts that we can cancel without a significant penalty are not included in the table above. |
(4) | No amounts related to Financial Accounting Standards Board (“FASB”), Accounting Standard Codification Topic 740-10, Income Taxes, are included. As of December 31, 2019, we had approximately $22.0 million of tax liabilities recorded related to uncertainty in income tax positions. |
Off-Balance Sheet Arrangements
Through December 31, 2019, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Critical Accounting Policies and Estimates
Our consolidated financial statements have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected.
The critical accounting policies requiring estimates, assumptions, and judgments that we believe have the most significant impact on our consolidated financial statements are described below.
Revenue Recognition
We derive our revenue from sales of Software Products, Hardware Products, term contracts, and professional services. To the extent a contract includes multiple promised goods or services, we apply judgment to determine whether promised goods or services are capable of being distinct and distinct in the context of the contract. If these criteria are not met, the promised goods or services are accounted for as a combined performance obligation.
Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price, or SSP, basis. We determine standalone selling price based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, we estimate the standalone selling price taking into account available information such as market conditions and internally approved pricing guidelines related to the performance obligations.
Contract Costs
Incremental contract origination costs relating to term contracts are capitalized and amortized over either the contractual performance period or on a straight-line basis over the average customer life of five years, depending on whether the costs relate to a specific term contract or the customer relationship. We determine our average customer life by taking into consideration our customer contracts, our technology, and other factors.
Stock-Based Compensation
Stock-based compensation expense is measured and recognized in the financial statements based on the grant date fair value of the award. The fair value of a stock option is estimated on the grant date using the Black-Scholes option-pricing model. The fair value of an RSU is measured using the fair value of our common stock on the date of the grant. Stock-based compensation expense is recognized over the requisite service periods of the awards, which is generally four years.
Our use of the Black-Scholes option-pricing model requires the input of highly subjective assumptions, including the fair value of our underlying common stock, expected term of the option, expected volatility of the price of industry peers, risk-free interest rates, and the expected dividend yield of our common stock. The assumptions used in our option-pricing model
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represent management’s best estimates. These estimates involve inherent uncertainties and the application of management’s judgment. If factors change and different assumptions are used, our stock-based compensation expense could be materially different in the future.
These assumptions and estimates are as follows:
• | Fair Value of Common Stock. Prior to our initial public offering in October 2017, our stock was not publicly traded and we estimated the fair value of common stock using various methodologies, including third-party valuations. After the initial public offering, we used the publicly quoted price as the fair value of our common stock. |
• | Expected Term. The expected term of employee stock options represents the weighted-average period that the stock options are expected to remain outstanding. To determine the expected term, we generally apply the simplified approach in which the expected term of an award is presumed to be the mid-point between the vesting date and the expiration date of the award as we do not have sufficient historical exercise data to provide a reasonable basis for an estimate of expected term. |
• | Risk-Free Interest Rate. We base the risk-free interest rate on the yields of U.S. Treasury securities with maturities approximately equal to the expected term of employee stock option awards. |
• | Expected Volatility. As we do not have a sufficient trading history of our common stock, the expected volatility for our common stock was estimated by taking the average historic price volatility for industry peers based on daily price observations over a period equivalent to the expected term of the stock option awards. Industry peers consist of several public companies in our industry which are either similar in size, stage of life cycle, or financial leverage. |
• | Dividend Rate. We have never declared or paid any cash dividends and do not presently plan to pay cash dividends in the foreseeable future. As a result, we use a dividend rate of zero. |
We estimate the fair value of the rights to acquire stock under our ESPP using the Black-Scholes option-pricing model. Our ESPP typically provides for consecutive six-month offering periods and we use our peer group volatility data in the valuation of ESPP shares. We recognize such compensation expense on a straight-line basis over the offering period.
We will continue to use judgment in evaluating the assumptions related to our stock-based compensation on a prospective basis. As we continue to accumulate additional data related to our common stock, we may have refinements to our estimates, which could materially impact our future stock-based compensation expense.
Income Taxes
We estimate our income taxes in each of the jurisdictions in which we operate. Further, we recognize liabilities for uncertain tax positions based on determining whether the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. We consider many factors when evaluating and estimating our tax positions, which may require periodic adjustments and may not accurately forecast actual outcomes. Determining whether an uncertain tax position is effectively settled requires judgment. Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision. The material uncertain tax position that was recorded since our last Annual Report on Form 10-K for the year ended December 31, 2018, filed March 1, 2019, related to the intra-group transfer of the IP.
Business Combinations
We account for acquisitions using the acquisition method of accounting for business combinations. When we acquire a business, the purchase price is allocated to the net tangible and identifiable intangible assets acquired based on their estimated fair values. Any residual purchase price is recorded as goodwill. The allocation of the purchase price requires us to make significant estimates in determining the fair values of assets acquired and liabilities assumed, especially with respect to intangible assets. These estimates can include, but are not limited to, the cash flows that an asset is expected to generate in the future, the appropriate weighted-average cost of capital, and the cost savings expected to be derived from acquiring an asset. These estimates are inherently uncertain and unpredictable. During the measurement period, which may be up to one year from the acquisition date, adjustments to the fair value of these tangible and intangible assets acquired and liabilities assumed may be recorded, with the corresponding offset to goodwill. Upon the conclusion of the measurement period or final determination of the fair value of
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assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to the consolidated statements of operations.
Goodwill and Other Long-Lived Assets
The excess of the purchase price over the estimated fair value of net assets of businesses acquired in a business combination is recognized as goodwill. Goodwill is tested for impairment annually on October 1st or more frequently if certain indicators are present.
We review long-lived assets, such as property and equipment and finite-lived intangible assets subject to amortization, for events and changes in circumstances that may indicate that carrying amounts of long-lived assets may not be recoverable. When such events or circumstances occur, recoverability of these assets is measured by a comparison of the carrying value to the future undiscounted cash flows the assets are expected to generate. If long-lived assets are considered to be impaired, the impairment to be recognized would equal the amount by which the carrying value of the asset exceeds its fair market value.
To date, we have not recorded any significant impairment to goodwill and other long-lived assets.
Recent Accounting Pronouncements
Refer to Note 1 of Notes to Consolidated Financial Statements, included in Part II. Item 8 of this Annual Report on Form 10-K for analysis of recent accounting pronouncements that are applicable to our business.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency Exchange Risk
Our sales contracts are primarily denominated in U.S. Dollar. A portion of our operating expenses are incurred outside of the United States, are denominated in foreign currencies, and are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Israeli Shekel, British Pound, and Euro. Additionally, fluctuations in foreign currency exchange rates may cause us to recognize transaction gains and losses in our consolidated statements of operations. The effect of an immediate 10% adverse change in foreign exchange rates on foreign-denominated accounts as of December 31, 2019 and December 31, 2018 would not result in a material loss on our consolidated statements of operations.
With the acquisition of SecurityMatters (now Forescout Technologies, B.V.) on November 7, 2018, we are further exposed to foreign currency exchange risk as the functional currency of Forescout Technologies, B.V. is the Euro. Translation from Euro to the U.S. Dollar is performed for balance sheet accounts using exchange rates in effect at the balance sheet date and for revenue and expense accounts using an average exchange rate for the period. Resulting translation adjustments are reported as a component of accumulated other comprehensive loss on the consolidated balance sheets. We re-assessed our functional currency and determined that, as of July 1, 2019, our functional currency for Forescout Technologies, B.V. had changed from the Euro to the U.S. dollar following the transfer of all of the intellectual property from Forescout Technologies, B.V. to the Company effective July 1, 2019. The change in functional currency was accounted for prospectively from July 1, 2019 and financial statements prior to and including the period ended June 30, 2019 were not restated for the change in functional currency.
As our international operations grow, we will continue to reassess our approach to managing the risks relating to fluctuations in foreign currency.
Interest Rate Sensitivity
As of December 31, 2019, we had cash and cash equivalents, and marketable securities of $98.2 million. The primary objectives of our investment activities are to preserve principal, provide liquidity, and maximize income without significantly increasing risk. Some of the marketable securities we invest in are subject to interest risk. To minimize this risk, we maintain our portfolio of cash and cash equivalents, and marketable securities in a variety of securities, including money market accounts, commercial paper, corporate debt securities, and U.S. government securities. Due to the short duration and conservative nature of our investment portfolio, the effect of an immediate 10% change in interest rates at December 31, 2019 would not have been material to our operating results and the total value of the portfolio assuming consistent investment levels.
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS | |
Page | |
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Report of Independent Registered Public Accounting Firm
To the Stockholders and the Board of Directors of Forescout Technologies, Inc.
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Forescout Technologies, Inc. (the Company) as of December 31, 2019 and 2018, the related consolidated statements of operations, comprehensive loss, stockholders' (deficit) equity and cash flows for each of the three years in the period ended December 31, 2019, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 28, 2020 expressed an unqualified opinion thereon.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matters
The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of the critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.
Revenue Recognition | |
Description of the Matter | As described in Note 2 to the consolidated financial statements, the Company’s contracts with customers sometimes contain multiple performance obligations, which are accounted for separately if they are distinct. In such cases, the transaction price is then allocated to the distinct performance obligations on a relative standalone selling price basis and revenue is recognized when control of the distinct performance obligation is transferred. For example, license revenue is recognized at the time of hardware shipment or delivery of software license, and subscription and service revenues are recognized over time as the services are performed. Auditing the Company’s revenue recognition was challenging, specifically related to the identification and determination of the distinct performance obligations and the timing of revenue recognition. For example, certain arrangements required judgment to determine the distinct performance obligations and the appropriate timing of revenue recognition. |
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How We Addressed the Matter in Our Audit | We obtained an understanding, evaluated the design and tested the operating effectiveness of the Company’s process and controls to determine the distinct performance obligations and the timing of revenue recognition. Among the procedures we performed to test the determination of the distinct performance obligations and the timing of revenue recognition, we read executed contracts and purchase orders to understand the rights and obligations conveyed in the contractual arrangement, evaluated management’s assessment of the performance obligations and whether they were distinct, and tested the timing of revenue recognition for a sample of individual sales transactions. We evaluated the accuracy of the Company’s accounting conclusions, specifically related to the identification and determination of distinct performance obligations and the timing of revenue recognition. |
Uncertain Tax Positions | |
Description of the Matter | As described in Note 11 to the consolidated financial statements, the Company recorded an accrual of $20.8 million related to its uncertain tax position from an intra-group transfer of certain intellectual property rights (the “IP”). Auditing the tax accrual resulting from the intra-group transfer of IP was complex and highly judgmental due to the significant uncertainty in determining the tax basis fair value of the intellectual property transferred. The fair value estimate was sensitive to the significant judgments and estimates management made based on their interpretation and application of tax laws in the applicable jurisdiction. |
How We Addressed the Matter in Our Audit | We obtained an understanding, evaluated the design, and tested the operating effectiveness of controls over the Company’s process to measure tax accruals related to the determination of the uncertain tax position. To test the Company’s measurement of the uncertain tax accrual related to the intra-group transfer, we involved our tax professionals to assess the appropriateness of the range of estimates reached based on the interpretation and application of tax laws in the applicable jurisdiction. For example, we compared the Company’s accrual estimate based on the methodology utilized by management to alternative methodologies. We also verified our understanding of the relevant facts by reading the Company’s correspondence documenting the relevant third-party advice obtained by the Company. In addition, we used our knowledge of international and local income tax laws in the applicable jurisdictions to evaluate the appropriateness of the Company’s measurement of the uncertain tax position related to the intra-group transfer. |
/s/ Ernst & Young LLP
We have served as the Company’s auditor since 2013.
San Jose, California
February 28, 2020
74
Report of Independent Registered Public Accounting Firm
To the Stockholders and the Board of Directors of Forescout Technologies, Inc.
Opinion on Internal Control Over Financial Reporting
We have audited Forescout Technologies, Inc.’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Forescout Technologies, Inc. (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the 2019 consolidated financial statements of the Company and our report dated February 28, 2020 expressed an unqualified opinion thereon.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.
Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
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/s/ Ernst & Young LLP
San Jose, California
February 28, 2020
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FORESCOUT TECHNOLOGIES, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
December 31, | |||||||
2019 | 2018 | ||||||
Assets | |||||||
Current assets: | |||||||
Cash and cash equivalents | $ | $ | |||||
Marketable securities | |||||||
Accounts receivable | |||||||
Inventory | |||||||
Deferred commissions - current | |||||||
Prepaid expenses and other current assets | |||||||
Total current assets | |||||||
Deferred commissions - non-current | |||||||
Property and equipment, net | |||||||
Operating lease right-of-use assets | — | ||||||
Restricted cash - non current | |||||||
Intangible assets, net | |||||||
Goodwill | |||||||
Other assets | |||||||
Total assets | $ | $ | |||||
Liabilities and stockholders' equity | |||||||
Current liabilities: | |||||||
Accounts payable | $ | $ | |||||
Accrued compensation | |||||||
Accrued expenses | |||||||
Deferred revenue - current | |||||||
Notes payable - current | |||||||
Operating lease liabilities - current | — | ||||||
Total current liabilities | |||||||
Deferred revenue - non-current | |||||||
Notes payable - non-current | |||||||
Operating lease liabilities - non-current | — | ||||||
Other liabilities | |||||||
Total liabilities | |||||||
Commitments and contingencies (Note 8) | |||||||
Stockholders' equity: | |||||||
Preferred stock, $0.001 par value; 100,000 shares authorized; zero shares issued and outstanding at December 31, 2019 and 2018. | |||||||
Common stock, $0.001 par value; 1,000,000 shares authorized; 48,064 and 43,403 shares issued and outstanding at December 31, 2019 and 2018, respectively. | |||||||
Additional paid-in capital | |||||||
Accumulated other comprehensive loss | ( | ) | ( | ) | |||
Accumulated deficit | ( | ) | ( | ) | |||
Total stockholders’ equity | |||||||
Total liabilities and stockholders' equity | $ | $ | |||||
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FORESCOUT TECHNOLOGIES, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
See Notes to Consolidated Financial Statements
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FORESCOUT TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
Revenue: | |||||||||||
License | $ | $ | $ | ||||||||
Subscription | |||||||||||
Professional services | |||||||||||
Total revenue | |||||||||||
Cost of revenue: | |||||||||||
License | |||||||||||
Subscription | |||||||||||
Professional services | |||||||||||
Total cost of revenue | |||||||||||
Total gross profit | |||||||||||
Operating expenses: | |||||||||||
Research and development | |||||||||||
Sales and marketing | |||||||||||
General and administrative | |||||||||||
Total operating expenses | |||||||||||
Loss from operations | ( | ) | ( | ) | ( | ) | |||||
Interest expense | ( | ) | ( | ) | ( | ) | |||||
Other income, net | |||||||||||
Revaluation of warrant liabilities | ( | ) | |||||||||
Loss before income taxes | ( | ) | ( | ) | ( | ) | |||||
Income tax provision | |||||||||||
Net loss | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
Deemed dividend on the conversion of Series G redeemable convertible preferred stock | |||||||||||
Net loss attributable to common stockholders | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
Net loss per share attributable to common stockholders, basic and diluted | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
Weighted-average shares used to compute net loss per share attributable to common stockholders, basic and diluted | |||||||||||
See Notes to Consolidated Financial Statements
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FORESCOUT TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands)
Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
Net loss | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
Other comprehensive loss, net of tax: | |||||||||||
Change in unrealized gains (losses) on marketable securities | ( | ) | |||||||||
Foreign currency translation adjustments | ( | ) | ( | ) | |||||||
Comprehensive loss | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
See Notes to Consolidated Financial Statements
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FORESCOUT TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK
AND STOCKHOLDERS’ (DEFICIT) EQUITY
(In thousands, except per share amounts)
Redeemable Convertible Preferred Stock | Common Stock | Additional Paid-In Capital | Accumulated Other Comprehensive Loss | Accumulated Deficit | Total Stockholders' (Deficit) Equity | ||||||||||||||||||||||||
Shares | Amount | Shares | Amount | ||||||||||||||||||||||||||
Balance as of December 31, 2016 | ( | ) | ( | ) | |||||||||||||||||||||||||
Cumulative effect of accounting change | — | — | — | — | — | ||||||||||||||||||||||||
Unrealized loss on marketable securities | — | — | — | — | — | ( | ) | — | ( | ) | |||||||||||||||||||
Stock-based compensation | — | — | — | — | — | — | |||||||||||||||||||||||
Issuance of common stock in connection with employee equity incentive plans | — | — | — | — | |||||||||||||||||||||||||
Issuance of common stock in connection with public offering, net of underwriter discounts and commissions and offering costs | — | — | — | — | |||||||||||||||||||||||||
Conversion of redeemable convertible preferred stock to common stock in connection with the initial public offering | ( | ) | ( | ) | — | — | |||||||||||||||||||||||
Conversion of preferred stock warrants to common stock warrants in connection with initial public offering | — | — | — | — | — | — | |||||||||||||||||||||||
Vesting of early exercised stock options | — | — | — | — | — | ||||||||||||||||||||||||
Shares issued for common stock warrant exercise | — | — | — | — | — | — | — | ||||||||||||||||||||||
Shares issued for preferred stock warrant exercise | — | — | — | — | |||||||||||||||||||||||||
Deemed dividend on the conversion of Series G redeemable convertible preferred stock | — | — | — | ( | ) | ||||||||||||||||||||||||
Net loss | — | — | — | — | — | — | ( | ) | ( | ) | |||||||||||||||||||
Balance as of December 31, 2017 | ( | ) | ( | ) | |||||||||||||||||||||||||
Other comprehensive loss, net of tax | — | — | — | — | — | ( | ) | — | ( | ) | |||||||||||||||||||
Stock-based compensation | — | — | — | — | — | — | |||||||||||||||||||||||
Issuance of common stock in connection with employee equity incentive plans | — | — | — | — | |||||||||||||||||||||||||
Issuance of common stock in connection with public offering, net of underwriter discounts and commissions and offering costs | — | — | — | — | |||||||||||||||||||||||||
Vesting of early exercised stock options | — | — | — | — | — | ||||||||||||||||||||||||
Issuance of common stock upon exercise of common stock warrants | — | — | — | — | — | — | — | ||||||||||||||||||||||
Net loss | — | — | — | — | — | — | ( | ) | ( | ) | |||||||||||||||||||
Balance as of December 31, 2018 | ( | ) | ( | ) | |||||||||||||||||||||||||
Other comprehensive loss, net of tax | — | — | — | — | — | ( | ) | — | ( | ) | |||||||||||||||||||
Stock-based compensation | — | — | — | — | — | — | |||||||||||||||||||||||
Issuance of common stock in connection with employee equity incentive plans | — | — | — | — | |||||||||||||||||||||||||
Vesting of early exercised stock options | — | — | — | — | — | ||||||||||||||||||||||||
Issuance of common stock upon exercise of common stock warrants | — | — | — | — | — | — | — | — | |||||||||||||||||||||
Net loss | — | — | — | — | — | — | ( | ) | ( | ) | |||||||||||||||||||
Balance as of December 31, 2019 | $ | $ | $ | $ | ( | ) | $ | ( | ) | $ | |||||||||||||||||||
See Notes to Consolidated Financial Statements
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Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
Cash flows from operating activities | |||||||||||
Net loss | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
Adjustments to reconcile net loss to net cash (used in) provided by operating activities | |||||||||||
Stock-based compensation | |||||||||||
Depreciation and amortization | |||||||||||
Revaluation of warrant liabilities | |||||||||||
Other | ( | ) | |||||||||
Changes in operating assets and liabilities, net of business acquisition | |||||||||||
Accounts receivable | ( | ) | ( | ) | ( | ) | |||||
Inventory | ( | ) | |||||||||
Deferred commissions | ( | ) | ( | ) | ( | ) | |||||
Prepaid expenses and other current assets | ( | ) | ( | ) | ( | ) | |||||
Other assets | ( | ) | ( | ) | |||||||
Accounts payable | ( | ) | |||||||||
Accrued compensation | |||||||||||
Accrued expenses | ( | ) | |||||||||
Deferred revenue | |||||||||||
Other liabilities | ( | ) | |||||||||
Net cash (used in) provided by operating activities | ( | ) | ( | ) | |||||||
Cash flows from investing activities | |||||||||||
Purchases of property and equipment | ( | ) | ( | ) | ( | ) | |||||
Purchases of marketable securities | ( | ) | ( | ) | ( | ) | |||||
Proceeds from maturities of marketable securities | |||||||||||
Business acquisition, net of cash acquired | ( | ) | ( | ) | |||||||
Net cash provided by (used in) investing activities | ( | ) | ( | ) | |||||||
Cash flows from financing activities | |||||||||||
Repayments of notes payable | ( | ) | ( | ) | ( | ) | |||||
Payment of accrued success fees | ( | ) | |||||||||
Proceeds from sales of shares through employee equity incentive plans | |||||||||||
Payment related to shares withheld for taxes on vesting of restricted stock units | ( | ) | ( | ) | |||||||
Payments of deferred offering costs | ( | ) | ( | ) | |||||||
Proceeds from public offering, net of underwriting discounts and commissions | |||||||||||
Others | |||||||||||
Net cash provided by financing activities | |||||||||||
Effect of exchange rate changes on cash, cash equivalents, and restricted cash | ( | ) | ( | ) | |||||||
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Net change in cash, cash equivalents, and restricted cash for period | ( | ) | |||||||||
Cash, cash equivalents, and restricted cash at beginning of period | |||||||||||
Cash, cash equivalents, and restricted cash at end of period | $ | $ | $ | ||||||||
Supplemental disclosure of cash flow information: | |||||||||||
Cash paid for income taxes | $ | $ | $ | ||||||||
Cash paid for interest | $ | $ | $ | ||||||||
Noncash disclosure of investing and financing activities: | |||||||||||
Change in liability for early exercise of stock options, net of vested portion | $ | $ | $ | ||||||||
Conversion of preferred stock warrants to common stock warrants in connection with initial public offering | $ | $ | $ | ||||||||
Cashless exercise of preferred stock warrants | $ | $ | $ | ||||||||
Leased assets obtained in exchange for new operating lease liabilities | $ | $ | — | $ | — | ||||||
Reconciliation of cash, cash equivalents, and restricted cash within the consolidated balance sheets to the amounts shown in the statements of cash flows above: | |||||||||||
Cash and cash equivalents | $ | $ | $ | ||||||||
Restricted cash included in prepaid expenses and other current assets | $ | ||||||||||
Restricted cash - non-current | $ | ||||||||||
Total cash, cash equivalents, and restricted cash | $ | $ | $ | ||||||||
See Notes to Consolidated Financial Statements
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Note 1. Description of Business and Summary of Significant Accounting Policies
Company and Background
Forescout Technologies, Inc. (the “Company”) was incorporated in the State of Delaware and commenced operations in April 2000. The Company designs, develops, and markets device visibility, control, and orchestration software that helps organizations gain complete situational awareness of all devices in their interconnected environment and orchestrate actions to mitigate both their cyber and operational risk.
The Company offers its solution across two product groups: (i) products for visibility and control capabilities, and (ii) products for orchestration capabilities. The Company’s products for visibility and control capabilities consist of eyeSight, eyeSegment, eyeControl, and SilentDefense. eyeSight, eyeSegment, and eyeControl provide for visibility and control capabilities across the extended enterprise, from campus to data center to hybrid cloud to operational technology (“OT”) devices, while SilentDefense provides for visibility and control capabilities deeper within the OT portion of the network. The Company’s products for orchestration capabilities are comprised of its portfolio of eyeExtend family of products.
The Company offers its solution across two product types: (i) software products and (ii) hardware products. The Company’s software products include eyeSight, eyeSegment, eyeControl, eyeExtend, SilentDefense, and SilentDefense Command Center (“Software Products”). The Company’s hardware products include hardware that is sold separately for use with the Company’s Software Products and appliances that are embedded with the Company’s software (“Hardware Products”).
The Company sells its Software Products, Hardware Products, support and maintenance contracts, and professional services to end-customers through distributors and resellers, who are supported by the Company’s sales and marketing organization, and to a lesser extent directly to end-customers.
Initial Public Offering
On October 31, 2017, the Company closed its initial public offering (“IPO”), in which it issued and sold 6,072,000 shares of common stock inclusive of the underwriters’ option to purchase additional shares that was exercised in full. The price per share to the public was $22.00 . The Company received aggregate proceeds of $124.2 million from the IPO, net of underwriters’ discounts and commissions, and before deducting offering costs of approximately $4.5 million. Upon the closing of the IPO, all shares of the Company's outstanding redeemable convertible preferred stock automatically converted into 25,370,616 shares of common stock.
Follow-On Offering
The Company closed its follow-on offering (the “Offering”) in March 2018, in which it issued and sold 500,000 shares of its common stock. Further, an additional 4,572,650 shares of its common stock were sold by certain stockholders in the Offering, inclusive of the underwriters’ option to purchase additional shares from certain of the selling stockholders. The price to the public was $29.00 per share. The Company received aggregate proceeds of $16.4 million from the Offering, net of underwriters’ discounts and commissions of $0.7 million and inclusive of approximately $2.6 million received by the Company in connection with the exercise by certain selling stockholders of options to purchase an aggregate of 425,436 shares of common stock that were sold in the Offering. The Company incurred offering costs of approximately $1.2 million. The Company did not receive any proceeds from the sale of shares by the selling stockholders in the Offering.
Basis of Presentation
The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s consolidated financial statements include the results of Forescout Technologies, Inc. and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
Reclassifications
Certain amounts in prior periods have been reclassified to conform with current period presentation. In prior years, the Company presented revenue and cost of revenue on the consolidated statements of operations as (i) product and (ii) maintenance and professional services. Under the current presentation of revenue and cost of revenue included in the consolidated statements
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of operations, product has been retitled as license revenue, and maintenance and professional services is now presented as two separate line items on the consolidated statements of operations as (i) subscription and (ii) professional services. The related prior period financial data were adjusted to reflect the new presentation of the Company’s revenue and cost of revenue. There is no impact on total revenue and total cost of revenue.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make use of estimates and assumptions that affect the reported amounts in the consolidated financial statements and accompanying notes. These estimates form the basis of judgments made about carrying values of assets and liabilities, which are not readily apparent from other sources. The areas where management has made estimates requiring judgment include, but are not limited to, the best estimate of selling prices for products and related support, the period over which deferred sales commissions are amortized to expense, sales return reserve, accruals, stock-based compensation including the fair value of common stock, redeemable convertible preferred stock warrant liabilities, provision for income taxes, including related reserves, identified intangibles and goodwill, and purchase price allocation of an acquired business. Actual results could differ materially from those estimates.
Reverse Stock Split
On October 16, 2017, the Company amended its amended and restated certificate of incorporation to effect a two-to-one reverse stock split of its common stock and convertible preferred stock (the “Reverse Stock Split”). Upon the filing of the amended and restated certificate of incorporation in the state of Delaware, (i) each two shares of outstanding convertible preferred stock and each two shares of outstanding common stock were exchanged and combined into one share of convertible preferred stock and one share of common stock, respectively; (ii) the number of shares of common stock issuable under each outstanding option to purchase common stock and issuable upon vesting under each restricted stock unit was proportionately reduced on a two-to-one basis; (iii) the exercise price of each outstanding option to purchase common stock was proportionately increased on a two-to-one basis; (iv) the number of shares of convertible preferred stock issuable under outstanding warrants was proportionally reduced on a two-to-one basis and the exercise price of such warrants was proportionally increased on a two-to-one basis; and (v) corresponding adjustments in the per share conversion prices, dividend rates and liquidation preferences of the convertible preferred stock were made on a two-to-one basis. Accordingly, all share and per share information presented in the consolidated financial statements herein, and notes thereto, have been retroactively adjusted to reflect the Reverse Stock Split.
Segment Information
The chief operating decision maker (“CODM”) is the Chief Executive Officer who reviews financial information presented on a consolidated basis. The Company has one business activity and there are no segment managers who are held accountable by the CODM for operations, operating results and planning for levels or components below the consolidated level. The Company operates in one segment.
Concentrations
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash, cash equivalents, marketable securities, accounts receivable, and restricted cash. The Company maintains all of its cash and cash equivalents in interest-bearing bank accounts and money market accounts. Management believes that the financial institutions that hold the Company’s cash and cash equivalents are financially sound and exposed to minimal credit risk. Deposits held with banks generally exceed the amount of insurance provided on such deposits.
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The Company purchases its hardware appliances from one contract manufacturer that assembles all of its products.
Foreign Currency
Prior to July 1, 2019, the Company’s functional currency was the U.S. dollar for the majority of its foreign operations except for Forescout Technologies, B.V. whose functional currency was the Euro. Translation gains and losses from the application of the U.S. dollar as the reporting currency during the period that the Euro was the functional currency for Forescout Technologies, B.V. were included as a component of accumulated other comprehensive loss on the consolidated balance sheets.
The Company re-assessed its functional currency and determined that, as of July 1, 2019, its functional currency for Forescout Technologies, B.V. had changed from the Euro to the U.S. dollar following the transfer of all of the intellectual property from Forescout Technologies, B.V. to the Company effective July 1, 2019. The change in functional currency was accounted for prospectively from July 1, 2019 and financial statements prior to and including the period ended June 30, 2019 were not restated for the change in functional currency.
Transactions denominated in currencies other than the applicable functional currency are converted to the functional currency at the exchange rate on the transaction date. At period end, monetary assets and liabilities are remeasured using the current exchange rate at the balance sheet date. Non-monetary assets and liabilities and capital accounts are remeasured using historical exchange rates. Revenue and expenses have been remeasured using the average exchange rates in effect during each period. Resulting foreign currency remeasurement gains and losses are recorded in other income (expense), net on the consolidated statements of operations.
Where a non-U.S. currency is the functional currency, translation from that functional currency to the U.S. dollar is performed for balance sheet accounts using exchange rates in effect at the balance sheet date and for revenue and expense accounts using an average exchange rate for the period. Resulting translation adjustments are reported as a component of accumulated other comprehensive loss on the consolidated balance sheets.
Cash and Cash Equivalents
The Company considers all highly liquid investments held at financial institutions with original maturities of three months or less at date of purchase to be cash equivalents. Cash and cash equivalents are stated at cost, which approximates fair value.
Marketable Securities
The Company’s marketable securities consist primarily of commercial paper, corporate debt securities, and U.S. government agency securities. The Company’s marketable securities are classified as available-for-sale and are reported at fair value. The Company determines any realized gains or losses on the sale of available-for-sale securities on a specific identification method, and such gains and losses are recorded as a component of other income, net on the consolidated statements of operations. Unrealized gains and losses of the available-for-sale securities are excluded from earnings and reported as a component of accumulated other comprehensive loss.
The Company has classified and accounted for its marketable securities as available-for-sale. After consideration of the Company’s risk versus reward objectives, as well as the Company’s liquidity requirements, the Company may sell these securities prior to their stated maturities. As the Company views these securities as available to support current operations, the Company classifies highly liquid securities with maturities beyond 12 months as current assets under the caption marketable securities in the consolidated balance sheets.
Restricted Cash
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As of December 31, 2019 and 2018, the Company had restricted cash of $1.0 million and $0.9 million recorded as prepaid expenses and other current assets, respectively, and $1.6 million and $1.3 million recorded as non-current restricted cash, respectively. Restricted cash primarily consists of letters of credit issued as security deposits required for facility leases.
Accounts Receivable
Inventory
Property and Equipment
Property and equipment is stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally three to five years . Demonstration units are not resold after use and are depreciated over the estimated useful life of three years or less. Leasehold improvements are depreciated over the shorter of the estimated useful lives of the improvements or the remaining lease term.
Business Combinations
The Company accounts for acquisitions using the acquisition method of accounting for business combinations. When the Company acquires a business, the purchase price is allocated to the net tangible and identifiable intangible assets acquired based on their estimated fair values. Any residual purchase price is recorded as goodwill. The allocation of the purchase price requires management to make significant estimates in determining the fair values of assets acquired and liabilities assumed, especially with respect to intangible assets. These estimates can include, but are not limited to, the cash flows that an asset is expected to generate in the future, the appropriate weighted-average cost of capital, and the cost savings expected to be derived from acquiring an asset. These estimates are inherently uncertain and unpredictable. During the measurement period, which may be up to one year from the acquisition date, adjustments to the fair value of these tangible and intangible assets acquired and liabilities assumed may be recorded, with the corresponding offset to goodwill. Upon the conclusion of the measurement period or final determination of the fair value of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to the consolidated statements of operations.
Goodwill and Other Long-Lived Assets
The excess of the purchase price over the estimated fair value of net assets of businesses acquired in a business combination is recognized as goodwill. Goodwill is tested for impairment annually on October 1st or more frequently if certain indicators are present.
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Deferred Offering Costs
Product Warranty
The Company provides a standard 90 day warranty on its hardware and software products. The Company also offers its customers post-contract support (“PCS”), which includes a warranty of between one to five-years on hardware. The Company will also provide its customers software releases or updates during the PCS term. The Company accrues for estimated standard warranty costs for those customers that do not purchase PCS at the time of product shipment. These potential warranty claims are accrued as a component of product cost of revenue based on historical experience and other data, which is reviewed periodically for adequacy. Warranty costs associated with PCS are expensed as incurred. To date, the Company has not incurred nor accrued any significant costs associated with product warranty.
Leases
Refer to Note 6 for a detailed discussion of accounting policies related to leases, including right-of-use (“ROU”) assets, lease liabilities, and lease expense.
Contract Manufacturer Liabilities
Manufacturing, repair, and supply chain management operations are outsourced to a third-party contract manufacturer. These costs are a significant portion of product cost of revenue. Although the Company is contractually obligated to purchase manufactured products, the Company generally does not own the manufactured products as product title transfers from the contract manufacturer to the Company and immediately to the customer upon shipment. The contract manufacturer assembles the Company’s products using design specifications, quality assurance programs, and standards that the Company establishes. Components are procured and assembled based on the Company’s demand forecasts. These forecasts represent management’s best estimates of future demand for the products based upon historical trends and analysis from sales and operations functions as adjusted for overall market conditions. The Company accrues for costs for contractual manufacturing commitments in excess of its forecasted demand, including costs incurred for excess components or for the carrying costs incurred by the contract manufacturer. To date, the Company has not accrued any significant contract manufacturer liabilities.
Redeemable Convertible Preferred and Common Stock Warrant Liabilities
Upon completion of the Company's IPO in October 2017, there were no freestanding warrants to purchase shares of convertible preferred stock. As such, no preferred stock warrant liability remained outstanding after the IPO. Before the Company's IPO, freestanding warrants related to shares that are redeemable or contingently redeemable were classified as a liability in the Company’s consolidated balance sheet. The convertible preferred stock warrants were subject to re-measurement at each balance sheet date, and any change in fair value was recognized in the consolidated statements of operations. The Company adjusted the redeemable convertible preferred stock warrant liability to the estimated fair value of the warrants until either the exercise or the completion of the Company’s IPO, at which time the redeemable convertible preferred stock issuable upon exercise of the warrants became warrants to purchase common stock and the related liability was reclassified to additional paid-in capital in stockholders' equity.
Severance Pay Deposits and Accrued Severance Pay Liability
The Company records a severance pay asset and liability on its consolidated balance sheets related to its employees located in Israel. Under Israeli law and labor agreements, the Company is required to make severance and pension payments to retired or dismissed employees and to employees leaving employment in certain other circumstances.
Liabilities for severance pay are calculated pursuant to Israeli severance pay law using the most recent monthly salary for the employees, multiplied by the number of years of employment, and are included in accrued expenses and other liabilities in the Company’s consolidated balance sheets for the current and non-current portions, respectively. The Company’s liability at each respective balance sheet date for its Israeli employees is fully accrued in the accompanying consolidated financial statements.
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The severance liability is funded through monthly deposits to the employee’s pension and management insurance carriers. The fair value of this deposit is recorded in prepaid expenses and other current assets, and other assets in the Company’s consolidated balance sheets for the current and non-current portions, respectively.
Revenue Recognition
Refer to Note 2 for a detailed discussion of accounting policies related to revenue recognition, including deferred revenue and commissions.
Software Development Costs
Software development costs are not capitalized as the software development process is essentially completed concurrent with the establishment of technological feasibility. As such, all software development costs are expensed as incurred and included in research and development expense in the accompanying consolidated statements of operations.
Advertising Costs
Stock-Based Compensation
Stock-based compensation for employees is measured based on the grant date fair value of the award and is expensed over the requisite service period, which is generally the vesting period. The fair value of option awards is determined on the date of grant using the Black-Scholes option pricing model. In applying the Black-Scholes option pricing model, the Company’s determination of the fair value of the option award on the grant date prior to its IPO is affected by the Company’s estimated fair value of the underlying common stock, as well as assumptions relating to subjective variables. Subsequent to its IPO, the Company uses the market closing price for its common stock as reported on the NASDAQ Global Select Market. These variables include the expected term of the award, the expected volatility of the common stock price, the risk-free interest rate, and the expected dividend yield of common stock.
Prior to the IPO, the fair value of restricted stock units (“RSUs”) was determined on the date of grant using the Company’s estimated fair value of the underlying common stock. Subsequent to its IPO, the Company uses the market closing price for its common stock as reported on the NASDAQ Global Select Market.
Beginning January 1, 2017 with the adoption of Accounting Standards Update (“ASU”) No. 2016-09, the Company elected to recognize forfeitures as they occur, and no longer estimates a forfeiture rate when calculating the stock-based compensation for equity awards.
Income Taxes
Deferred income taxes are recognized using the asset and liability method, whereby deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to differences between the Company’s (1) financial statement carrying amounts and their respective tax bases and (2) operating loss and tax credit carryforwards. Valuation allowances are provided when the expected realization of tax assets does not meet a more-likely-than-not criterion. Due to the Company’s lack of earnings history, the U.S. net deferred tax assets have been fully offset by a valuation allowance.
The Company recognizes tax benefits from uncertain tax positions if it is more likely than not that the tax position will be sustained upon examination by a taxing authority based on the technical merits of the position. The tax benefits recognized from such positions are measured based on the largest benefit that has a greater than 50% likelihood to be realized upon settlement.
The Company recognizes accrued interest and penalties related to unrecognized tax benefits in income tax expense in the accompanying consolidated statements of operations, when and if incurred.
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Recently Adopted Accounting Pronouncements
In February 2016, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2016-02 (Topic 842), Leases (“ASU 2016-02”), followed by ASU No. 2018-10 (Topic 842), Codification Improvements to Topic 842, Leases (“ASU 2018-10”), and ASU No. 2018-11 (Topic 842), Targeted Improvements (“ASU 2018-11”) in July 2018 (collectively, “Topic 842”). The Company adopted Topic 842 effective January 1, 2019 using the transition method. See Note 6 for the details of any impact on the adoption.
Recently Issued and Not Yet Adopted Accounting Pronouncements
In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. ASU 2016-13 replaces the existing incurred loss impairment model with an expected loss model which requires the use of forward-looking information to calculate credit loss estimates. It also eliminates the concept of other-than-temporary impairment and requires credit losses related to available-for-sale debt securities to be recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. These changes will result in earlier recognition of credit losses. The Company will adopt ASU 2016-13 effective January 1, 2020 with the cumulative effect of adoption recorded as an adjustment to retained earnings. The effect on its consolidated financial statements and related disclosures is not expected to be material.
In December 2019, the FASB issued ASU No. 2019-12, Simplifying the Accounting for Income Taxes that eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. It also clarifies and simplifies other aspects of the accounting for income taxes. The standard is effective for annual and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption is permitted. The Company is currently evaluating the timing and impact of the adoption of this standard on its consolidated financial statements.
Note 2. Revenue, Deferred Revenue and Deferred Commissions
Revenue Recognition
The Company derives its revenue from sale of Software Products, Hardware Products, term contracts, and professional services. All revenue recognized in the consolidated statements of operations is considered to be revenue from contracts with customers. The Company offers its solution across two product groups: (i) products for visibility and control capabilities, and (ii) products for orchestration capabilities and across two product types: (i) software products, and (ii) hardware products.
The Company determines revenue recognition through the following steps, which are described in more detail below:
• | Identification of the contract, or contracts, with a customer—A contract with a customer exists when (i) the Company enters into an enforceable contract with a customer that defines each party’s rights regarding the goods or services to be transferred and identifies the payment terms related to these goods or services, (ii) the contract has commercial substance, and (iii) the Company determines that collection of substantially all consideration for goods or services that are transferred is probable based on the customer’s intent and ability to pay the promised consideration. The Company applies judgment in determining the customer’s ability and intention to pay, which is based on a variety of factors, including the customer’s historical payment experience or, in the case of a new customer, published credit and financial information pertaining to the customer. The Company’s payment terms typically range between |
• | Identification of the performance obligation(s) in the contract—Performance obligations promised in a contract are identified based on the goods or services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the goods or services either on their own or together with other resources that are readily available from third parties or from the Company, and are distinct in the context of the contract, whereby the transfer of the goods or services is separately identifiable from other promises in the contract. To the extent a contract includes multiple promised goods or services, the Company applies judgment to determine whether promised goods or services are capable of being distinct, and are distinct in the context of the contract. If these criteria are not met, the promised goods or services are accounted for as a combined performance obligation. |
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• | Determination of the transaction price—The transaction price is determined based on the consideration that the Company will be entitled to in exchange for transferring goods or services to the customer. In determining the transaction price, the Company considers uncertainties such as historical rates of product returns and/or concessions. |
• | Allocation of the transaction price to the performance obligation(s) in the contract—If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price (“SSP”) basis. The Company determines standalone selling price based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, the Company estimates the standalone selling price taking into account available information such as market conditions and internally approved pricing guidelines related to the performance obligations. |
• | Recognition of revenue when, or as, a performance obligation is satisfied—The Company satisfies performance obligations either over time or at a point in time as discussed in further detail below. Revenue is recognized at the time the related performance obligation is satisfied by transferring a promised good or service to a customer. Revenue is recorded net of sales taxes. |
The following describes the nature of the Company’s primary types of revenue and the revenue recognition policies as they pertain to the types of transactions the Company enters into with its customers.
License Revenue
License revenue consists of sales of Software Products and Hardware Products. Software Products are sold with either a perpetual license or a term license. License revenue includes the value allocated to license within Software Products subscription contracts. License revenue is recognized at the time of transfer of control, which is generally upon delivery of access to software downloads or shipment, provided that all other revenue recognition criteria have been met.
Subscription Revenue
Subscription revenue is derived from support and maintenance contracts, the value allocated to support and maintenance within Software Products subscription contracts, and software as a service (“SaaS”) offering contracts. Customers do not have the right to take possession of the cloud-based software. Subscription contracts have terms that are generally either one or three years, but can be up to five years. Subscription revenue is recognized ratably over the term of the contract and any unearned subscription revenue is included in deferred revenue.
Professional Services Revenue
Professional services revenue is derived primarily from customer fees for optional installation of the Company’s products or training. Generally, the Company recognizes revenue for professional services as the services are rendered.
Contract Costs
The Company capitalizes contract origination costs that are incremental and recoverable costs of obtaining a contract with a customer. The Company expects that sales commissions and associated payroll taxes and third-party referral fees related to customer contracts are both incremental and recoverable. The contract origination costs are capitalized and amortized to sales and marketing expense when the related performance obligations are met. Incremental contract origination costs relating to products are expensed as the related products are delivered. Incremental contract origination costs relating to term contracts are capitalized and amortized over either the contractual performance period or on a straight-line basis over the average customer life of five years , depending on whether the costs relate to a specific term contract or the customer relationship. The Company determines its average customer life by taking into consideration its customer contracts, technology, and other factors. Capitalized costs are periodically reviewed for impairment.
Capitalized contract costs were $36.0 million and $35.9 million as of December 31, 2019 and December 31, 2018, respectively. For the years ended December 31, 2019, 2018, and 2017, amortization expense for the contract costs was $14.4 million, $14.9 million, and $11.4 million, respectively. There were no impairment losses in relation to the costs capitalized for the years ended December 31, 2019, 2018, and 2017.
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Revenue from Contracts with Customers
Contract Assets and Contract Liabilities
A contract asset is a right to consideration in exchange for products or services that the Company has transferred to a customer when that right is conditional and is not just subject to the passage of time. The Company has no material contract assets. A receivable will be recorded on the consolidated balance sheets when the Company has unconditional rights to consideration. A contract liability is an obligation to transfer products or services for which the Company has received consideration, or for which an amount of consideration is due from the customer. Contract liabilities include customer deposits under non-cancelable contracts and current and non-current deferred revenue balances. The Company’s contract balances are reported in a net contract asset or liability position on a contract-by-contract basis at the end of each reporting period.
Significant changes in contract liabilities during the periods presented are as follows (in thousands):
Contract Liabilities | |||
Balance as of December 31, 2017 | |||
Additions | |||
Assumed in a business combination | |||
Gross revenue recognized | ( | ) | |
Balance as of December 31, 2018 | |||
Additions | |||
Gross revenue recognized | ( | ) | |
Balance as of December 31, 2019 | $ | ||
During the years ended December 31, 2019 and 2018, the Company recognized revenue of $101.9 million and $80.0 million that was included in the contract liabilities balance as of December 31, 2018 and 2017, respectively.
Contract modifications entered into during the year ended December 31, 2019 and 2018 did not have a significant impact on the Company’s contract assets or contract liabilities.
Performance Obligations
The majority of the contracted but not invoiced performance obligations are subject to cancellation terms. Revenue allocated to remaining performance obligations represent contracted revenue that has not yet been recognized (“contracted not recognized”), which includes deferred revenue, certain customer deposits, and non-cancelable amounts that will be invoiced and recognized as revenue in future periods and excludes performance obligations that are subject to cancellation terms. Contracted not recognized revenue was $188.9 million as of December 31, 2019, of which the Company expects to recognize approximately 60 % of the revenue over the next 12 months and the remainder thereafter.
Practical Expedients
The Company does not disclose the value of consideration associated with unsatisfied or partially unsatisfied performance obligations for contracts for which the Company recognizes revenue at the amount to which it will have the right to invoice for services performed.
The Company also reflects the aggregate effect of all modifications to a contract that occurred before the earliest period presented in the current period’s financial statements instead of retrospectively restating contracts for all previous contract modifications.
Disaggregation of Revenue
The following table depicts the disaggregation of revenue according to revenue type and is consistent with how the Company evaluates its financial performance (in thousands):
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Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
Revenue: | |||||||||||
License | |||||||||||
Software products | |||||||||||
Perpetual license | $ | $ | $ | ||||||||
Term license | |||||||||||
Hardware products | |||||||||||
Subscription | |||||||||||
SaaS | |||||||||||
Support and maintenance | |||||||||||
Professional services | |||||||||||
Total revenue | $ | $ | $ | ||||||||
Note 3. Fair Value Measurements
Financial assets and liabilities are recorded at fair value on the consolidated balance sheets and are categorized based upon the level of judgment associated with inputs used to measure their fair value.
Fair value reflects the price that would be received on the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining fair value measurements, the Company considers the principal or most advantageous market and also market-based risk.
The accounting guidance for fair value measurements requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The accounting guidance also establishes a fair value hierarchy based on the independence of the source and objective evidence of the inputs used. There are three fair value hierarchies based upon the level of inputs that are significant to fair value measurement:
• | Level 1—Observable inputs that reflect quoted prices in active markets for identical assets or liabilities. |
• | Level 2—Observable inputs that reflect quoted prices for identical assets and liabilities in markets that are not active, quoted prices for similar assets or liabilities in active markets, inputs other than quoted prices that are observable for the assets or liabilities, or inputs that are derived principally from or corroborated by observable market data by correlation or other means. |
• | Level 3—Inputs that are generally unobservable and are supported by little or no market activity, and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability. |
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There have been no transfers between fair value measurement levels during the periods presented. The following table presents the fair value of the Company’s financial assets and liabilities according to the fair value hierarchy (in thousands):
December 31, 2019 | December 31, 2018 | ||||||||||||||||||||||
Level 1 | Level 2 | Level 3 | Level 1 | Level 2 | Level 3 | ||||||||||||||||||
Financial Assets | |||||||||||||||||||||||
Cash and cash equivalents: | |||||||||||||||||||||||
Cash | $ | $ | $ | $ | $ | $ | |||||||||||||||||
Money market accounts | |||||||||||||||||||||||
Total cash and cash equivalents | |||||||||||||||||||||||
Marketable securities: | |||||||||||||||||||||||
Commercial paper | |||||||||||||||||||||||
Corporate debt securities | |||||||||||||||||||||||
U.S. government securities | |||||||||||||||||||||||
Total marketable securities | |||||||||||||||||||||||
Restricted cash (current and non-current) | |||||||||||||||||||||||
Total financial assets | $ | $ | $ | $ | $ | $ | |||||||||||||||||
Note 4. Marketable Securities
The following table summarizes the unrealized gains and losses, and fair value of the Company’s marketable securities as of December 31, 2019 and 2018 (in thousands):
December 31, 2019 | December 31, 2018 | ||||||||||||||||||||||||||||||
Amortized Cost | Unrealized Gains | Unrealized Losses | Fair Value | Amortized Cost | Unrealized Gains | Unrealized Losses | Fair Value | ||||||||||||||||||||||||
Marketable securities: | |||||||||||||||||||||||||||||||
Available-for-sale: | |||||||||||||||||||||||||||||||
Commercial paper | $ | $ | $ | $ | $ | $ | $ | $ | |||||||||||||||||||||||
Corporate debt securities | ( | ) | |||||||||||||||||||||||||||||
U.S. government securities | ( | ) | |||||||||||||||||||||||||||||
Total marketable securities | $ | $ | $ | $ | $ | $ | $ | ( | ) | $ | |||||||||||||||||||||
The following table summarizes the amortized cost and fair value of the Company’s available-for-sale securities as of December 31, 2019 and 2018, by the contractual maturity date (in thousands):
2019 | 2018 | ||||||||||||||
Amortized Cost | Fair Value | Amortized Cost | Fair Value | ||||||||||||
Due within one year | $ | $ | $ | $ | |||||||||||
Total | $ | $ | $ | $ | |||||||||||
The Company had no marketable securities in unrealized loss position and no other-than-temporary impairments for marketable securities as of December 31, 2019. The Company had 13 marketable securities in unrealized loss positions as of December 31, 2018. For individual marketable securities that were in an unrealized loss position as of December 31, 2018, the fair value and gross unrealized loss for these securities aggregated by investment category and length of time in an unrealized loss position are presented in the following tables (in thousands):
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December 31, 2018 | |||||||||||||||||||||||
Less Than 12 Months | Greater Than 12 Months | Total | |||||||||||||||||||||
Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | ||||||||||||||||||
Corporate debt securities | $ | $ | ( | ) | $ | $ | ( | ) | $ | $ | ( | ) | |||||||||||
U.S. government securities | ( | ) | ( | ) | |||||||||||||||||||
Total | $ | $ | ( | ) | $ | $ | ( | ) | $ | $ | ( | ) | |||||||||||
Unrealized losses related to these marketable securities are due to interest rate fluctuations as opposed to credit quality. In addition, the Company does not intend to sell and it is not likely that the Company would be required to sell these marketable securities before recovery of their amortized cost basis, which may be at maturity. As a result, there are no other-than-temporary impairments for these marketable securities at December 31, 2018.
Note 5. Property and Equipment, Net
Property and equipment, net consisted of the following (in thousands):
December 31, | |||||||
2019 | 2018 | ||||||
Leasehold improvements | $ | $ | |||||
Computer, equipment and software | |||||||
Furniture and fixtures | |||||||
Demonstration units | |||||||
Total property and equipment | |||||||
Less: accumulated depreciation | ( | ) | ( | ) | |||
Total property and equipment, net | $ | $ | |||||
Depreciation expense related to property and equipment for the years ended December 31, 2019, 2018, and 2017 was approximately $8.6 million, $7.5 million and $6.1 million, respectively.
Note 6. Leases
Effective January 1, 2019, the Company adopted Topic 842 using the transition method to apply the new lease standard at the adoption date and recognized a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. The adoption had a material impact on the total assets and total liabilities reported on the Company’s consolidated balance sheets resulting in an increase in long-term assets and total liabilities of approximately $20.3 million as of January 1, 2019.
The Company has operating leases for corporate offices, vehicles, and office equipment. The leases have remaining lease terms of up to seven years , some of which may include options to extend the leases for up to five years .
Leases with an initial term of 12 months or less are not recorded on the balance sheet. The Company recognizes lease expense for these leases on a straight-line basis over the lease term. The Company elected to combine the lease components (e.g., fixed payments including rent, real estate taxes, and insurance costs) and the non-lease components (e.g., common-area maintenance costs) for all classes of underlying assets, and to not reassess prior conclusions related to contracts containing leases, lease classification, and initial direct costs.
The Company determines if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use assets, current operating lease liabilities, and non-current operating lease liabilities on the Company’s consolidated balance sheets. Operating lease ROU assets and operating lease liabilities are recognized based on the present value of the lease payments over the lease term at commencement date. As most of the Company’s leases do not provide an implicit rate, the Company uses an incremental borrowing rate based on the information available at commencement date in determining the present value of
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future payments. For leases that commenced prior to January 1, 2019, the Company uses the incremental borrowing rate as of January 1, 2019 to determine the present value of future payments on those leases. The operating lease ROU asset also includes any lease payments made and excludes lease incentives and initial direct costs incurred. The lease terms may include options to extend the lease when it is reasonably certain that the Company will exercise that option. Lease expense is recognized on a straight-line basis over the lease term.
During the year ended December 31, 2019, the Company recognized operating lease cost of $9.4 million, which included short-term leases and variable lease costs that were immaterial.
Maturities of lease liabilities as of December 31, 2019 were as follows (in thousands):
Years Ending December 31, | Operating Leases | |||
2020 | $ | |||
2021 | ||||
2022 | ||||
2023 | ||||
2024 | ||||
Thereafter | ||||
Total lease payments | $ | |||
Less: Imputed interest | ||||
Present value of lease liabilities | $ | |||
Lease Term and Discount Rate | December 31, 2019 | ||
Operating leases | |||
Weighted-average remaining lease term | |||
Weighted-average discount rate | % | ||
Other information (in thousands) | December 31, 2019 | |||
Cash paid for amounts included in the measurement of lease liabilities | ||||
Operating cash flows from operating leases | $ | |||
Leased assets obtained in exchange for new operating lease liabilities | $ | |||
Supplemental Information for Comparative Periods
As of December 31, 2018, prior to the adoption of Topic 842, future minimum lease payments by fiscal year under non-cancelable leases are as follows (in thousands):
Years Ending December 31, | Operating Leases | |||
2019 | $ | |||
2020 | ||||
2021 | ||||
2022 | ||||
2023 | ||||
2024 and thereafter | ||||
Total | $ | |||
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Note 7. Acquisitions, Goodwill, and Intangible Assets
Bullguard Israel Ltd.
On October 2, 2019, the Company entered into a definitive Asset Purchase Agreement to acquire certain assets from Bullguard Israel Ltd., an IoT security company, for a total purchase price of $10.3 million in cash (the “Bullguard Acquisition”). The Bullguard Acquisition has been accounted for as a business combination and is intended to support and accelerate the Company’s development of cloud-delivered products as part of its end-to-end device visibility and control platform. The purchase price was allocated as follows (in thousands):
Amount | |||
Intangible assets - Developed technology | $ | ||
Goodwill | |||
Total purchase price allocation | $ | ||
The weighted average useful life of the developed technology acquired was four years . The goodwill recognized in connection with the acquisition is primarily attributable to anticipated synergies from future growth and is not expected to be deductible for tax purposes. Acquisition transaction costs recognized in general and administrative expense in the Company’s consolidated statements of operations during the year ended December 31, 2019 were immaterial.
SecurityMatters B.V.
On November 7, 2018, the Company acquired 100 % of the equity interests of SecurityMatters B.V. (“SecurityMatters” or “Forescout Technologies, B.V.”), a privately-held entity that develops cybersecurity solutions for the operational technology market, through a share purchase agreement (the “Purchase Agreement”) in exchange for cash consideration (the “Acquisition”). This Acquisition has been accounted for as a business combination and is intended to enhance the Company’s market-leading solutions with deeper visibility into the operational technology network stack.
The total consideration transferred as part of the closing of the Acquisition for all of the vested and outstanding equity interests of SecurityMatters consisted of cash payments (adjusted for customary closing adjustments) of $109.3 million (the “Purchase Consideration”). There were no other components of Purchase Consideration other than cash payments.
Also, as part of the Purchase Agreement, the Company agreed to pay cash on the closing date of the Acquisition of $6.2 million to be held by a third-party escrow agent and to be released to a continuing employee of SecurityMatters (the “Holdback Amounts”). At closing, such Holdback Amounts were recorded as prepaid expenses and other current assets for the current portion and other assets for the non-current portion, and released or will be released at future dates following the one and two-year anniversaries of the Acquisition in exchange for future employee services to the Company (assuming the employee provides the required service). In addition, as part of the Purchase Agreement, the Company agreed to pay cash on future dates of $1.2 million to continuing employees of SecurityMatters in exchange for such employees’ equity awards that were unvested as of the closing of the Acquisition. Such cash payments were paid on future dates that are consistent with the original SecurityMatters equity awards’ vesting terms (assuming the employees provide employee services to the Company through such future dates). Such amounts were not included as Purchase Consideration, but instead will be recognized as post-combination compensation expense over the period the employees provide the required services.
Also in connection with the Acquisition, the Company issued RSUs with a grant date fair value of $5.9 million to continuing employees of SecurityMatters in exchange for future employee services to the Company, which vest annually over four years from the grant date. Such amounts are recorded as post-combination compensation expense over the period the employees provide the requisite service.
Additionally, the Company recognized $2.7 million of acquisition transaction costs as general and administrative expense in the Company’s consolidated statements of operations during the year ended December 31, 2018.
The Purchase Consideration of $109.3 million was allocated as follows (in thousands):
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Amount | |||
Net tangible assets acquired | $ | ||
Intangible assets | |||
Deferred tax liabilities, net | ( | ) | |
Goodwill | |||
Total purchase price allocation | $ | ||
The following table sets forth the components of identifiable intangible assets acquired and their estimated useful lives as of the date of acquisition (in thousands, except useful life):
Intangible Assets | |||||
Cost | Weighted Average Useful Life (in years) | ||||
Developed technology | $ | ||||
Customer relationships | |||||
Total intangible assets acquired | $ | ||||
Goodwill represents the excess of the preliminary estimated Purchase Consideration over the preliminary estimates of the fair value of the net tangible and intangible assets acquired and has been allocated to the Company’s one operating segment. Goodwill is primarily attributable to expected post-acquisition synergies from integrating SecurityMatters’ technology into the Company’s security solutions and product offerings and cross-selling opportunities. None of the goodwill recorded is deductible for income tax purposes.
The results of operations of SecurityMatters have been included in the Company’s consolidated statements of operations from the acquisition date. Pro forma results of operations for the transaction have not been presented as they were not material to the consolidated statements of operations.
Effective July 1, 2019, all of the intellectual property from Forescout Technologies, B.V. was transferred to the Company.
Goodwill and Acquired Intangible Assets
There was no goodwill related to acquisitions as of December 31, 2017 and in prior periods. The changes in the carrying amount of goodwill are as follows (in thousands):
Amount | |||
Balance as of December 31, 2017 | $ | ||
Goodwill acquired | |||
Foreign currency translation adjustments | ( | ) | |
Balance as of December 31, 2018 | |||
Goodwill acquired | |||
Goodwill adjustments | ( | ) | |
Foreign currency translation adjustments | ( | ) | |
Balance as of December 31, 2019 | $ | ||
Intangible assets subject to amortization realized from acquisitions are as follows (in thousands):
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December 31, 2019 | December 31, 2018 | ||||||||||||||||||||||||||||||
Cost | Accumulated Amortization | Foreign Currency Translation Adjustments | Net | Cost | Accumulated Amortization | Foreign Currency Translation Adjustments | Net | ||||||||||||||||||||||||
Developed technology | $ | $ | ( | ) | $ | ( | ) | $ | $ | $ | ( | ) | $ | ( | ) | $ | |||||||||||||||
Customer relationships | ( | ) | ( | ) | ( | ) | ( | ) | |||||||||||||||||||||||
$ | $ | ( | ) | $ | ( | ) | $ | $ | $ | ( | ) | $ | ( | ) | $ | ||||||||||||||||
Amortization expense of intangible assets for the years ended December 31, 2019 and 2018 was $3.3 million and $0.5 million, respectively, which was recognized in the consolidated statements of operations, within product cost of revenue, research and development expenses, and sales and marketing expenses. There was no amortization expense of intangible assets during the year ended December 31, 2017.
The expected future annual amortization expense of intangible assets as of December 31, 2019 is presented below (in thousands):
Year Ending December 31, | Amount | ||
2020 | $ | ||
2021 | |||
2022 | |||
2023 | |||
2024 and thereafter | |||
Total | $ | ||
Note 8. Commitments and Contingencies
Contract Manufacturer Commitments
As of December 31, 2019, the Company had contract manufacturer commitments of $7.0 million to purchase components and products from the Company’s third-party contract manufacturer. The contract manufacturer commitments result from the Company’s contractual obligation to order or build inventory in advance of anticipated sales.
Purchase Obligations
As of December 31, 2019, the Company had purchase obligations of $4.6 million primarily related to non-cancelable license obligations for software licenses.
Litigation
The Company is a party to various legal proceedings and claims which arise in the ordinary course of business. The Company records a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. If the Company determines that a loss is possible and a range of the loss can be reasonably estimated, the range of the possible loss is disclosed.
On January 2, 2020, a complaint was filed in the United States District Court, Northern District of California, by Christopher L. Sayce, individually, and on behalf of all others similarly situated, against the Company and two of its executive officers, for violations of the federal securities laws following the Company’s pre-earnings release announcement on October 10, 2019. The complaint, which purports to be brought on behalf of a class of purchasers of the Company’s securities during the period from February 7, 2019 through October 9, 2019, seeks to recover damages for such violations and to pursue remedies under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The claim does not state a value for potential damages. Based on the Company’s preliminary review, the Company believes the claim to be without merit and plans to vigorously defend itself to the maximum extent allowed by the law.
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Indemnification
The Company enters into indemnification provisions in its standard sales contracts with its customers in which it agrees to defend its channel partners and end-customers against third-party claims asserting infringement of certain intellectual property rights, which may include patents, copyrights, trademarks, or trade secrets, and the responsibility to pay judgments entered on such claims. In addition, we indemnify our officers, directors and certain key employees while they are serving in good faith in their respective capacities. To date, there have been no claims under any indemnification provisions.
Note 9. Debt Agreements
On December 22, 2016, the Company amended its amended and restated loan and security agreement, which was originally entered into in May 2009 (the “Amended and Restated 2009 Loan and Security Agreement”) to increase the maximum amount of credit available for borrowing under the revolving line of credit to 80 % of qualified accounts receivable up to $40.0 million. Additionally, the Company borrowed $30.0 million under the Amended and Restated 2009 Loan and Security Agreement, which carries a maturity date of December 2020. The combined outstanding balances of the revolving line of credit and the term loan cannot exceed $40.0 million. The agreement is subject to the Company maintaining an adjusted quick ratio of 1.25 . The agreement requires equal monthly installments of principal of $625,000 and monthly interest payments at a fixed interest rate per annum of 3.25 %. Concurrent with the final monthly installment payment on the maturity date in December 2020, the Company is required to pay an additional payment of $825,000 .
On April 4, 2019, the Company signed a Second Amended and Restated Loan and Security Agreement to extend the maturity period of the revolving line of credit by two years to March 31, 2021 and amend the borrowing base and interest of the revolving line of credit.
The amortization expense related to the total discount of the Company’s debt for the years ended December 31, 2019, 2018, and 2017 was $0.2 million, $0.3 million, and $0.3 million, respectively.
As of December 31, 2019 and 2018, there was no outstanding balance under the revolving line of credit. The following table presents the carrying value of the Company’s notes payable (in thousands):
December 31, | |||||||
2019 | 2018 | ||||||
Principal amount of notes payable | $ | $ | |||||
Unamortized debt discount | ( | ) | ( | ) | |||
Net carrying amount of notes payable | |||||||
Less current portion | ( | ) | ( | ) | |||
Non-current portion of notes payable | $ | $ | |||||
The Amended and Restated 2009 Loan and Security Agreement and the Second Amended and Restated Loan and Security Agreement provide certain financial-related covenants, among others, relating to delivery of audited financial statements to the lenders. The Company was in compliance with respect to all financial-related covenants under its loan agreements as of December 31, 2019 and 2018.
Note 10. Common Stock and Stockholders’ Equity
Redeemable Convertible Preferred Stock
Upon the closing of the IPO in October 2017, all shares of the Company's then-outstanding redeemable convertible preferred stock automatically converted into 25,370,616 shares of common stock, including 582,254 additional shares issuable upon conversion of our Series G redeemable convertible preferred stock based on the initial public offering price of $22.00 per share. As of December 31, 2019 and 2018, there were no shares of redeemable convertible preferred stock issued and outstanding.
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Redeemable Convertible Preferred Stock Warrants
Concurrent with the closing of the IPO, all shares of outstanding redeemable convertible preferred stock warrants were either exercised or converted to common stock warrants. In lieu of payment of the aggregate warrant price, the warrant holders elected a "cashless exercise", whereby a portion of the shares equal to the aggregate warrant price were withheld. The average fair market value at the time of exercise was $25.12 , which resulted in 224,691 shares being issued by the Company.
Common Stock Warrants
Common Stock
As of December 31, 2019 and 2018, 4.1 million shares and 3.9 million shares of our common stock were reserved for future grants under the 2017 Plan, respectively.
As of December 31, 2019, common stock reserved, on an as-if converted basis for issuance are as follows (in thousands):
December 31, 2019 | ||
Reserved for future issuance under equity award plans | ||
Common stock options outstanding | ||
Restricted stock units outstanding | ||
Total common stock reserved for issuance | ||
Stock Option and Incentive Plan
The 2000 Stock Option and Incentive Plan (the “2000 Plan”) allows for the issuance of stock options and RSUs to employees, non-employees and directors. The Plan provides for incentive stock options to be granted to employees at an exercise price at least equal to 100 % of the fair value at the grant date as determined by the Company’s Board of Directors. If a stock-based award is issued to an executive officer that owns more than 10 % of the Company’s outstanding common stock, the exercise price will be 110 % of the fair market value. The Plan also provides for non-qualified stock options to be issued to employees, non-employees and directors. Options granted generally have a maximum term of 10 years from grant date, allow for early exercise unless otherwise designated by the Board of Directors at the time of grant. Stock options and RSUs generally vest over a four-year period.
In October 2017, the Company’s stockholders approved the Company’s 2017 Equity Incentive Plan (the “2017 Plan”). The 2017 Plan provides for the grant of incentive stock options, non-statutory stock options, restricted stock, restricted stock units, stock appreciation rights, performance stock units, performance shares, and performance awards. A total of 3,800,000 shares of the Company’s common stock are reserved for future issuance pursuant to the 2017 Plan. In addition, shares subject to outstanding awards granted under the 2000 Plan, that are canceled, expire, or otherwise terminate without having been exercised in full and shares previously issued under the 2000 Plan that are forfeited to the Company, tendered to or withheld by the Company for the payment of an award’s exercise price or for tax withholding, or repurchased by the Company, may be added to the 2017 Plan (provided that the maximum number of shares that may be added to the Company’s 2017 Plan pursuant to the provision in this sentence is 12,500,000 shares). The number of shares available for future issuance under the Company’s 2017 Plan also includes automatic annual increases on the first day of the Company’s fiscal year beginning with 2018, equal to the lesser of: 3,800,000 shares; 5 % of the outstanding shares of common stock as of the last day of the Company’s immediately preceding fiscal year; or such lower number of shares as determined by the administrator of the 2017 Plan.
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Prior to the IPO, options granted allowed for early exercise unless otherwise designated by the Board of Directors at the time of grant. The Company had no early exercise liability as at December 31, 2019. The Company had an early exercise liability of approximately $0.4 million as at December 31, 2018. Including early exercises, the Company has 48,063,761 and 43,450,819 shares of legally outstanding common stock as at December 31, 2019 and 2018, respectively.
2017 Employee Stock Purchase Plan
In October 2017, the Company’s stockholders approved the 2017 Employee Stock Purchase Plan (the “ESPP”).
The ESPP allows eligible employees to purchase shares of the Company’s common stock through payroll deductions and is intended to qualify under Section 423 of the Internal Revenue Code. A total of 800,000 shares of the Company’s common stock are available for sale under the ESPP. The number of shares available for issuance under the Company’s ESPP will also include an automatic, annual increase on the first day of each fiscal year of the Company beginning in 2018, equal to the lesser of: 800,000 shares; 1 % of the total number of shares of the Company’s common stock outstanding on the last day of the Company’s immediately preceding fiscal year; or such lower number of shares as determined by the Administrator. The Company’s ESPP provides for consecutive, six-month offering periods. The offering periods are scheduled to start on the first trading day on or after May 20 and November 20 of each year, except for the first offering period which began following the closing of the IPO, and will end on the first trading day on May 18, 2018. Participants may purchase the Company’s common stock through payroll deductions, of up to a maximum of 15 % of their eligible compensation. Participation will end automatically upon termination of employment with the Company. The purchase price of the shares will be 85 % of the lower of the fair market value of the Company’s common stock on the first trading day of each offering period or on the exercise date.
During the year ended December 31, 2019, 379,306 shares of common stock were purchased under the ESPP at a weighted-average exercise price of $24.23 per share, resulting in cash proceeds of $9.2 million. The Company selected the Black-Scholes option-pricing model as the method for determining the estimated fair value for the Company’s ESPP. As of December 31, 2019, total unrecognized compensation cost related to the ESPP was $1.3 million, which will be amortized over a period of 0.4 years.
As of December 31, 2019, 848,345 shares of our common stock were reserved for future sales under the 2017 ESPP Plan.
Stock Option Activity
The following table summarizes option activity under the Plan and related information (in thousands, except per share and contractual life amounts):
Options Outstanding | ||||||||||||
Number of Shares | Weighted- Average Exercise Price | Weighted- Average Remaining Contractual Life (Years) | Aggregate Intrinsic Value | |||||||||
Balance—December 31, 2017 | $ | $ | ||||||||||
Granted | $ | |||||||||||
Exercised | ( | ) | $ | |||||||||
Forfeited | ( | ) | $ | |||||||||
Balance—December 31, 2018 | $ | $ | ||||||||||
Exercised | ( | ) | $ | |||||||||
Forfeited | ( | ) | $ | |||||||||
Balance—December 31, 2019 | $ | $ | ||||||||||
Options vested and exercisable—December 31, 2019 | $ | $ | ||||||||||
No stock option awards were granted for the year ended December 31, 2019. The weighted-average fair value per share for all options granted was $14.95 , and $9.79 for the years ended December 31, 2018 and 2017, respectively. The aggregate intrinsic value of employee options exercised was $72.3 million, $71.9 million, and $4.4 million for the years ended December 31, 2019,
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2018, and 2017, respectively. The aggregate intrinsic value represents the difference between the Company’s estimated fair value of its common stock and the exercise price of the outstanding options.
As of December 31, 2019, total unrecognized compensation cost related to unvested options was $2.5 million, net of estimated forfeitures, which was expected to be amortized over a weighted-average period of approximately 1.1 years.
Restricted Stock Units (“RSUs”) and Performance Based Stock Units (“PSUs”)
The following table summarizes RSU and PSU activity under the Plan and related information (in thousands, except per share and contractual life amounts):
RSUs and PSUs Outstanding | ||||||||||||
Number of Shares | Weighted- Average Grant Date Fair Value Per Share | Weighted- Average Remaining Contractual Life (Years) | Aggregate Intrinsic Value | |||||||||
Balance—December 31, 2017 | $ | $ | ||||||||||
Granted | $ | |||||||||||
Released | ( | ) | $ | |||||||||
Forfeited | ( | ) | $ | |||||||||
Balance—December 31, 2018 | $ | $ | ||||||||||
Granted | $ | |||||||||||
Released | ( | ) | $ | |||||||||
Forfeited | ( | ) | $ | |||||||||
Balance—December 31, 2019 | $ | $ | ||||||||||
Beginning in 2019, the Company issued PSUs to select executives under the 2017 Plan. The majority of the PSUs vest over a period of four years from the date of grant subject to both the continued employment of the participant with the Company and the achievement of one or more pre-established financial performance goals. Stock-based compensation expense for PSUs is recognized using the accelerated attribution method over the requisite service periods when it is probable that the performance condition will be achieved.
During the year ended December 31, 2019, the Company entered into a Separation and Release Agreement with a former employee in which the Company agreed to grant future RSUs amounting to $3.0 million in exchange for consulting service during a two-year period. The Company will issue the grant upon acceptance of the deliverables at the end of each year of the consulting period. The Company accrued the stock-based compensation expense arising from this transaction over the requisite service period with a credit to accrued expenses. The accrued expenses will be reclassified to additional paid in capital upon the issuance of the grant. For the year ended December 31, 2019, the stock-based compensation expense related to this transaction was included in sales and marketing expense in the accompanying consolidated statements of operations and was immaterial.
On June 5, 2019, the Company granted a number of PSUs with a grant date fair value of $2.1 million to one of the members of the board of directors of the Company as part of a consulting agreement. Refer to Note 15 for detailed discussion of the agreement.
The aggregate fair value, as of the respective vesting dates, of RSUs and PSUs vested during the years ended December 31, 2019 and 2018 was $58.9 million and $51.2 million, respectively. There were no RSUs and PSUs vested during the year ended December 31, 2017.
As of December 31, 2019, total unrecognized compensation cost related to unvested RSUs and PSUs was $155.4 million, which was expected to be amortized over a weighted-average period of approximately 2.7 years.
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Stock-Based Compensation
Stock-based compensation expense for both employees and non-employees included in the accompanying consolidated statements of operations is as follows (in thousands):
Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
Cost of revenue: | |||||||||||
License | $ | $ | $ | ||||||||
Subscription | |||||||||||
Professional services | |||||||||||
Research and development | |||||||||||
Sales and marketing | |||||||||||
General and administrative | |||||||||||
Total | $ | $ | $ | ||||||||
Prior to the IPO, certain employees and advisors have been granted stock options with vesting subject to a future liquidity event. Upon the liquidity event, these stock options became fully exercisable, and all of the associated stock-based compensation expense was recognized. Upon the closing of the Company’s IPO on October 31, 2017, the Company recognized stock-based compensation expense of approximately $21.2 million related to these performance-based stock options and RSUs.
During the year ended December 31, 2017, the Company amended its Chief Executive Officer's (“CEO”) employment agreement to provide for accelerated vesting of all of the CEO’s equity awards upon his termination due to death or disability while executing his employment duties. As a result of this modification to the CEO’s vesting terms, the Company expects to record an incremental $7.6 million in stock-based compensation expense over the service period beginning in October 2017 (following the completion of the Company’s IPO), $6.5 million of which was recorded by the Company during the three months ended December 31, 2017. The remaining $1.1 million was recorded by the Company in the year ended December 31, 2018.
Determining the Fair Value of Stock Options
The fair value of stock option awards granted to employees and ESPP purchase rights are estimated using the Black-Scholes option-pricing model. The key assumptions within the model are described as follows:
Fair Value of Common Stock
Prior to the Company’s IPO, the Company’s Board of Directors considered numerous objective and subjective factors to determine the fair value of its common stock. These factors included, but were not limited to (i) contemporaneous third-party valuations of common stock; (ii) the rights and preferences of redeemable convertible preferred stock relative to common stock; (iii) the lack of marketability of common stock; (iv) developments in the business; and (v) the likelihood of achieving a liquidity event, such as an initial public offering or sale of the Company, given prevailing market conditions.
Subsequent to its IPO, the Company uses the market closing price for its common stock as reported on the NASDAQ Global Select Market on the date of grant.
Risk-Free Interest Rate
The risk-free interest rate is based on the rate for a U.S. Treasury zero-coupon issue with a term that approximates the expected life of the option on the date of grant.
Expected Term
The expected term represents the period that stock-based awards are expected to be outstanding. The expected term is calculated using the simplified method for stock options issued at-the-money. For stock options that have been issued out-of-the-money, the expected term was determined by calculating the midpoint of the simplified method and the contractual life of
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the option of 10 years, as neither historical experience nor other relevant data was available to estimate the future exercise behavior of out-of-the money stock options. The Company uses the remaining contractual life as the expected term for non-employee awards.
Volatility
The expected volatility is based on the average historic price volatility for the Company’s publicly traded industry peers based on daily price observations over a period equivalent to the expected term of stock-based awards. The historical volatility data of a peer group is used as there is insufficient trading history for the Company’s common stock.
Dividend Yield
The Company has never paid dividends and at present, does not expect to pay dividends in the foreseeable future.
The assumptions used to determine the grant date fair value of employee stock options and ESPP purchase rights for the periods presented are as follows:
Year Ended December 31, | |||||
2019 | 2018 | 2017 | |||
Employee Stock Options | |||||
Fair value of common stock | $ | $29.92 – $30.97 | $16.73 – $31.16 | ||
Risk-free interest rate | 2.4% – 2.8% | 1.9% – 2.2% | |||
Expected term (in years) | 6.0 – 6.1 | ||||
Volatility | 46% – 49% | ||||
Dividend yield | |||||
Employee Stock Purchase Plan | |||||
Fair value of common stock | $33.69 – $35.03 | $24.65 – $31.00 | $ | ||
Risk-free interest rate | 1.6% – 2.4% | 2.14% – 2.52% | |||
Expected term (in years) | |||||
Volatility | 35% – 40% | 30% – 43% | |||
Dividend yield | |||||
Note 11. Income Taxes
The components of loss before provision for income taxes are as follows (in thousands):
Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
Domestic | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
Foreign | |||||||||||
Total | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
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Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
Current | |||||||||||
Federal | $ | $ | $ | ||||||||
State | |||||||||||
Foreign | |||||||||||
Total current | |||||||||||
Deferred | |||||||||||
Foreign | ( | ) | ( | ) | ( | ) | |||||
Total deferred | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
Total | $ | $ | $ | ||||||||
Deferred income taxes reflect 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 and tax effects of net operating loss and credit carryforwards. Significant components of the Company’s deferred tax assets and liabilities are as follows (in thousands):
December 31, | |||||||
2019 | 2018 | ||||||
Deferred tax assets: | |||||||
Federal and state net operating losses | $ | $ | |||||
Research/other credits | |||||||
Non-deductible and accrued expenses | |||||||
Deferred revenue | |||||||
Property and equipment | |||||||
Stock-based compensation | |||||||
Lease liability | |||||||
Other | |||||||
Gross deferred tax assets | |||||||
Valuation allowance | ( | ) | ( | ) | |||
Net deferred tax assets | |||||||
Deferred tax liabilities: | |||||||
Acquired intangible assets | ( | ) | ( | ) | |||
Right of use asset | ( | ) | |||||
Deferred commission | ( | ) | ( | ) | |||
Others | ( | ) | ( | ) | |||
Net deferred tax liabilities | ( | ) | ( | ) | |||
Total | $ | $ | ( | ) | |||
Reconciliation of the statutory federal income tax to the Company’s effective tax (in thousands):
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Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
Tax at federal statutory rate | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
State, net of federal benefit | |||||||||||
Meals and entertainment disallowance | |||||||||||
Stock-based compensation | ( | ) | ( | ) | |||||||
Non-deductible warrant expenses | |||||||||||
Tax Reform federal rate change | |||||||||||
Impact of intangible property transfer | |||||||||||
Change in valuation allowance | ( | ) | |||||||||
Other | ( | ) | |||||||||
Total | $ | $ | $ | ||||||||
A valuation allowance has been provided to reduce the deferred tax asset to an amount management believes is more likely than not to be realized. The valuation allowance increased by $29.5 million and $29.1 million for the years ended December 31, 2019 and 2018, respectively.
As of December 31, 2019, the Company had net operating loss carryforwards for federal income tax purposes of approximately $378.6 million, which begin to expire in 2021 if not utilized. The Company also has California net operating loss carryforwards of approximately $36.6 million, which begin to expire in 2028 if not utilized. The Company also has other state net operating loss carryforwards of approximately $168.1 million, which begin to expire in 2020 if not utilized. The Company has federal, California, and Texas research and development credit carryforwards of $2.4 million, $1.5 million, and $0.3 million respectively. The federal research and development credits will begin to expire in 2035, if not utilized. California research and development credits can be carried forward indefinitely.
Utilization of the Company’s net operating loss carryforwards may be subject to substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. Such a limitation could result in the expiration of the net operating loss carryforwards before utilization.
The Company provides U.S. income taxes on the earnings of foreign subsidiaries, unless the subsidiaries’ earnings are considered indefinitely reinvested outside the United States. As of December 31, 2019, there was no income tax expense accrual related to undistributed earnings from its foreign subsidiaries as they are considered indefinitely reinvested. The Company has not determined the unrecognized deferred tax liability associated with un-remitted foreign earnings because it is not practicable to do so.
Uncertain Tax Positions
For benefits to be realized, a tax position must be more likely than not to be sustained upon examination. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement. As a result of the implementation of these provisions, the Company did not recognize any adjustments to retained earnings for uncertain tax positions.
A reconciliation of the gross unrecognized tax benefit is as follows (in thousands):
Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
Unrecognized tax benefits at the beginning of the period | $ | $ | $ | ||||||||
Additions for tax positions taken in prior years | |||||||||||
Additions for tax positions taken in current year | |||||||||||
Reductions for tax positions taken in prior years | ( | ) | |||||||||
Settlements with taxing authorities | ( | ) | |||||||||
Statute of limitation expirations | ( | ) | |||||||||
Unrecognized tax benefits at the end of the period | $ | $ | $ | ||||||||
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It is the Company’s policy to recognize interest and penalties related to income tax matters in income tax expense. During the years ended December 31, 2019, 2018, and 2017, the Company did not recognize any significant accrued interest and penalties related to uncertain tax positions.
For the year ended December 31, 2019, the Company recorded an accrual for uncertain tax position of $20.8 million related to the completion of an intra-group transfer of certain intellectual property rights from the Netherlands to the United States.
The Company is subject to federal income tax as well as income tax in multiple state and foreign jurisdictions. Due to the Company’s net operating loss carryforwards, all tax years since inception remain subject to examination for United States federal tax returns, and fiscal year 2016 remains subject to examination for Israel. There are tax years which remain subject to examination in various other jurisdictions that are not material to the Company’s financial statements. We expect the amount of unrecognized tax benefits to be reduced within the next 12 months by at least $0.9 million as a result of settlement with tax authorities.
On April 22, 2018, the Supreme Court of Israel ruled to uphold a decision for stock based compensation to be included within Israeli entities’ transfer pricing reimbursement arrangements. As a result, the Company changed its tax return filing position for fiscal year 2018 and the uncertain tax position associated with this liability decreased by approximately $0.4 million, there was a corresponding increase to current income tax payable included in accrued expenses.
The total amount of unrecognized tax benefits that, if recognized, would impact the effective tax rate would be $21.3 million, $1.1 million, and $1.4 million for the years ended December 31, 2019, 2018, and 2017.
Note 12. Net Loss per Share
Net loss per share of common stock is computed using the two-class method required for participating securities based on their participation rights. All series of redeemable convertible preferred stock are participating securities as the holders are entitled to participate in common stock dividends with common stock on an as converted basis.
Basic net loss per share is computed by dividing net loss attributable to common stockholders by basic weighted-average shares outstanding during the period. All participating securities are excluded from basic weighted-average shares outstanding. In computing diluted net loss attributable to common stockholders, undistributed earnings are re-allocated to reflect the potential impact of dilutive securities. Diluted net loss per share attributable to common stockholders is computed by dividing net loss attributable to common stockholders by diluted weighted-average shares outstanding, including potentially dilutive securities, unless anti-dilutive.
The following table presents the computation of basic and diluted net loss per share attributable to common stockholders (in thousands, except per share amounts):
Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
Net loss | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
Deemed dividend on the conversion of Series G redeemable convertible preferred stock | |||||||||||
Net loss attributable to common stockholders | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
Weighted-average shares used to compute net loss per share attributable to common stockholders, basic and diluted | |||||||||||
Net loss per share attributable to common stockholders, basic and diluted | $ | ( | ) | $ | ( | ) | $ | ( | ) | ||
The following securities were excluded from the computation of diluted net loss per share attributable to common stockholders for the periods presented because their inclusion would reduce the net loss per share (in thousands).
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Year Ended December 31, | ||||||||
2019 | 2018 | 2017 | ||||||
Options to purchase common stock | ||||||||
Unvested early exercised common shares | ||||||||
Unvested restricted stock units | ||||||||
Shares estimated under ESPP | ||||||||
Warrants to purchase common stock | ||||||||
Note 13. Employee Benefit Plans
Israeli labor laws and agreements require the Company’s Israeli subsidiary to make severance payments to retired or dismissed Israeli employees, as well as to employees leaving employment under certain other circumstances. The Company’s severance obligations to employees are measured based upon length of service and latest monthly salary amount. The Company has recorded a non-current liability of $3.0 million and $2.5 million as of December 31, 2019 and 2018, respectively, for the estimated amount of accrued severance benefits in other liabilities in the accompanying consolidated balance sheet. The current portion of the liability was immaterial as of December 31, 2019 and 2018. The deposits are held with a severance pay fund in order to fund the obligation, which totaled $2.4 million and $2.0 million as of December 31, 2019 and 2018, respectively, and are recorded as a non-current asset in other assets in the accompanying consolidated balance sheets. The current portion of the deposit was immaterial as of December 31, 2019 and 2018.
Note 14. Segment Information
The Company’s business is conducted globally. The Company’s chief operating decision maker is the Chief Executive Officer who reviews financial information presented on a consolidated basis accompanied by information about revenue by geographic region for purposes of allocating resources and evaluating financial performance. There is one business activity and there are no segment managers who are held accountable for operations, operating results, and plans for levels, components, or types of products or services below the consolidated unit level. Accordingly, there is a single reporting segment and operating unit structure.
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Revenue by geographic area is attributed based on the billing address of the customer and is as follows (in thousands):
Year Ended December 31, | |||||||||||
2019 | 2018 | 2017 | |||||||||
Revenue: | |||||||||||
Americas | |||||||||||
United States | $ | $ | $ | ||||||||
Other Americas | |||||||||||
Total Americas | |||||||||||
Europe, Middle East, and Africa (“EMEA”) | |||||||||||
Asia Pacific and Japan (“APJ”) | |||||||||||
Total revenue | $ | $ | $ | ||||||||
Long-lived assets, net by geographic area are attributed based on legal entity structure and are as follows (in thousands):
December 31, | |||||||
2019 | 2018 | ||||||
Long-lived assets, net: | |||||||
United States | $ | $ | |||||
Israel | |||||||
Other | |||||||
Total long-lived assets, net | $ | $ | |||||
Note 15. Related Party Transactions
Consulting agreement with Night Dragon II, LLC
On June 5, 2019, the Company entered into a consulting agreement (the “Consulting Agreement”) with Night Dragon II, LLC (“Night Dragon”). One of the members of the board of directors (“the Board”) of the Company is a principal and the chief executive officer of Night Dragon and will personally provide services to the Company under the Consulting Agreement.
Pursuant to the Consulting Agreement, Night Dragon will provide consulting and business development services to the Company, including customer engagement, speaking activities, competitive and market analysis, business development assistance and expertise, and other services as described in the Consulting Agreement. In consideration for the consulting and business development services to the Company, the Board granted the director a number of PSUs with a grant date fair value of $2.1 million. The PSUs will vest on the achievement of certain milestones detailed in the Consulting Agreement, in each case, so long as the Consulting Agreement remains in effect. The term of the Consulting Agreement commenced on June 5, 2019 and will continue for two years or until terminated in accordance with its terms.
For the year ended December 31, 2019, the stock-based compensation expense related to the Consulting Agreement was included in general and administrative expense and was immaterial. The balance of approximately $1.4 million will be recorded over the remaining period.
Related party sale
In the third quarter of fiscal 2019, the Company entered into an arrangement with a company affiliated with a member of the Company’s Board of Directors for the sale of the Company’s products and services. Specifically, for the year ended December 31, 2019, the Company recorded license revenue of $1.4 million and subscription revenue of $0.1 million relating to this contract. As of December 31, 2019, the related amounts receivable and deferred revenue were immaterial and $0.6 million, respectively.
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Note 16. Selected Quarterly Financial Data (Unaudited)
The following tables set forth selected unaudited quarterly consolidated statements of operations data for each of the eight quarters in the period ended December 31, 2019. The information for each of these quarters has been prepared on the same basis as the audited annual consolidated financial statements included elsewhere in this report and, in the opinion of management, includes all adjustments, which consist only of normal recurring adjustments, necessary for the fair presentation of the results of operations for these periods in accordance with GAAP. This data should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this report. These quarterly operating results are not necessarily indicative of our operating results for a full year or any future period.
Three Months Ended | |||||||||||||||||||||||||||||||
December 31, 2019 | September 30, 2019 | June 30, 2019 | March 31, 2019 | December 31, 2018 | September 30, 2018 | June 30, 2018 | March 31, 2018 | ||||||||||||||||||||||||
(In thousands, except per share amounts) | |||||||||||||||||||||||||||||||
Revenue: | |||||||||||||||||||||||||||||||
License | $ | $ | $ | $ | $ | $ | $ | $ | |||||||||||||||||||||||
Subscription | |||||||||||||||||||||||||||||||
Professional services | |||||||||||||||||||||||||||||||
Total revenue | |||||||||||||||||||||||||||||||
Cost of revenue: | |||||||||||||||||||||||||||||||
License (1) | |||||||||||||||||||||||||||||||
Subscription (1) | |||||||||||||||||||||||||||||||
Professional services (1) | |||||||||||||||||||||||||||||||
Total cost of revenue | |||||||||||||||||||||||||||||||
Total gross profit | |||||||||||||||||||||||||||||||
Operating expenses: | |||||||||||||||||||||||||||||||
Research and development (1) | |||||||||||||||||||||||||||||||
Sales and marketing (1) | |||||||||||||||||||||||||||||||
General and administrative (1) | |||||||||||||||||||||||||||||||
Total operating expenses | |||||||||||||||||||||||||||||||
Loss from operations | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | |||||||||||||||
Interest expense | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | |||||||||||||||
Other income, net | |||||||||||||||||||||||||||||||
Loss before income taxes | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | ( | ) | |||||||||||||||
Income tax provision | |||||||||||||||||||||||||||||||
Net loss | $ | ( | ) | $ | ( | ) | $ | ( | ) | $ | ( | ) | $ | ( | ) | $ | ( | ) | $ | ( | ) | $ | ( | ) | |||||||
Net loss per share, basic and diluted | $ | ( | ) | $ | ( | ) | $ | ( | ) | $ | ( | ) | $ | ( | ) | $ | ( | ) | $ | ( | ) | $ | ( | ) | |||||||
Weighted-average shares used to compute net loss per share, basic and diluted | |||||||||||||||||||||||||||||||
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_____________________
(1) | Includes stock-based compensation expense as follows: |
Three Months Ended | |||||||||||||||||||||||||||||||
December 31, 2019 | September 30, 2019 | June 30, 2019 | March 31, 2019 | December 31, 2018 | September 30, 2018 | June 30, 2018 | March 31, 2018 | ||||||||||||||||||||||||
(In thousands) | |||||||||||||||||||||||||||||||
Cost of revenue: | |||||||||||||||||||||||||||||||
License | $ | $ | $ | $ | $ | $ | $ | $ | |||||||||||||||||||||||
Subscription | |||||||||||||||||||||||||||||||
Professional services | |||||||||||||||||||||||||||||||
Research and development | |||||||||||||||||||||||||||||||
Sales and marketing | |||||||||||||||||||||||||||||||
General and administrative | |||||||||||||||||||||||||||||||
Total | $ | $ | $ | $ | $ | $ | $ | $ | |||||||||||||||||||||||
Note 17. Subsequent Event
On February 6, 2020, the Company entered into an Agreement and Plan of Merger with Ferrari Group Holdings, L.P., a Delaware limited partnership, and Ferrari Merger Sub, Inc., a Delaware corporation and a wholly owned subsidiary of Parent. Parent and Merger Sub are affiliates of Advent.
The Merger Agreement provides that, subject to the terms and conditions set forth in the Merger Agreement, Merger Sub will merge with and into the Company, with the Company surviving the Merger and becoming a wholly owned subsidiary of Parent. Under the Merger Agreement, at the effective time of the Merger, each issued and outstanding share of the Company’s common stock (except for certain shares specified in the Merger Agreement) will be canceled and automatically converted into the right to receive cash in an amount equal to $33.00 , without interest.
Consummation of the Merger is subject to the satisfaction or waiver of customary closing conditions, including (1) approval of the Merger Agreement by the Company’s stockholders; (2) the absence of any law or order restraining, enjoining or otherwise prohibiting the Merger; and (3) the expiration or termination of the waiting period under the United States Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and clearance under the antitrust laws of certain non-United States jurisdictions. The Merger is expected to close in the second fiscal quarter of 2020. Upon consummation of the Merger, the Company’s common stock will no longer be listed on any public market.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.
Based on our evaluation, our chief executive officer and chief financial officer concluded that, as of December 31, 2019, our disclosure controls and procedures are effective to provide reasonable assurance that information we are required to disclose
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in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission (“SEC”) rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.
Management’s Annual Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended). Our management, with the participation of our chief executive officer and chief financial officer, conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the 2013 framework in Internal Control-Integrated Framework, our management has concluded that our internal control over financial reporting was effective as of December 31, 2019.
The effectiveness of our internal control over financial reporting as of December 31, 2019 has been audited by Ernst & Young LLP, the independent registered public accounting firm that audited our consolidated financial statements included in this Annual Report on Form 10-K, as stated in their report that is included herein.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the quarter ended December 31, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Limitations on the Effectiveness of Controls
Our management, including our chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Our disclosure controls and procedures and our internal controls have been designed to provide reasonable assurance of achieving their objectives. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
ITEM 9B. OTHER INFORMATION
None.
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PART III
ITEM 10. | DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE |
Executive Officers and Directors
The information required by this item will be contained in our definitive proxy statement to be filed with the SEC in connection with our 2020 annual meeting of stockholders (the “Proxy Statement”), which is expected to be filed not later than 120 days after the end of our fiscal year ended December 31, 2019, and is incorporated in this report by reference.
ITEM 11. | EXECUTIVE COMPENSATION |
The information required by this item will be set forth in the Proxy Statement and is incorporated herein by reference.
ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS |
The information required by this item will be set forth in the Proxy Statement and is incorporated herein by reference.
ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE |
The information required by this item will be set forth in the Proxy Statement and is incorporated herein by reference.
ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND SERVICES |
The information required by this item will be set forth in the Proxy Statement and is incorporated herein by reference.
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PART IV
ITEM 15. | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES |
Documents filed as part of this Annual Report on Form 10-K are as follows:
1. | Consolidated Financial Statements |
Our consolidated financial statements are listed in the “Index to Consolidated Financial Statements” under Part II, Item 8 of this Annual Report on Form 10-K.
2. | Financial Statement Schedules |
Financial statement schedules have been omitted because they are not required, not applicable, not present in amounts sufficient to require submission of the schedule, or the required information is shown in the Consolidated Financial Statements or Notes thereto.
3. | Exhibits |
See the Exhibit Index below in this Annual Report on Form 10-K.
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EXHIBIT INDEX
Exhibit Number | Description | Form | File No. | Exhibit | Filing Date | Filed Herewith | ||||||
3.1* | 10-Q | 001-38253 | 3.1 | December 8, 2017 | ||||||||
3.2* | 8-K | 001-38253 | 3.1 | November 25, 2019 | ||||||||
4.1* | S-1/A | 333-220767 | 4.1 | October 16, 2017 | ||||||||
4.2* | S-1 | 333-220767 | 4.2 | October 2, 2017 | ||||||||
4.3 | X | |||||||||||
10.1* | S-1 | 333-220767 | 10.1 | October 2, 2017 | ||||||||
10.2*+ | S-1/A | 333-220767 | 10.3 | October 16, 2017 | ||||||||
10.3*+ | S-1/A | 333-220767 | 10.4 | October 16, 2017 | ||||||||
10.4*+ | S-1 | 333-220767 | 10.5 | October 2, 2017 | ||||||||
10.5* | S-1 | 333-220767 | 10.6 | October 2, 2017 | ||||||||
10.6+* | S-1 | 333-220767 | 10.14 | October 2, 2017 | ||||||||
10.7+* | S-1 | 333-220767 | 10.15 | October 2, 2017 | ||||||||
10.8+* | S-1 | 333-220767 | 10.16 | October 2, 2017 | ||||||||
10.9+* | S-1 | 333-220767 | 10.17 | October 2, 2017 | ||||||||
10.10* | S-1 | 333-220767 | 10.18 | October 2, 2017 | ||||||||
10.11+* | 10-K | 001-38253 | 10.18 | February 22, 2018 | ||||||||
10.12+* | 10-Q | 001-38253 | 10.1 | May 9, 2019 | ||||||||
10.13+* | S-1/A | 333-220767 | 10.22 | October 16, 2017 | ||||||||
10.14* | 10-K | 001-38253 | 10.21 | February 22, 2018 | ||||||||
10.15*+ | 10-K | 001-38253 | 10.15 | March 1, 2019 | ||||||||
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10.16 | 10-K | 001-38253 | 10.16 | March 1, 2019 | ||||||||
10.17* | 10-Q | 001-38253 | 10.2 | May 9, 2019 | ||||||||
10.18*+ | 8-K | 001-38253 | 10.1 | June 7, 2019 | ||||||||
10.19*+ | 10-Q | 001-38253 | 10.1 | August 7, 2019 | ||||||||
10.20*+ | 10-Q | 001-38253 | 10.2 | August 7, 2019 | ||||||||
10.21+ | X | |||||||||||
10.22+ | X | |||||||||||
10.23+ | X | |||||||||||
10.24+ | X | |||||||||||
21.1 | X | |||||||||||
23.1 | X | |||||||||||
31.1 | X | |||||||||||
31.2 | X | |||||||||||
32.1** | X | |||||||||||
32.2** | X | |||||||||||
101.INS | XBRL Instance Document. | |||||||||||
101.SCH | Inline XBRL Taxonomy Extension Schema Linkbase Document. | |||||||||||
101.CAL | Inline XBRL Taxonomy Calculation Linkbase Document. | |||||||||||
101.DEF | Inline XBRL Taxonomy Definition Linkbase Document. | |||||||||||
101.LAB | Inline XBRL Taxonomy Labels Linkbase Document. | |||||||||||
101.PRE | Inline XBRL Taxonomy Presentation Linkbase Document. | |||||||||||
104 | Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101). | |||||||||||
______________
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* | Previously filed. |
** | The certifications attached as Exhibit 32.1 and 32.2 that accompany this Annual Report on Form 10-K are not deemed filed with the Securities and Exchange Commission and are not to be incorporated by reference into any filing of Forescout Technologies, Inc. under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this Annual Report on Form 10-K, irrespective of any general incorporation language contained in such filing. |
+ | Indicates a management or compensatory plan. |
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ITEM 16. | FORM 10-K SUMMARY |
Not applicable.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, on February 28, 2020.
FORESCOUT TECHNOLOGIES, INC. | |
By: | /s/ Michael DeCesare |
Michael DeCesare | |
Chief Executive Officer | |
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POWER OF ATTORNEY
KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Michael DeCesare and Christopher Harms, and each of them, as his or her true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitutes, may lawfully do or cause to be done by virtue thereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated:
Signature | Title | Date | ||
/s/ Michael DeCesare | Chief Executive Officer, President & Director (Principal Executive Officer) | February 28, 2020 | ||
MICHAEL DECESARE | ||||
/s/ Christopher Harms | Chief Financial Officer (Principal Financial Officer & Principal Accounting Officer) | February 28, 2020 | ||
CHRISTOPHER HARMS | ||||
/s/ Theresia Gouw | Chair of the Board of Directors | February 28, 2020 | ||
THERESIA GOUW | ||||
/s/ David G. DeWalt | Director | February 28, 2020 | ||
DAVID G. DEWALT | ||||
/s/ Elizabeth Hackenson | Director | February 28, 2020 | ||
ELIZABETH HACKENSON | ||||
/s/ Enrique Salem | Director | February 28, 2020 | ||
ENRIQUE SALEM | ||||
/s/ James Beer | Director | February 28, 2020 | ||
JAMES BEER | ||||
/s/ Kathy McElligott | Director | February 28, 2020 | ||
KATHY MCELLIGOTT | ||||
/s/ Mark Jensen | Director | February 28, 2020 | ||
MARK JENSEN | ||||
/s/ Yehezkel Yeshurun | Co-Founder and Director | February 28, 2020 | ||
YEHEZKEL YESHURUN | ||||
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