Proofpoint, Inc.
PROOFPOINT INC (Form: 10-Q, Received: 04/28/2016 16:17:17)
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
__________________________________
FORM 10-Q
þ
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended March 31, 2016
OR

o
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from to
Commission File Number 001-35506
PROOFPOINT, INC.
(Exact name of Registrant as specified in its charter)
Delaware  
(State or other jurisdiction of  
incorporation or organization)
 
51-0414846  
(I.R.S. employer  
identification no.)

892 Ross Drive
Sunnyvale, California  
(Address of principal executive offices)
 
94089  
(Zip Code)

(408) 517-4710
__________________________________
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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 þ NO o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     
YES þ NO o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer þ  
 
Accelerated filer o
 
 
Non-accelerated filer o
(Do not check if a smaller reporting company)
 
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

Shares of Proofpoint, Inc. common stock, $0.0001 par value per share, outstanding as of April 22, 2016 : 41,494,727 shares.




Table of Contents



TABLE OF CONTENTS


2

Table of Contents

PART I. FINANCIAL INFORMATION


ITEM 1. FINANCIAL STATEMENTS.
Proofpoint, Inc.
Condensed Consolidated Balance Sheets
(In thousands, except per share amounts)
(Unaudited)
 
March 31,
 
December 31,
 
2016
 
2015
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
377,441

 
$
346,205

Short-term investments
32,344

 
60,032

Accounts receivable, net of allowance for doubtful accounts of $182 and $199 as of March 31, 2016 and December 31, 2015, respectively
55,414

 
54,522

Inventory
582

 
485

Deferred product costs
1,799

 
2,228

Deferred commissions
17,857

 
19,314

Prepaid expenses and other current assets
6,148

 
5,695

Total current assets
491,585

 
488,481

Property and equipment, net
37,973

 
34,501

Deferred product costs
578

 
314

Goodwill
133,769

 
133,769

Intangible assets, net
37,925

 
41,330

Long-term deferred commissions
3,464

 
3,488

Other assets
3,756

 
3,733

Total assets
$
709,050

 
$
705,616

Liabilities and Stockholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
15,082

 
$
14,081

Accrued liabilities
26,207

 
35,053

Capital lease obligations
32

 
32

Deferred rent
513

 
496

Deferred revenue
203,142

 
182,195

Total current liabilities
244,976

 
231,857

Convertible senior notes
350,796

 
345,699

Long-term capital lease obligations
115

 
123

Long-term deferred rent
2,025

 
2,033

Other long-term liabilities
1,188

 
1,188

Long-term deferred revenue
39,886

 
41,531

Total liabilities
638,986

 
622,431

Commitments and contingencies (note 5)
 
 
 
Stockholders’ equity:
 
 
 
Convertible preferred stock, $0.0001 par value; 5,000 shares authorized; no shares issued and outstanding

 

Common stock, $0.0001 par value; 200,000 shares authorized; 41,413 and 40,840 shares issued and outstanding at March 31, 2016 and December 31, 2015, respectively
4

 
4

Additional paid-in capital
459,618

 
441,104

Accumulated other comprehensive loss
(2
)
 
(23
)
Accumulated deficit
(389,556
)
 
(357,900
)
Total stockholders’ equity
70,064

 
83,185

Total liabilities and stockholders’ equity
$
709,050

 
$
705,616

See accompanying Notes to the Condensed Consolidated Financial Statements.

3

Table of Contents

Proofpoint, Inc.
Condensed Consolidated Statements of Operations
(In thousands, except per share amounts)
(Unaudited)

 
Three Months Ended
March 31,
 
2016
 
2015
Revenue:
 
 
 
Subscription
$
77,397

 
$
55,856

Hardware and services
1,606

 
1,907

Total revenue
79,003

 
57,763

Cost of revenue: (1)(2)
 
 
 
Subscription
21,682

 
16,334

Hardware and services
3,142

 
2,954

Total cost of revenue
24,824

 
19,288

Gross profit
54,179

 
38,475

Operating expense: (1)(2)
 
 
 
Research and development
22,653

 
15,708

Sales and marketing
46,523

 
32,951

General and administrative
10,604

 
7,333

Total operating expense
79,780

 
55,992

Operating loss
(25,601
)
 
(17,517
)
Interest expense
(5,800
)
 
(2,853
)
Other income (expense), net
2

 
(1,180
)
Loss before provision for income taxes
(31,399
)
 
(21,550
)
Provision for income taxes
(257
)
 
(162
)
Net loss
$
(31,656
)
 
$
(21,712
)
Net loss per share, basic and diluted
$
(0.77
)
 
$
(0.56
)
Weighted average shares outstanding, basic and diluted
41,093

 
38,957

 
 
 
 
(1) Includes stock-based compensation expense as follows:
 
 
Cost of subscription revenue
$
1,638

 
$
1,115

Cost of hardware and services revenue
353

 
254

Research and development
5,602

 
3,938

Sales and marketing
6,818

 
4,869

General and administrative
4,072

 
2,250

(2) Includes intangible amortization expense as follows:
 
 
Cost of subscription revenue
$
2,117

 
$
1,380

Research and development
15

 
23

Sales and marketing
1,273

 
1,293

General and administrative

 
11

See accompanying Notes to the Condensed Consolidated Financial Statements.

4

Table of Contents

Proofpoint, Inc.
Condensed Consolidated Statements of Comprehensive Loss
(In thousands)
(Unaudited)

 
Three Months Ended
March 31,
 
2016
 
2015
Net loss
$
(31,656
)
 
$
(21,712
)
Other comprehensive income, net of tax:
 
 
 
Unrealized gain on short-term investments, net
21

 
20

Comprehensive loss
$
(31,635
)
 
$
(21,692
)


See accompanying Notes to the Condensed Consolidated Financial Statements.

5

Table of Contents

Proofpoint, Inc.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
 
Three Months Ended
March 31,
 
2016
 
2015
Cash flows from operating activities
 
 
 
Net loss
$
(31,656
)
 
$
(21,712
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization
7,236

 
5,464

Loss on disposal of property and equipment
189

 
3

Amortization of investment premiums, net of accretion of purchase discounts
50

 
128

Recovery of allowance for doubtful accounts
(17
)
 
(274
)
Stock-based compensation
18,483

 
12,426

Amortization of debt issuance costs and accretion of debt discount
5,096

 
2,266

Foreign currency transaction (gain) loss
(224
)
 
1,137

Changes in assets and liabilities, net of effect of acquisitions:
 
 
 
Accounts receivable
(879
)
 
9,310

Inventory
(96
)
 
73

Deferred products costs
164

 
203

Deferred commissions
1,481

 
39

Prepaid expenses
(257
)
 
(799
)
Other current assets
56

 
647

Deferred income taxes
(126
)
 
281

Long-term assets
3

 
15

Accounts payable
1,472

 
247

Accrued liabilities
(2,868
)
 
(5,410
)
Deferred rent
9

 
(111
)
Deferred revenue
19,302

 
8,591

Net cash provided by operating activities
17,418

 
12,524

Cash flows from investing activities
 
 
 
Proceeds from sales and maturities of short-term investments
54,639

 
11,012

Purchase of short-term investments
(26,980
)
 

Purchase of property and equipment
(7,838
)
 
(4,584
)
Acquisitions of businesses, net of cash acquired

 
(28,114
)
Net cash provided by (used in) investing activities
19,821

 
(21,686
)
Cash flows from financing activities
 
 
 
Proceeds from issuance of common stock
1,872

 
4,019

Withholding taxes related to restricted stock net share settlement
(6,698
)
 
(4,137
)
Repayments of equipment loans and capital lease obligations
(8
)
 
(415
)
   Holdback payments for prior acquisitions
(1,397
)
 

Net cash used in financing activities
(6,231
)
 
(533
)
Effect of exchange rate changes on cash and cash equivalents
228

 
(637
)
Net increase (decrease) in cash and cash equivalents
31,236

 
(10,332
)
Cash and cash equivalents
 
 
 
Beginning of period
346,205

 
180,337

End of period
$
377,441

 
$
170,005

 
 
 
 
Supplemental disclosure of noncash investing and financing information
 
 
 
Unpaid purchases of property and equipment
$
4,559

 
$
3,656

Liability awards converted to equity
$
6,059

 
$
1,745


See accompanying Notes to the Condensed Consolidated Financial Statements.

6

Table of Contents

Proofpoint, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)
(Dollars and share amounts in thousands, except per share amounts)
1. The Company and Summary of Significant Accounting Policies
The Company
Proofpoint, Inc. (the “Company”) was incorporated in Delaware in June 2002 and is headquartered in California.
Proofpoint is a leading security-as-a-service provider that enables large and mid-sized organizations worldwide to defend, protect, archive and govern their most sensitive data. The Company's security-as-a-service platform is comprised of an integrated suite of on-demand data protection solutions, including threat protection, incident response, regulatory compliance, archiving, governance, eDiscovery, and secure communication.

Basis of Presentation and Consolidation

These condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All inter-company transactions and balances have been eliminated in consolidation.

Starting January 1, 2016, the Company began separately presenting the effect of exchange rate changes on cash and cash equivalents in its condensed consolidated statements of cash flows due to growing operations in foreign currency environments. Amounts in the comparable prior period have been reclassified to conform to the current period presentation.

The Company completed a number of acquisitions during the year ended December 31, 2015, which are more fully described in Note 2, "Acquisitions". The condensed consolidated financial statements include the results of operations from these business combinations from their date of acquisition.

These condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (“GAAP”), pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and note disclosures have been condensed or omitted pursuant to such rules and regulations. The accompanying Condensed Consolidated Balance Sheet as of December 31, 2015 is derived from audited financial statements as of that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The unaudited condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary for a fair statement of the periods presented. The results of operations for the three months ended March 31, 2016 are not necessarily indicative of the results to be expected for the year ending December 31, 2016 or for other interim periods or for future years.

These condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and accompanying notes for the year ended December 31, 2015 included in the Company’s Annual Report on Form 10-K filed with the SEC. The Company’s significant accounting policies are described in Note 1 to those audited consolidated financial statements. Refer to "Sales Commissions" below regarding the Company's change in accounting policy for sales commissions effective January 1, 2016.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates and such difference may be material to the financial statements.




7


Goodwill and Intangible Assets
Goodwill represents the excess of the purchase price of the acquired enterprise over the fair value of identifiable assets acquired and liabilities assumed. The Company performs an annual goodwill impairment test during the fourth quarter of a calendar year and more frequently if an event or circumstances indicates that impairment may have occurred. For the purposes of impairment testing, the Company has determined that it has one operating segment and one reporting unit. The Company performs a two-step impairment test of goodwill whereby the fair value of the reporting unit is compared to its carrying value. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not considered impaired and further testing is not required. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then the Company must perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then impairment loss equal to the difference is recorded. The identification and measurement of goodwill impairment involves the estimation of the fair value of the Company. The estimate of fair value of the Company, based on the best information available as of the date of the assessment, is subjective and requires judgment, including management assumptions about expected future revenue forecasts and discount rates, changes in the overall economy, trends in the stock price and other factors. No impairment indicators were identified by the Company as of March 31, 2016 .

Intangible assets consist of developed technology, customer relationships, non-compete arrangements, trademarks and patents and order backlog. The values assigned to intangibles are based on estimates and judgments regarding expectations for success and life cycle of solutions and technologies acquired.

Intangible assets are amortized on a straight-line basis over their estimated lives, which approximate the pattern in which the economic benefits of the intangible assets are consumed, as follows (in years):

 
Low
 
High
Patents
4
 
5
Developed technology
3
 
7
Customer relationships
2
 
7
Non-compete agreements
2
 
4
Order backlog
1
 
3
Trade names and trademarks
1
 
5
    
Revenue Recognition
The Company derives its revenue primarily from two sources: (1) subscription revenue for rights related to the use of the security-as-a-service platform and (2) hardware, training and professional services revenue provided to customers related to their use of the platform. The Company records its revenues net of any value added or sales tax. Subscription revenue is derived from a subscription‑based enterprise licensing model with contract terms typically ranging from one to three years, and consists of (i) subscription fees from the licensing of the security-as-a-service platform, (ii) subscription fees for access to the on-demand elements of the platform and (iii) subscription fees for the right to access the Company’s customer support services.

Revenue is recognized when all of the following criteria have been met:

Persuasive evidence of an arrangement exists;

Delivery has occurred or services have been rendered;

Sales price is fixed or determinable; and

Collectability is reasonably assured.

The Company generates sales directly through its sales team and, to a growing extent, through its channel partners. Sales to channel partners are made at a discount and revenues are recorded at this discounted price once all revenue recognition criteria are met. Channel partners generally receive an order from an end-customer prior to placing an order with the Company, and these partners do not carry any inventory of the Company's products or solutions. Payment from channel partners is not

8


contingent on the partner’s success in sales to end-customers. In the event that the Company offers rebates, joint marketing funds, or other incentive programs to a partner, recorded revenues are reduced by these amounts accordingly.

From time to time, certain third parties that the Company has an arrangement with provide the Company with referrals for which the Company pays a referral fee. The referral fee paid could vary depending on the level of effort. These fees are recorded in sales and marketing expense in proportion to the related revenue streams consistent with the sales commissions accounting. The Company did not incur any material referral fee expenses during the three months ended March 31, 2016 and 2015.
The Company applies industry-specific software revenue recognition guidance to transactions involving the licensing of software, as well as related support, training, and other professional services. The Company has analyzed all of the elements included in its multiple element software arrangements and has determined that it does not have sufficient VSOE of fair value to allocate revenue to its subscription and software license agreements, support, training and professional services. The Company defers all revenue under the software arrangement until the commencement of the subscription services and any associated professional services. Once the subscription services and the associated professional services have commenced, the entire fee from the arrangement is recognized ratably over the remaining period of the arrangement. If the professional services are essential to the functionality of the subscription, then the revenue recognition does not commence until such services are completed.

The Company's revenue arrangements typically include subscription services to its security-as-a-service platform. These hosted on demand service arrangements do not provide customers with the right to take possession of the software supporting the hosted services. Certain arrangements also include the sale of hardware appliances. Revenue from hardware appliances containing software components and hardware components that function together to deliver the hardware appliance's essential functionality is excluded from the scope of the industry specific revenue recognition guidance. The Company recognizes revenue from its hosted on demand services in accordance with general revenue recognition accounting guidance. Only revenue derived from the licensing of the software is recognized in accordance with the industry specific revenue guidance.
    
When a sales arrangement contains multiple elements, such as hardware appliances, subscription services, customer support services, and/or professional services, the Company allocates revenue to each unit of accounting or element based on a selling price hierarchy. An element constitutes a separate unit of accounting when the delivered item has standalone value and delivery of the undelivered element is probable and within the Company's control. When applying the relative selling price method, the Company determines the selling price for each deliverable using vendor-specific objective evidence (“VSOE”) of selling price. If VSOE does not exist, the Company uses third-party evidence (“TPE”) of selling price. If neither VSOE nor TPE of selling price exist for a deliverable, the Company uses its best estimate of selling price ("BESP") for that deliverable. Revenue allocated to each element is then recognized when the basic revenue recognition criteria are met for each element. The Company determines BESP for an individual element within a multiple element revenue arrangement using the same methods utilized to determine the selling price of an element sold on a standalone basis. The Company estimates the selling price for its subscription solutions by considering internal factors such as historical pricing practices and it estimates the selling price of hardware and other services using a cost plus model.

Hardware appliance revenue is recognized upon shipment. Subscription and support revenue are recognized over the contract period commencing on the start date of the contract. Professional services and training, when sold with hardware appliances or subscription and support services, are accounted for separately when those services have standalone value. In determining whether professional services and training services can be accounted for separately from subscription and support services, the Company considers the following factors: availability of the services from other vendors, the nature of the services, and the dependence of the subscription services on the customer’s decision to buy the professional services. If professional services and training do not qualify for separate accounting, the Company recognizes the professional services and training ratably over the contract term of the subscription services.

Delivery generally occurs when the hardware appliance is delivered to a common carrier freight on board shipping point by the Company or the hosted service has been activated and communicated to the customer accordingly. The Company’s fees are typically considered to be fixed or determinable at the inception of an arrangement and are negotiated at the outset of an arrangement, generally based on specific products and quantities to be delivered. In the event payment terms are provided that differ significantly from the Company's standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized as the fees become paid.


9


The Company assesses collectability based on a number of factors, including credit worthiness of the customer and past transaction history of the customer. Through March 31, 2016 , the Company has not experienced significant credit losses.

Deferred Revenue
Deferred revenue primarily consists of billings or payments received in advance of revenue recognition from the sale of the Company’s subscription fees, training and professional services. Once the revenue recognition criteria are met, this revenue is recognized ratably over the term of the associated contract.

Comprehensive Loss

Comprehensive loss includes all changes in equity that are not the result of transactions with stockholders. The Company’s comprehensive loss consists of its net loss and changes in unrealized gains (losses) from its available-for-sale investments. The Company had no material reclassifications out of accumulated other comprehensive loss into net loss for the three months ended March 31, 2016 and 2015 .
Sales Commissions
Effective January 1, 2016, the Company changed its accounting policy for sales commissions that are incremental and directly related to its customer sales contracts in which revenue is deferred. These commission costs are accrued and capitalized upon execution of a non-cancelable customer contract, and subsequently expensed over the term of such contract in proportion to the related future revenue streams. For commission costs where revenue is recognized, the related commission costs are recorded in the period of revenue recognition. Prior to this change in accounting policy, commission costs were expensed in the period in which they were incurred. The adoption of this accounting policy change has been applied retrospectively to all periods presented in this Quarterly Report on Form 10-Q, in which the cumulative effect of the change has been reflected as of the beginning of the first period presented. Deferred commissions as of March 31, 2016 and December 31, 2015 were $21,321 and $22,802 , respectively. During the three months ended March 31, 2016, the Company deferred $5,929 of commission costs and amortized $7,411 within sales and marketing expense. During the three months ended March 31, 2015, the Company deferred $4,500 of commission costs and amortized $4,539 within sales and marketing expense.

The Company believes this change in accounting policy is preferable as the direct and incremental commission costs are closely related to the revenue, and therefore they should be recorded as an asset and recognized as an expense over the same period that the related revenue is recognized.

The cumulative effect of the change on accumulated deficit and accumulated other comprehensive loss was $15,060 as of December 31, 2014. The following tables present the changes to the financial statement lines as a result of the accounting change for the periods presented in the accompanying unaudited Condensed Consolidated Financial Statements:

Condensed Consolidated Balance Sheet
 
As of December 31, 2015
 
As reported
 
Adjustment
 
As adjusted
Short-term deferred commissions
$

 
$
19,314

 
$
19,314

Long-term deferred commissions
$

 
$
3,488

 
$
3,488

Accumulated deficit
$
(380,702
)
 
$
22,802

 
$
(357,900
)

Condensed Consolidated Statement of Operations

10


 
Three months ended March 31, 2015
 
As reported
 
Adjustment
 
As adjusted
Operating expenses: Sales and marketing
$
32,912

 
$
39

 
$
32,951

Net loss
$
(21,673
)
 
$
(39
)
 
$
(21,712
)
Net loss per share, basic and diluted
$
(0.56
)
 
$

 
$
(0.56
)
Weighted average shares outstanding, basic and diluted
38,957

 

 
38,957

Condensed Consolidated Statement of Comprehensive Loss
 
Three months ended March 31, 2015
 
As reported
 
Adjustment
 
As adjusted
Net loss
$
(21,673
)
 
$
(39
)
 
$
(21,712
)
Unrealized gains on short-term investments, net
$
20

 
$

 
$
20

Comprehensive loss
$
(21,653
)
 
$
(39
)
 
$
(21,692
)
There have been no changes, other than as discussed above, in our significant accounting policies for the three months ended March 31, 2016, as compared to the significant accounting policies described in our Annual Form 10-K for the year ended December 31, 2015.
Recent Accounting Pronouncements
In March 2016, the Financial Standards Board (FASB) issued Accounting Standards Update No. 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (ASU 2016-09). ASU 2016-09 changes how companies account for certain aspects of share-based payment awards to employees, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. The update to the standard is effective for interim and annual periods beginning after December 15, 2016. The Company is currently evaluating the impact of the adoption of ASU 2016-09 on its consolidated financial statements.

In February 2016, FASB issued Accounting Standards Update No. 2016-02, Leases (Topic 842) (ASU 2016-02), which requires lessees to put most leases on their balance sheets but recognize the expenses on their statements of operations in a manner similar to current practice. ASU 2016-02 states that a lessee would recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use the underlying asset for the lease term. The new standard is effective for interim and annual periods beginning after December 15, 2018 and early adoption is permitted. The Company is currently evaluating the impact of the adoption of ASU 2016-02 on its consolidated financial statements.

In May 2014, the FASB issued Accounting Standards Update No. 2014-09,  Revenue from Contracts with Customers: Topic 606  (ASU 2014-09), to supersede nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing U.S. GAAP including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. Originally, ASU 2014-09 would be effective for the Company starting January 1, 2017 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within ASU 2014-09; or (ii) retrospective with the cumulative effect of initially applying ASU 2014-09 recognized at the date of initial application and providing certain additional disclosures as defined per ASU 2014-09. In July 2015, the FASB voted to amend ASU 2014-09 by approving a one-year deferral of the effective date as well as providing the option to early adopt the standard on the original effective date. The Company is currently evaluating the timing and impact of the adoption of ASU 2014-09 on its consolidated financial statements.

2. Acquisitions

Acquisitions are accounted for under the purchase method of accounting in which the tangible and identifiable intangible assets and liabilities of each acquired company are recorded at their respective fair values as of each acquisition date,

11


including an amount for goodwill representing the difference between the respective acquisition consideration and fair values of identifiable net assets. The Company believes that for each acquisition, the combined entities will achieve savings in corporate overhead costs and opportunities for growth through expanded geographic and customer segment diversity with the ability to leverage additional products and capabilities. These factors, among others, contributed to a purchase price in excess of the estimated fair value of each acquired company's net identifiable assets acquired and, as a result, goodwill was recorded in connection with each acquisition. Goodwill related to each acquisition below, except for one of the acquisitions made in the fourth quarter of 2015, is deductible for tax purposes.

While the Company uses its best estimates and assumptions as part of the purchase price allocation process to value assets acquired and liabilities assumed at the acquisition date, these estimates and assumptions are subject to refinement. When additional information becomes available, such as finalization of negotiations of working capital adjustments and tax related matters, the Company may revise its preliminary purchase price allocation. As a result, during the preliminary purchase price allocation period, which may be up to one year from the acquisition date, the Company may record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill. Subsequent to the purchase price allocation period, adjustments to assets acquired or liabilities assumed are recognized in the operating results.

2015 Acquisitions
    
In the fourth quarter of the year ended December 31, 2015, the Company made two acquisitions that were accounted for as business combinations. The Company has provisionally estimated fair values of acquired tangible and intangible assets at the respective date of each acquisition. The amounts reported were considered provisional as the Company was completing the valuation work to determine the fair value of certain assets acquired. The results of operations and the provisional fair values of the acquired assets and liabilities assumed have been included in the accompanying condensed consolidated financial statements from the respective date of each acquisition.

The aggregate purchase price was $11,568 . The following table summarizes the fair values of acquired tangible and intangible assets, liabilities and goodwill:

 
Estimated
Fair Value
Estimated
Useful Life (in years)
Current assets acquired
$
414

N/A
Fixed assets acquired
73

N/A
Liabilities assumed
(234
)
N/A
Deferred revenue assumed
(1,400
)
N/A
Deferred tax liability, net
(45
)
N/A
Customer relationships
2,800

7
Order Backlog
900

3
Developed technology
3,000

4
Goodwill
6,060

Indefinite
 
$
11,568

 

Marble Security, Inc.

On July 22, 2015 (the "Marble Acquisition Date"), pursuant to the terms of an asset purchase agreement, the Company acquired certain assets of Marble Security, Inc. ("Marble"). The Marble mobile security technology proactively removes malicious mobile applications by leveraging its tight integration with the leading enterprise mobility management platforms, including MobileIron and AirWatch by VMware. The acquisition extends the Company’s threat intelligence and advanced threat protection for email and social media security into the realm of mobile devices.

The Company has provisionally estimated fair values of acquired tangible and intangible assets at the Marble Acquisition Date. The amounts reported were considered provisional as the Company was completing the valuation work to determine the fair value of certain assets acquired. The results of operations and the provisional fair values of the acquired assets and liabilities assumed have been included in the accompanying condensed consolidated financial statements since the Marble Acquisition Date.


12


The total purchase price was $8,500 . Of the cash consideration paid, $1,700 was held in escrow, to secure indemnification obligations, which has not been released as of the filing date of this Quarterly Report on Form 10-Q.

Fair value of acquired assets

The determination of the fair values of the assets acquired has been prepared on a provisional basis and changes to that determination may occur as additional information becomes available. The following table summarizes the fair values of acquired tangible, intangible assets and goodwill:

 
Estimated
Fair Value
Estimated
Useful Life (in years)
Fixed assets acquired
$
25

N/A
Developed technology
7,300

4
Goodwill
1,175

Indefinite
 
$
8,500

 
 
Emerging Threats Pro, LLC

On March 6, 2015 (the "Emerging Threats Acquisition Date"), pursuant to the terms of a purchase agreement, the Company acquired 100% of membership interests in Emerging Threats Pro, LLC ("Emerging Threats"). Based in Indianapolis, Indiana, Emerging Threats provides threat intelligence solutions to help protect networks from known or potentially malicious threats. With this acquisition, the Company integrated Emerging Threat's advanced threat intelligence solutions with its existing Targeted Attack Protection and Threat Response security solutions to advance threat detection and response across the completed attack chain.  The combined technology provides customers with deeper insight into cyberthreats, enabling them to react faster to inbound cyberattacks, and to identify, block, and disable previously undetected malware already embedded in their organizations.

The results of operations and the fair values of the acquired assets and liabilities assumed have been included in the accompanying condensed consolidated financial statements since the Emerging Threat Acquisition Date.

The total purchase price was $31,803 , net of cash acquired of $52 , of which  $3,662  was paid in the second quarter of 2015. Of the cash consideration paid,  $6,000  was held in escrow, to secure indemnification obligations, which has not been released as of the filing date of this Quarterly Report on Form 10-Q.

Fair value of acquired assets and liabilities assumed

The following table summarizes the fair values of tangible and intangible assets acquired, liabilities assumed and goodwill:

 
Fair Value
Estimated
Useful Life (in years)
Current assets acquired
$
1,275

N/A
Fixed assets acquired
174

N/A
Liabilities assumed
(448
)
N/A
Deferred revenue assumed
(700
)
N/A
Holdback liability to the sellers
(3,662
)
N/A
Trade names
200

2
Customer relationships
4,200

7
Order Backlog
200

1
Developed technology
7,900

7
Goodwill
19,054

Indefinite
 
$
28,193

 


13


3. Goodwill and Intangible Assets
The goodwill activity and balances are presented below:
Balance at December 31, 2015
$
133,769

Add: Goodwill from acquisitions

Less: Other purchase price allocation adjustments to Goodwill

Balance at March 31, 2016
$
133,769


Intangible Assets
Intangible assets, excluding goodwill, consisted of the following:
 
March 31, 2016
 
December 31, 2015
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
Developed technology
$
57,268

 
$
(30,736
)
 
$
26,532

 
$
57,268

 
$
(28,618
)
 
$
28,650

Customer relationships
18,384

 
(8,341
)
 
10,043

 
23,382

 
(12,291
)
 
11,091

Non-compete agreements
500

 
(428
)
 
72

 
804

 
(691
)
 
113

Trade names and patents
930

 
(487
)
 
443

 
1,006

 
(502
)
 
504

Order backlog
1,100

 
(265
)
 
835

 
1,300

 
(328
)
 
972

 
$
78,182

 
$
(40,257
)
 
$
37,925

 
$
83,760

 
$
(42,430
)
 
$
41,330

Amortization of intangible assets expense was $3,405 and $2,707 for the three months ended March 31, 2016 and 2015 , respectively.
Future estimated amortization of intangible assets expense as of March 31, 2016 are presented below:
Year ending December 31,
 
2016, remainder
$
9,114

2017
9,174

2018
8,530

2019
5,164

2020
2,806

Thereafter
3,137

 
$
37,925


4. Fair Value Measurements and Investments
Fair Value Measurements
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date. A hierarchy for inputs used in measuring fair value has been defined to minimize the use of unobservable inputs by requiring the use of observable market data when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on active market data. Unobservable inputs are inputs that reflect the Company’s assumptions about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances.
The fair value hierarchy prioritizes the inputs into three broad levels:

14


Level 1: Quoted (unadjusted) prices in active markets for identical assets or liabilities.
The Company’s Level 1 assets generally consist of money market funds.
Level 2: Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.
The Company’s Level 2 assets and liabilities generally consist of corporate debt securities, commercial papers, U.S. agency and Treasury securities and convertible senior notes.
Level 3: Unobservable inputs to the valuation methodology that are supported by little or no market activity and that are significant to the measurement of the fair value of the assets or liabilities. Level 3 assets and liabilities include those whose fair value measurements are determined using pricing models, discounted cash flow methodologies or similar valuation techniques, as well as significant management judgment or estimation.
The following tables summarize, for each category of assets or liabilities carried at fair value, the respective fair value as of March 31, 2016 and December 31, 2015 and the classification by level of input within the fair value hierarchy:
 
Balance as of
March 31,
2016
 
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Unobservable
Inputs
(Level 3)
Assets
 
 
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
345,475

 
$
345,475

 
$

 
$

Corporate debt securities
1,804

 

 
1,804

 

Short-term investments:
 
 
 
 
 
 
 
Corporate debt securities
17,952

 

 
17,952

 

Commercial papers
14,392

 

 
14,392

 

Total financial assets
$
379,623

 
$
345,475

 
$
34,148

 
$

 
Balance as of
December 31,
2015
 
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Unobservable
Inputs
(Level 3)
Assets
 
 
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
306,983

 
$
306,983

 
$

 
$

Corporate debt securities
3,178

 

 
3,178

 

Commercial paper
8,996

 

 
8,996

 

Short-term investments:
 
 
 
 
 
 
 
Corporate debt securities
36,527

 

 
36,527

 

Commercial paper
16,290

 

 
16,290

 

U.S. agency securities
5,414

 

 
5,414

 

U.S. Treasury securities
1,801

 

 
1,801

 

Total financial assets
$
379,189

 
$
306,983

 
$
72,206

 
$


15


Based on quoted market prices as of March 31, 2016 , the fair values of the 0.75% and 1.25% Convertible Senior Notes were approximately $222,175 and $294,175 , respectively, determined using Level 2 inputs as they are not actively traded in markets.
The carrying amounts of the Company's cash equivalents, accounts receivable and accounts payable approximate their fair values due to their short maturities.
Investments
The cost and fair value of the Company’s cash and cash equivalents and available-for-sale investments as of March 31, 2016 and December 31, 2015 were as follows:
 
March 31, 2016
 
Cost Basis
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash
$
30,162

 
$

 
$

 
$
30,162

Money market funds
345,475

 

 

 
345,475

Corporate debt securities
1,804

 

 

 
1,804

Total
$
377,441

 
$

 
$

 
$
377,441

 
 
 
 
 
 
 
 
Short-term investments:
 
 
 
 
 
 
 
Corporate debt securities
$
17,954

 
$
1

 
$
(3
)
 
$
17,952

Commercial paper
14,392

 

 

 
14,392

Total
$
32,346

 
$
1

 
$
(3
)
 
$
32,344

 
December 31, 2015
 
Cost Basis
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash
$
27,048

 
$

 
$

 
$
27,048

Money market funds
306,983

 

 

 
306,983

Corporate debt securities
3,178

 

 

 
3,178

Commercial papers
8,996

 

 

 
8,996

Total
$
346,205

 
$

 
$

 
$
346,205

 
 
 
 
 
 
 
 
Short-term investments:
 
 
 
 
 
 
 
Corporate debt securities
$
36,549

 
$

 
$
(22
)
 
$
36,527

Certificate of deposit
16,290

 

 

 
16,290

U.S. agency securities
5,415

 

 
(1
)
 
5,414

U.S. Treasury securities
1,801

 

 

 
1,801

Total
$
60,055

 
$

 
$
(23
)
 
$
60,032

As of March 31, 2016 and December 31, 2015 , all investments mature in less than one year. Estimated fair values for marketable securities are based on quoted market prices for the same or similar instruments.
The Company reviews its investments on a quarterly basis to identify and evaluate investments that have an indication of possible impairment and has determined that no other-than-temporary impairments were required to be recognized during three months ended March 31, 2016 .

16


5. Commitments and Contingencies
Operating Leases
The Company leases certain of its facilities under noncancellable operating leases with various expiration dates through 2020.

Premises rent expense was $1,179 and $867 for the three months ended March 31, 2016 and 2015 , respectively.

Capital Leases

In July 2012, the Company entered into two lease agreements to lease certain office equipment which expired in July and October 2015. These leases bore an annual interest rate of 4.5% . In July 2015, the Company entered into a new lease agreement (the "July 2015 Lease") to lease certain office equipment with expiration in August 2020. The July 2015 Lease bears an annual interest rate of 6.5% . All leases are secured by fixed assets used in the Company's office locations.
At March 31, 2016 , future annual minimum lease payments under noncancellable operating and capital leases were as follows:
 
Capital
Leases
 
Operating
Leases
Year ending December 31,
 
 
 
2016, remainder
$
31

 
$
8,265

2017
41

 
7,149

2018
39

 
5,063

2019
37

 
4,371

2020
22

 
1,350

Thereafter

 
2,574

Total minimum lease payments
170

 
$
28,772

Less: Amount representing interest
(23
)
 
 
Present value of capital lease obligations
147

 
 
Less: current portion
(32
)
 
 
Long-term portion of capital lease obligations
$
115

 
 

Contingencies

Under the indemnification provisions of the Company's customer agreements, the Company agrees to indemnify and defend and hold harmless its customers against, among other things, infringement of any patent, trademark or copyright under any country's laws or the misappropriation of any trade secret arising from the customers' legal use of the Company's solutions. The exposure to the Company under these indemnification provisions is generally limited to the total amount paid by the customers under the applicable customer agreement. However, certain indemnification provisions potentially expose the Company to losses in excess of the aggregate amount paid to the Company by the customer under the applicable customer agreement. To date, there have been no claims against the Company or its customers pursuant to these indemnification provisions.

Legal Contingencies

From time to time, the Company may be involved in legal proceedings and subject to claims in the ordinary course of business. On December 16, 2013, Finjan, Inc. sued the Company and its wholly-owned subsidiary, Armorize Technologies, Inc., in the United States District Court, Northern District of California for alleged patent infringement of a variety of its patents, demanding preliminary and permanent injunctive relief, and unspecified damages. The Company and Armorize filed an answer to the complaint on February 10, 2014. On April 15, 2014, Finjan’s initial disclosures in the lawsuit alleged approximately  $13,500  in damages, but provided no basis or facts in support of this sum. On April 2, 2015, the court ordered that the claims construction hearing be held in June 2015. On April 23, 2015, Finjan amended its infringement contentions pursuant to court order that Finjan comply with the Patent Local Rules. On June 24, 2015, the court held the claims

17


construction hearing in this matter. On December 3, 2015, the court issued its claim construction order. On December 17, 2015, the court held its hearing on defendants’ motion to strike Finjan’s additional infringement contentions and ordered that trial be set for June 13, 2016. On February 16, 2016, the court issued its order on the motion to strike additional infringement contentions, granting the majority of defendants’ requests. On February 22, 2016, the Company and Armorize filed their motion for summary judgment with the court. On April 12, 2016, the Court issued its ruling on that motion granting summary judgment of non-infringement on two of the eight patents in the case. Finjan has since confirmed that it will not further pursue infringement claims for an additional patent. The parties have agreed to meet for a settlement conference on May 5, 2016, and further stipulated to moving the pretrial conference and Daubert motion hearing to May 24, 2016. Based on the claims and the still-to-be filed pre-trial and Daubert motions, and based on our evaluation of the facts available at this time, the amount or range of reasonable possible losses to which the Company or Armorize is exposed cannot be estimated and the ultimate resolution of this matter and the associated financial statement impact, if any, remains uncertain at this time. The Company and Armorize are vigorously defending the lawsuit. Intellectual property litigation is subject to inherent uncertainties, and there can be no assurance that the expenses associated with defending any litigation or the resolution of this dispute would not have a material adverse impact on the Company's balance sheet, results of operations or cash flows. Regardless of the outcome, such proceedings and claims can have an adverse impact on the Company because of defense and settlement costs, diversion of resources and other factors, and there can be no assurances that favorable outcomes will be obtained.

6. Convertible Senior Notes

0.75% Convertible Senior Notes due June 2020

On June 17, 2015 , the Company issued $200,000 principal amount of 0.75% Convertible Senior Notes (the "0.75% Notes") due 2020 in a private offering to qualified institutional buyers ("Holders") pursuant to Rule 144A under the Securities Act of 1934, as amended (the "Securities Act"). The initial Holders of the 0.75% Notes also had an option to purchase an additional $30,000 in principal amount which was exercised in full. The net proceeds after the agent's discount and issuance costs of $6,581 from the 0.75% Notes offering were approximately $223,419 . The Company uses the net proceeds for working capital and general corporate purposes, which may include funding the Company's operations, capital expenditures, potential acquisitions of businesses, products or technologies believed to be of strategic importance. The 0.75% Notes bear interest at 0.75% per year, payable semi-annually in arrears every June 15 and December 15, beginning on December 15, 2015.

The 0.75% Notes are unsecured and rank senior in right of payment to any indebtedness expressly subordinated in right of payment to the 0.75% Notes. They rank equally with the Company's other existing and future unsecured indebtedness that is not subordinated and are structurally subordinated to any current or future secured indebtedness to the extent of the value of the assets securing the indebtedness and other liabilities of the Company's subsidiaries.

The initial conversion rate is 12.3108 shares of the Company’s common stock per $1 principal amount of notes which equates to 2,831 shares of common stock, or a conversion price equivalent of $81.23 per share of common stock. Throughout the term of the 0.75% Notes, the conversion rate may be adjusted upon the occurrence of certain events, such as the payment of cash dividends or issuance of stock warrants. The 0.75% Notes mature on June 15, 2020 , unless repurchased, redeemed or converted in accordance with their terms prior to such date.

At the Company's option, on or after June 20, 2018 , the Company will be able to redeem all or a portion of the 0.75% Notes at 100% of the principal amount, plus any accrued and unpaid interest, under certain conditions. The Company may redeem the 0.75% Notes in shares of the Company’s common stock, cash, or some combination of each.

Prior to December 15, 2019 , the 0.75% Notes will be convertible at the option of the Holders only upon the satisfaction of certain conditions and during certain periods if any of the following events occur:

during the calendar quarter commencing after September 30, 2015, if the last reported sale price of the Company's common stock is greater than or equal to 130% of the applicable conversion price on each such trading day for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the preceding calendar quarter;
during the 5 business day period after any 5 consecutive trading day period in which the trading price, as defined, per $1 principal amount of the 0.75% Notes for each trading day of such measurement period was less than 98% of the product of the last reported sale price of the Company's common stock and the applicable conversion rate on each such trading day;
upon a notice of redemption by the Company; or
upon the occurrence of specified corporate transactions.

18



Subsequent to December 15, 2019 , Holders may convert their 0.75% Notes at the applicable conversion rate at any time prior to the close of business on the second scheduled trading day immediately preceding the maturity date.

Holders of the 0.75% Notes also have the right to require the Company to repurchase all or a portion of the 0.75% Notes at 100% of the principal amount, plus accrued and unpaid special interest, if any, upon the occurrence of certain fundamental changes to the Company.

In accordance with the authoritative accounting guidance, the Company allocated the total amount of the 0.75% Notes into liability and equity components. The carrying value of the liability component at issuance was calculated as the present value of its cash flows using a discount rate of 6.5% based on the a blended rate between the yield rate for a Moody's B1 rating and the average debt rate for comparable convertible transactions from similar companies. The difference between the 0.75% Notes principal and the carrying value of the liability component, representing the value of conversion premium assigned to the equity component, was recorded as an increase to additional paid in capital and as a debt discount on the issuance date. The equity component is being accreted using the effective interest rate method over the period from the issuance date through June 15, 2020 as a non-cash charge to interest expense. The amount recorded to additional paid in capital is not remeasured as long as it continues to meet the conditions for equity classification. Upon issuance of the 0.75% Notes, the Company recorded $174,359 as debt and $55,641 as additional paid in capital within stockholders' equity.
 
Additionally, the debt discount and issuance costs were allocated based on the total amount incurred to the liability and equity components using the same proportions as the proceeds from the 0.75% Notes. The equity issuance costs of $1,592 were recorded as a decrease to additional paid-in capital at the issuance date.

1.25% Convertible Senior Notes due December 2018    

On December 11, 2013 , the Company issued $175,000 principal amount of 1.25% Convertible Senior Notes (the "1.25% Notes," and together with the 0.75% Notes, the “Notes”) due 2018 in a private offering to Holders pursuant to Rule 144A under the Securities Act. The initial Holders of the 1.25% Notes also had an option to purchase an additional $26,250 in principal amount which was exercised in full. The net proceeds after the agent's discount and issuance costs of $5,803 from the 1.25% Notes offering were approximately $195,446 . The Company uses the net proceeds for working capital and general corporate purposes, which may include funding the Company's operations, capital expenditures, potential acquisitions of businesses, products or technologies believed to be of strategic importance. The 1.25% Notes bear interest at 1.25% per year, payable semi-annually in arrears every June 15 and December 15, beginning on June 15, 2014.

The 1.25% Notes are unsecured and rank senior in right of payment to any indebtedness expressly subordinated in right of payment to the 1.25% Notes. They rank equally with the Company's other existing and future unsecured indebtedness that is not subordinated and are structurally subordinated to any current or future secured indebtedness to the extent of the value of the assets securing the indebtedness and other liabilities of the Company's subsidiaries.

The initial conversion rate is 25.6271 shares of the Company’s common stock per $1 principal amount of notes which equates to 5,158 shares of common stock, or a conversion price equivalent of $39.02 per share of common stock. Throughout the term of the 1.25% Notes, the conversion rate may be adjusted upon the occurrence of certain events, such as the payment of cash dividends or issuance of stock warrants. The 1.25% Notes mature on December 15, 2018 , unless repurchased, redeemed or converted in accordance with their terms prior to such date.

At the Company's option, on or after December 20, 2016 , the Company will be able to redeem all or a portion of the 1.25% Notes at 100% of the principal amount, plus any accrued and unpaid interest, under certain conditions. The Company may redeem the 1.25% Notes in shares of the Company’s common stock, cash, or some combination of each.

Prior to June 15, 2018 , the 1.25% Notes will be convertible at the option of the Holders only upon the satisfaction of certain conditions and during certain periods if any of the following events occur:

during the calendar quarter commencing after March 31, 2014, if the last reported sale price of the Company's common stock is greater than or equal to 130% of the applicable conversion price on each such trading day for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the preceding calendar quarter;
during the 5 business day period after any 5 consecutive trading day period in which the trading price, as defined, per $1 principal amount of the 1.25% Notes for each trading day of such measurement period was less than 98% of the

19


product of the last reported sale price of the Company's common stock and the applicable conversion rate on each such trading day;
upon a notice of redemption by the Company; or
upon the occurrence of specified corporate transactions.

Subsequent to June 15, 2018 , Holders may convert their 1.25% Notes at the applicable conversion rate at any time prior to the close of business on the second scheduled trading day immediately preceding the maturity date.

Holders of the 1.25% Notes also have the right to require the Company to repurchase all or a portion of the 1.25% Notes at 100% of the principal amount, plus accrued and unpaid special interest, if any, upon the occurrence of certain fundamental changes to the Company.

In accordance with the authoritative accounting guidance, the Company allocated the total amount of the 1.25% Notes into liability and equity components. The carrying value of the liability component at issuance was calculated as the present value of its cash flows using a discount rate of 6.5% based on the a blended rate between the yield rate for a Moody's B1-rating and the average debt rate for comparable convertible transactions from similar companies. The difference between the 1.25% Notes principal and the carrying value of the liability component, representing the value of conversion premium assigned to the equity component, was recorded as an increase to additional paid in capital and as a debt discount on the issuance date. The equity component is being accreted using the effective interest rate method over the period from the issuance date through December 15, 2018 as a non-cash charge to interest expense. The amount recorded to additional paid in capital is not remeasured as long as it continues to meet the conditions for equity classification. Upon issuance of the 1.25% Notes, the Company recorded $156,672 as debt and $44,578 as additional paid in capital within stockholders' equity.
 
Additionally, the discount and issuance costs were allocated based on the total amount incurred to the liability and equity components using the same proportions as the proceeds from the 1.25% Notes. The equity issuance costs of $1,285 were recorded as a decrease to additional paid-in capital at the issuance date.

The following table presents the carrying values of all Notes as of March 31, 2016 :    

 
0.75% Notes
 
1.25% Notes
 
Total
Liability component:
 
 
 
 
 
Principal
$
230,000

 
$
201,250

 
$
431,250

Less: debt discount and issuance costs, net of amortization
(52,251
)
 
(28,203
)
 
(80,454
)
Net carrying amount
$
177,749

 
$
173,047

 
$
350,796

 
 
 
 
 
 
Equity component (1)
$
54,049

 
$
43,293

 
$
97,342


(1) Recorded on the accompanying Condensed Consolidated Balance Sheets as additional paid-in capital, net of the $2,877 issuance costs.

For the three months ended March 31, 2016 and 2015 , the Company incurred the following interest expense related to the Notes:

 
Three Months Ended
March 31,
 
2016
 
2015
Interest expense related to contractual interest coupon
$
1,060

 
$
629

Amortization of debt discount and issuance costs
5,096

 
2,266

 
$
6,156

 
$
2,895


7. Stock Equity Plans

Stock-Based Compensation Plans

20


On March 30, 2012, the Board of Directors and the Company’s stockholders approved the 2012 Equity Incentive Plan (the "2012 Plan"), which became effective in April 2012. The Company has two  equity incentive plans: the Company’s 2002 stock option plan (the “2002 Plan”) and the 2012 Plan. Upon the Company's initial public offering, all shares that were reserved under the 2002 Plan but not issued, and shares issued but subsequently returned to the plan through forfeitures, cancellations and repurchases became part of the 2012 Plan and no further shares will be granted pursuant to the 2002 Plan. All outstanding stock awards under the 2002 and 2012 Plans will continue to be governed by their existing terms. Under the 2012 Plan, the Company has the ability to issue incentive stock options (“ISOs”), nonstatutory stock options (“NSOs”), restricted stock awards, stock bonus awards, stock appreciation rights ("SARs"), restricted stock units ("RSUs"), and performance stock units ("PSUs"). The 2012 Plan also allows direct issuance of common stock to employees, outside directors and consultants at prices equal to the fair market value at the date of grant of options or issuance of common stock. Additionally, the 2012 Plan provides for the grant of performance cash awards to employees, directors and consultants. The Company has the right to repurchase any unvested shares (at the option exercise price) of common stock issued directly or under option exercises. The right of repurchase generally expires over the vesting period.
Stock bonus and other liability awards are accounted for as liability-classified awards, because the obligations are based predominantly on fixed monetary amounts that are generally known at the inception of the obligation, to be settled with a variable number of shares of the Company's common stock.
Under the 2002 and 2012 Plans, the term of an option grant shall not exceed ten years from the date of its grant and options generally vest over a three to four -year period, with vesting on a monthly or annual interval. Under the 2012 Plan, 20,316 shares of common stock are reserved for issuance to eligible participants. As of March 31, 2016 , 6,825 shares were available for future grant. Restricted stock awards generally vest over a four -year period.
Stock Options

The fair value of options granted is estimated on the grant date using the Black-Scholes option valuation model. This valuation model for stock-based compensation expense requires the Company to make assumptions and judgments about the variables used in the calculation, including the expected term (weighted-average period of time that the options granted are expected to be outstanding), the volatility of the common stock price and the assumed risk-free interest rate. The Company recognizes stock-based compensation expense for only those shares expected to vest over the requisite service period of the award. The Company determines its estimated forfeiture rate based on an analysis of its actual forfeitures and will continue to evaluate the appropriateness of the forfeiture rate based on recent forfeiture activity and expected future employee turnover, if any. Changes in the estimated forfeiture rate can have a significant effect on reported stock-based compensation expense, as the cumulative effect of adjusting the rate for all expense is recognized in the period the forfeiture estimate is changed. No compensation cost is recorded for options that do not vest and the compensation cost from vested options, whether forfeited or not, is not reversed.

There were no options granted during the three months period ended March 31, 2016. The weighted average fair value of stock options granted to employees was $23.92 during the three months ended March 31, 2015. The fair values were estimated on the grant dates using the Black-Scholes option-pricing model with the following weighted-average assumptions:

 
Three months ended March 31,
 
Three months ended March 31,
 
2016
 
2015
Expected life (in years)
n/a
 
6.08

Volatility
n/a
 
52
%
Risk-free interest rate
n/a
 
1.6
%
Dividend yield
n/a
 
%

The estimate for expected life of options granted reflects the midpoint of the vesting term and the contractual life computed utilizing the simplified method as allowed by the SEC staff. The Company does not have significant historical share option exercise experience and hence considers the expected term assumption calculated using the simplified method to be reasonable. Starting January 1, 2016, the expected volatility of the Company's common stock will be based on the Company's historical volatility. Prior to January 1, 2016, the common stock price volatility was determined based on the historical average volatilities of the common stock of a group of publicly-traded peer companies that operate in a similar industry as the Company

21


did not have sufficient trading history for its common stock. The risk-free interest rate used was the Federal Reserve Bank's constant maturities interest rate commensurate with the expected life of the options in effect at the time of the grant. The expected dividend yield was zero, as the Company does not anticipate paying a dividend within the relevant time frame.

The Company realized no income tax benefit from stock option exercises in each of the periods presented due to recurring losses and the valuation allowances for deferred tax assets.

Stock option activity under the Plan is as follows:

 
Shares subject to Options Outstanding
 
Number of
Shares
 
Weighted Average
Exercise Price
 
Weighted Average
Remaining Contractual Term
(in years)
 
Aggregate
Intrinsic
Value
Balance at December 31, 2015
4,042

 
$
15.10

 
5.77
 
$
201,736

Options granted

 

 
 
 
 
Options exercised
(310
)
 
6.58

 
 
 
 
Options forfeited and canceled
(10
)
 
24.58

 
 
 
 
Balance at March 31, 2016
3,722

 
$
15.78

 
5.69
 
$
142,610


The total intrinsic value of options exercised was $14,153 and $24,627 for the three months ended March 31, 2016 and 2015 , respectively. Total cash proceeds from such option exercises were $2,042 and $4,029 for the three months ended March 31, 2016 and 2015 , respectively.

The fair value of option grants that vested was $3,231 and $3,601 for the three months ended March 31, 2016 and 2015 , respectively.

As of March 31, 2016 , the Company had unamortized stock-based compensation expense of $11,711 related to stock options, that will be recognized net of forfeitures over the average remaining vesting term of the options of 1.74  years.
    
Restricted Stock and Performance Stock Units

A following table summarized the activity of RSUs and PSUs:

 
RSUs and PSUs Outstanding
 
Number of
Shares
 
Granted Fair Value Per Unit
Awarded and unvested at December 31, 2015
3,311

 
$
47.94

Awards granted
528

 
50.19

Awards vested
(320
)
 
43.74

Awards forfeited
(79
)
 
49.24

Awarded and unvested at March 31, 2016
3,440

 
$
48.65


As of March 31, 2016 , there was $103,629 of unamortized stock-based compensation expense related to unvested RSUs, which is expected to be recognized over a weighted average period of 3.24 years.

The Company granted 105 and 172 PSUs in the three months ended March 31, 2016 and 2015, respectively. The PSU vesting conditions were based on individual performance targets. Unamortized expense was $11,639 as of March 31, 2016, net of estimated forfeitures.
Stock Bonus and Other Liability Awards

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The total accrued liability for the stock bonus awards was $1,063 and $5,676 as of March 31, 2016 and December 31, 2015, respectively.
During the three months ended March 31, 2016 and 2015, 93 and 27 shares, respectively, of common stock earned under the stock bonus program were issued. Stock based compensation expense related to stock bonus program was $1,035 and $764 for the three months ended March 31, 2016 and 2015, respectively.
In March 2015, the Company issued liability awards with a fair value of $6,885 , which vest annually over a three-year period and are subject to continuous service and other conditions. The liability awards will be settled with a variable number of shares of the Company's common stock. During the three months ended March 31, 2016, 45 shares were vested and issued. The Company recognized $572 and $154 of stock-based compensation expense related to these liability awards for the three months ended March 31, 2016 and 2015, respectively.
Employee Stock Purchase Plan
On March 30, 2012, the Board of Directors and the Company’s stockholders approved the 2012 Employee Stock Purchase Plan (the "ESPP"), which became effective in April 2012. A total of 745 shares of the Company's common stock were initially reserved for future issuance under the ESPP. The number of shares reserved for issuance under the ESPP will increase automatically on January 1 of each of the first eight years commencing with 2013 by the number of shares equal to 1% of the Company's shares outstanding on the immediately preceding December 31, but not to exceed 1,490 shares, unless the Board of Directors, in its discretion, determines to make a smaller increase. As of March 31, 2016 , there were 1,560 shares of the Company's common stock available for future issuance under the ESPP.
As of March 31, 2016 , the Company expects to recognize $390 of the total unamortized compensation cost related to employee purchases under the ESPP over a weighted average period of 0.1 years.
Restricted Stock
The Company granted 54 shares of restricted stock in the fourth quarter of 2014 to certain key employees with the total fair value of $2,357 and two-year cliff vesting in 2016. The Company recognized $295 of stock based compensation expense in each of the three month periods ended March 31, 2016 and 2015, respectively. As of March 31, 2016, there was $688 of unamortized stock-based compensation expense related to the unvested shares of restricted stock. The shares of restricted stock are subject to forfeiture if employment terminates prior to the lapse of the restrictions, and are expensed over the vesting period. They are considered issued and outstanding shares of the Company at the grant date and have the same rights as other shares of common stock.
8. Net Loss per Share
Basic net loss per share of common stock is calculated by dividing the net loss by the weighted-average number of shares of common stock outstanding for the period. The weighted-average number of shares of common stock used to calculate basic net loss per share of common stock excludes those shares subject to repurchase related to stock options or restricted stock that were exercised or issued prior to vesting as these shares are not deemed to be issued for accounting purposes until they vest. Diluted net loss per share of common stock is computed by dividing the net loss using the weighted-average number of shares of common stock, excluding common stock subject to repurchase, and, if dilutive, potential shares of common stock outstanding during the period. Basic and diluted net loss per common share was the same for all periods presented as the impact of all potentially dilutive securities outstanding was anti-dilutive.
The following table presents the potentially dilutive common shares outstanding that were excluded from the computation of diluted net loss per share for the periods presented because including them would have been anti-dilutive:


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As of March 31,
 
2016
 
2015
Stock options to purchase common stock
3,722

 
4,743

Restricted stock units
3,440

 
3,274

Employee stock purchase plan
81

 
90

Common stock subject to repurchase
78

 
54

Bonus and other liability awards
120

 
171

1.25% Convertible senior notes
5,158

 
5,158

0.75% Convertible senior notes
2,831

 

Total
15,430

 
13,490


9. Segment Reporting
Operating segments are reported in a manner consistent with the internal reporting supported and defined by the components of an enterprise about which separate financial information is available, provided and is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is its Chief Executive Officer. The Company’s Chief Executive Officer reviews financial information presented on a consolidated basis. The Company has one business activity, and there are no segment managers who are held accountable for operations, operating results and plans for levels or components below the consolidated unit level. Accordingly, the Company determined that it has one operating and reportable segment.
Starting January 1, 2016, the Company included privacy solutions into the "Archiving, Privacy and Governance" group. Amounts in the comparable prior period have been reclassified to conform to the current presentation. The following sets forth total revenue by solutions offered by the Company and geographic area. Revenue by geographic area is based upon the billing address of the customer:
 
Three Months Ended
March 31,
 
2016
 
2015
Total revenue by solution:
 
 
 
Protection and Advanced Threat
$
56,462

 
$
38,874

Archiving, Privacy and Governance
22,541

 
18,889

Total revenue
$
79,003

 
$
57,763


 
Three Months Ended
March 31,
 
2016
 
2015
Total revenue:
 
 
 
United States
$
65,449

 
$
47,054

Rest of world
13,554

 
10,709

Total revenue
$
79,003

 
$
57,763


Long-lived assets by geographic area are presented below:

 
As of
March 31,
 
As of
December 31,
 
2016
 
2015
Long-lived assets:
 
 
 
United States
$
32,004

 
$
29,514

Rest of world
5,969

 
4,987

Total long‑lived assets
$
37,973

 
$
34,501


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10. Income Taxes
The Company’s quarterly provision for income taxes is based on an estimated effective annual income tax rate. The Company’s quarterly provision for income taxes also includes the tax impact of certain unusual or infrequently occurring items, if any, including changes in judgment about valuation allowances and effects of changes in tax laws or rates, in the interim period in which they occur.

Income tax expense for the three months ended March 31, 2016 was $257 on a pre-tax loss of $31,399 . The Company recognized income tax expense of $162 for the three months ended March 31, 2015 on a pre-tax loss of $21,550 . The income tax rate for the three months ended March 31, 2016 and 2015 varies from the United States statutory income tax rate primarily due to valuation allowances in the United States whereby pre-tax losses and income do not result in the recognition of corresponding income tax benefits and expenses.

The Company's effective tax rate for each of the three months ended March 31, 2016 and 2015 was negative 0.8% .

The Company reviews the likelihood that it will realize the benefit of its deferred tax assets and, therefore, the need for valuation allowances, on a quarterly basis. There is no corresponding income tax benefit recognized with respect to losses incurred and no corresponding income tax expense recognized with respect to earnings generated in jurisdictions with a valuation allowance. This causes variability in the Company’s effective tax rate. The Company intends to maintain the valuation allowances until it is more likely than not that the net deferred tax assets will be realized.

As of March 31, 2016, the Company's gross uncertain tax benefits totaled $5,102 , excluding related accrued interest and penalties of $242 . As of March 31, 2016, $1,243 of the Company's uncertain tax benefits, including related accrued interest and penalties, would affect the effective tax rate if recognized. During the three months ended March 31, 2016, the Company's gross uncertain tax benefits increased $282 . The increase is comprised of a $257 increase for tax positions taken in the current period, a $29 increase for tax positions taken in prior periods, offset by a $4 decrease related to statute of limitation expirations.

The Company is not currently under audit by the IRS or any similar taxing authority in any other material jurisdiction. The Company believes it has recorded all appropriate provisions for all jurisdictions and open years. However, the Company can give no assurance that taxing authorities will not propose adjustments that would increase its tax liabilities.


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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the (1) unaudited condensed consolidated financial statements and the related notes thereto included elsewhere in this Quarterly Report on Form 10-Q, and (2) the audited consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2015 included in our 2015 Annual Report on Form 10-K. This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These statements are often identified by the use of words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “estimate,” or “continue,” and similar expressions or variations. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified herein, and those discussed in the section titled “Risk Factors”, set forth in Part II, Item 1A of this Form 10-Q and in our other SEC filings, including our 2015 Annual Report on Form 10-K. We disclaim any obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.
Overview
Proofpoint is a leading security-as-a-service ("SaaS") provider that enables large and mid-sized organizations worldwide to defend, protect, archive and govern their most sensitive data. Our SaaS platform is comprised of an integrated suite of on-demand data protection solutions, including threat protection and incident response, regulatory compliance, archiving, data governance and eDiscovery, and secure communication. Our solutions are built on a flexible, cloud-based platform and leverage a number of proprietary technologies, including big data analytics, machine learning, deep content inspection, secure storage, advanced encryption, intelligent message routing, dynamic malware analysis, threat correlation, and virtual execution environments, to address today’s rapidly changing threat landscape.

Our platform addresses this growing challenge by not only protecting data as it flows into and out of the enterprise via on-premise and cloud-based email, instant messaging, social media and other web-based applications, but also by keeping track of this information as it is modified and distributed throughout the enterprise for compliance and data loss prevention, and securely archiving these communications for compliance and discovery. We address four important problems for the enterprise:
protecting users from the advanced attacks that target them via email, social media and mobile applications;
preventing the theft or inadvertent loss of sensitive information and, in turn, ensuring compliance with regulatory data protection mandates;
collecting, retaining, governing and discovering sensitive data for compliance and litigation support; and
enabling organizations to respond quickly to security issues, providing both the intelligence and the context to prioritize incidents and orchestrate remediation actions.

Our platform and its associated solutions are sold to customers on a subscription basis and can be deployed through our unique cloud-based architecture that leverages both our global data centers as well as optional points-of-presence behind our customers’ firewalls. Our flexible deployment model enables us to deliver superior security and compliance while maintaining the favorable economics afforded by cloud computing, creating a competitive advantage for us over legacy on-premise and cloud-only offerings.

We were founded in 2002 to provide a unified solution to help enterprises address their growing data security requirements. Our first solution was commercially released in 2003 to combat the burgeoning problem of spam and viruses and their impact on corporate email systems. To address the evolving threat landscape and the adoption of communication and collaboration systems beyond corporate email and networks, we have broadened our solutions to defend against a wide range of threats, protect against outbound security risks, and archive and govern corporate information. As the threat environment has continued to evolve, we have dedicated significant resources to meet the ongoing challenges that this highly dynamic environment creates for our customers such as investing significantly to expand the breadth of our data protection platform as these expenditures are primarily in connection with the replacement and upgrade of equipment to lower the cost of deployment as well as to improve the efficiency for our cloud-based architecture.

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Our business is based on a recurring revenue model. Our customers pay a subscription fee to license the various components of our SaaS platform for a contract term that is typically one to three years. At the end of the license term, customers may renew their subscription and in each year since the launch of our first solution in 2003, we have maintained a renewal rate with our existing customers over 90% . We derive this retention rate by calculating the total annually recurring subscription revenue from customers currently using our SaaS platform and dividing it by the total annually recurring subscription revenue from both these current customers as well as all business lost through non-renewal. A growing number of our customers increase their annual subscription fees after their initial purchase by broadening their use of our platform or by adding more users, and these sales have consistently represented greater than 15% of our billings each year since 2008.

We market and sell our solutions worldwide both directly through our sales teams and indirectly through a hybrid model where our sales organization actively assists our network of distributors and resellers. We also derive a lesser portion of our total revenue from the license of our solutions to strategic partners who offer our solutions in conjunction with one or more of their own products or services.

Our solutions are designed to be implemented, configured and operated without the need for any training or professional services. We offer various trainings and professional services for those customers that seek to develop deeper expertise in the use of our solutions or would like assistance with complex configurations or the importing of data. In some cases, we provide a hardware appliance to those customers that elect to host elements of our solution behind their firewall. Increasing adoption of virtualization in the data center has led to a decline in the sales of our hardware appliances and a shift towards our software-based virtual appliances, which are delivered as a download via the Internet. Our hardware and services offerings carry lower margins and are provided as a courtesy to our customers. We expect the overall proportion of revenue derived from the hardware and services offerings to generally remain below 5% of our total revenue.

Historically, the majority of our revenue was derived from our customers in the United States. We believe the markets outside of the United States offer an opportunity for growth and we intend to make additional investments in sales and marketing to expand in these markets. Revenue from customers outside of the United States grew 27% for the three months ended March 31, 2016 as compared to the prior year period. In terms of customer concentration, there were no individual customers or partners that accounted for more than 10% of our total revenue for the three months ended March 31, 2016 .

We have not been profitable to date and will need to grow revenue at a rate faster than our investments in cost of revenue and operating expenses in order to achieve profitability, as discussed in more detail below.

Key Opportunities and Challenges
The total costs associated with the teams tasked with closing business with new customers and additional business with our existing customers have represented more than 90% of our total sales and marketing costs since 2008. Although we expect customers to be profitable over the duration of the customer relationship, the upfront costs typically exceed related revenue during the earlier periods of a contract. As a result, while our practice of invoicing our customers for the entire amount of the contract at the start of the term provides us with a relatively immediate contribution to cash flow, the revenue is recognized ratably over the term of the contract, and hence contributions toward operating income are limited in the period where the sales and marketing costs are incurred. Accordingly, an increase in the mix of new customers as a percentage of total customers would likely negatively impact our near-term operating results. On the other hand, we expect that an increase in the mix of existing customers as a percentage of total customers would positively impact our operating results over time. As we accumulate customers that continue to renew their contracts, we anticipate that our mix of existing customers will increase, contributing to a decrease in our sales and marketing costs as a percentage of total revenue and a commensurate improvement in our operating income.

As part of maintaining our SaaS platform, we provide ongoing updates and enhancements to the platform services both in terms of the software as well as the underlying hardware and data center infrastructure. These updates and enhancements are provided to our customers at no additional charge as part of the subscription fees paid for the use of our platform. While more traditional products eventually become obsolete and require replacement, we are constantly updating and maintaining our cloud-based services and as such they operate with a continuous product life cycle. Much of this work is designed to both maintain and enhance the customers' experience over time while also lowering our costs to deliver the service. Our SaaS platform is a shared infrastructure that is used by all of our customers. Accordingly, the costs of the platform are spread in a relatively uniform manner across the entire customer base and no specific infrastructure elements are directly attached to any particular customer. As such, in the event that a customer chooses to not renew its subscription, the underlying resources are reallocated either to new customers or to accommodate the expanding needs of our existing customers and, as a

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result, we do not believe that the loss of any particular customer has a meaningful impact on our gross profit as long as we continue to grow our customer base.

To date, our customers have primarily used our solutions in conjunction with email messaging content. We have developed solutions to address new and evolving messaging solutions such as social media and file sharing applications, but these solutions are relatively nascent. If customers increase their use of these new messaging solutions in the future, we anticipate that our growth in revenue associated with older email messaging solutions may slow over time. Although revenue associated with our social media and file sharing applications has not been material to date, we believe that our ability to provide security, archiving, governance and discovery for these new solutions will be viewed as valuable by our existing customers, enabling us to derive revenue from these new forms of messaging and communication.

While the majority of our current and prospective customers run their email systems on premise, we believe that there is a trend for large and mid-sized enterprises to migrate these systems to the cloud. While our current revenue derived from customers using cloud-based email systems continues to grow as a percentage of our total revenue, many of these cloud-based email solutions offer some form of threat protection and governance services, potentially mitigating the need for customers to buy these capabilities from third parties such as ourselves. We believe that we can continue to provide security, archiving, governance, and discovery solutions that are differentiated from the services offered by cloud-based email providers, and as such our platform will continue to be viewed as valuable to enterprises once they have migrated their email services to the cloud, enabling us to continue to derive revenue from this new trend toward cloud-based email deployment models.

With the majority of our business, we invoice our customers for the entire contract amount at the start of the term and these amounts are recorded as deferred revenue on our balance sheet, with the dollar weighted average duration of these contracts for any given period over the past three years typically ranging from 14 to 22 months. As a result, while our practice of invoicing customers for the entire amount of the contract at the start of the term provides us with a relatively immediate contribution to cash flow, the revenue is recognized ratably over the term of the contract, and hence contributions toward operating income are realized over an extended period. As such, our efforts to improve our profitability require us to invest far less in operating expenses than the cash flow generated by our business might otherwise allow. As we strive to invest in an effort to continue to increase the size and scale of our business, we expect that the level of investment afforded by our growth in revenue should be sufficient to fund the investments needed to drive revenue growth and broaden our product line.
    
Considering all of these factors, we do not expect to be profitable on a GAAP basis in the near term and in order to achieve profitability we will need to grow revenue at a rate faster than our investments in operating expenses and cost of revenue.

We intend to grow our revenue through acquiring new customers by investing in our sales and marketing activities. We believe that an increase in new customers in the near term will result in a larger base of renewal customers, which, over time, we expect to be more profitable for us.

Sales and marketing is our largest expense and hence a significant contributing factor to our operating losses. We believe that our opportunity to improve our return on investment on sales and marketing costs relies primarily on our ongoing ability to cost-effectively renew our business with existing customers, thereby lowering our overall sales and marketing costs as a percentage of revenue as the mix of revenue derived from this more profitable renewal activity increases over time. Therefore, we anticipate that our initial significant investments in sales and marketing activities will, over time, generate a larger base of more profitable customers. Cost of subscription revenue is also a significant expense for us, and we expect to continue to build on the improvements over the past years, such as in replacing third-party technology with our proprietary technology and improving the utilization of our fixed investments in equipment and infrastructure, in order to provide the opportunity for improved subscription gross margins over time. Although we plan to continue enhancing our solutions, we intend to lower our rate of investment in research and development as a percentage of revenue over time by deriving additional revenue from our existing platform of solutions rather than by adding entirely new categories of solutions. In addition, as personnel costs are one of the primary drivers of the increases in our operating expenses, we plan to reduce our historical rate of headcount growth over time.

Key Metrics

We regularly review a number of metrics, including the following key metrics presented in the table below, to evaluate our business, measure our performance, identify trends in our business, prepare financial projections and make strategic decisions. Many of these key metrics, such as non-GAAP gross margin, billings, adjusted EBITDA and free cash flows, are non-GAAP measures. This non-GAAP information is not necessarily comparable to non-GAAP information of other

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companies. Users of this financial information should consider the types of events and transactions for which adjustments have been made.
 
Three Months Ended
March 31,
 
2016
 
2015
 
(dollars in thousands)
Total revenue
$
79,003

 
$
57,763

Growth
37
%
 
35
%
Gross margin percentage
69
%
 
67
%
Non-GAAP gross margin (non-GAAP)
74
%
 
71
%
Billings (non-GAAP)
$
98,305

 
$
66,354

Growth
48
%
 
42
%
Adjusted EBITDA (non-GAAP)
$
1,317

 
$
1,153

Free cash flows (non-GAAP)
$
9,580

 
$
7,940

Non-GAAP gross margin
We define non-GAAP gross margin as non-GAAP gross profit divided by GAAP revenue. We define non-GAAP gross profit as GAAP gross profit, adjusted to exclude stock-based compensation expense and the amortization of intangibles associated with acquisitions. We consider this non-GAAP financial measure to be a useful metric for management and investors because it excludes the effect of stock-based compensation expense and the amortization of intangibles associated with acquisitions so that our management and investors can compare our recurring core business operating results over multiple periods. However, there are a number of limitations related to the use of non-GAAP gross margin versus gross margin calculated in accordance with GAAP. For example, stock-based compensation has been and will continue to be for the foreseeable future a significant recurring expense in our business. Stock-based compensation is an important part of our employees’ compensation and impacts their performance. In addition, the components of the costs that we exclude in our calculation of non-GAAP gross margin may differ from the components that our peer companies exclude when they report their non-GAAP results.  Management compensates for these limitations by providing specific information regarding the GAAP amounts excluded from non-GAAP gross margin and evaluating non-GAAP gross margin together with gross margin calculated in accordance with GAAP.
The following table presents the reconciliation of gross margin to Non-GAAP gross margin for the three months ended March 31, 2016 and 2015 :
 
Three Months Ended
March 31,
 
2016
 
2015
 
(in thousands)
GAAP gross profit
$
54,179

 
$
38,475

GAAP gross margin
69
%
 
67
%
Plus:
 
 
 
Stock-based compensation expense
1,991

 
1,369

Intangible amortization expense
2,117

 
1,380

Non-GAAP gross profit
$
58,287

 
$
41,224

Non-GAAP gross margin
74
%
 
71
%
Billings
We have included billings, a non‑GAAP financial measure, in this report because it is a key measure used by our management and board of directors to manage our business and monitor our near term cash flows. We define billings as total

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revenue plus change in deferred revenue during a period. We have provided a reconciliation between total revenue, the most directly comparable GAAP financial measure, and billings. Accordingly, we believe that billings provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management and board of directors.

Our use of billings as a non-GAAP measure has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for revenue or an analysis of our results as reported under GAAP. Some of these limitations are:
Billings is not a substitute for revenue, as trends in billings are not necessarily directly correlated to trends in revenue;
Billings is affected by a combination of factors including the timing of renewals, the sales of our solutions to both new and existing customers, the relative duration of contracts sold, and the relative amount of business derived from strategic partners. As each of these elements has unique characteristics in the relationship between billings and revenue, our billings activity is not necessarily closely correlated to revenue; and
Other companies, including companies in our industry, may not use billings, may calculate billings differently, or may use other financial measures to evaluate their performance ‑ all of which reduce the usefulness of billings as a comparative measure.
Our deferred revenue consists of amounts that have been invoiced but have not been recognized as revenue as of the period end. 
The following table presents the reconciliation of total revenue to billings for the three months ended March 31, 2016 and 2015 :
 
Three Months Ended
March 31,
 
2016
 
2015
 
(in thousands)
Total revenue
$
79,003

 
$
57,763

Deferred revenue
 
 
 
Ending
243,028

 
171,966

Beginning
223,726

 
162,675

Net change
19,302

 
9,291

Less: deferred revenue contributed by acquisitions

 
(700
)
Billings
$
98,305

 
$
66,354

Adjusted EBITDA
We define adjusted EBITDA as net loss, adjusted to exclude: depreciation, amortization of intangibles, interest (income) expense, net, provision for (benefit from) income taxes, stock-based compensation, acquisition- and litigation-related expenses, other (income) expense, net. We believe that adjusted EBITDA is useful to investors and other users of our financial statements in evaluating our operating performance because it provides them with an additional tool to compare business performance across companies and across periods. We believe that:

Adjusted EBITDA provides investors and other users of our financial information consistency and comparability with our past financial performance, facilitates period-to-period comparisons of operations and facilitates comparisons with our peer companies, many of which use similar non-GAAP financial measures to supplement their GAAP results; and
It is useful to exclude certain non-cash charges, such as depreciation, amortization of intangible assets and stock-based compensation and non-core operational charges, such as acquisition- and litigation-related expenses, from

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adjusted EBITDA because the amount of such expenses in any specific period may not be directly correlated to the underlying performance of our business operations and these expenses can vary significantly between periods as a result of new acquisitions, full amortization of previously acquired tangible and intangible assets or the timing of new stock‑based awards, as the case may be.
We use adjusted EBITDA in conjunction with traditional GAAP operating performance measures as part of our overall assessment of our performance, for planning purposes, including the preparation of our annual operating budget, to evaluate the effectiveness of our business strategies and to communicate with our board of directors concerning our financial performance.
We do not place undue reliance on adjusted EBITDA as our only measure of operating performance. Adjusted EBITDA should not be considered as a substitute for other measures of financial performance reported in accordance with GAAP. There are limitations to using non-GAAP financial measures, including that other companies may calculate these measures differently than we do, that they do not reflect our capital expenditures or future requirements for capital expenditures and that they do not reflect changes in, or cash requirements for, our working capital.
The following table presents the reconciliation of net loss to adjusted EBITDA for the three months ended March 31, 2016 and 2015 :
 
Three Months Ended
March 31,
 
2016
 
2015
 
(in thousands)
Net loss
$
(31,656
)
 
$
(21,712
)
Depreciation
3,831

 
2,757

Amortization of intangible assets
3,405

 
2,707

Interest expense
5,800

 
2,853

Provision for income taxes
257

 
162

EBITDA
(18,363
)
 
(13,233
)
Stock-based compensation expense
18,483

 
12,426

Acquisition-related expense
4

 
247

Litigation-related expense
1,195

 
533

Other (income) expense, net
(2
)
 
1,180

Adjusted EBITDA
$
1,317

 
$
1,153

Free cash flows
We define free cash flow as net cash provided by operating activities minus capital expenditures. We consider free cash flow to be a liquidity measure that provides useful information to management and investors about the amount of cash generated by the business that, after the acquisition of property and equipment, can be used for strategic opportunities, including investing in our business, making strategic acquisitions, and strengthening the balance sheet. Analysis of free cash flow facilitates management’s comparisons of our operating results to competitors’ operating results. A limitation of using free cash flow versus the GAAP measure of net cash provided by operating activities as a means for evaluating our company is that free cash flow does not represent the total increase or decrease in the cash balance from operations for the period because it excludes cash used for capital expenditures during the period. Management compensates for this limitation by providing information about our capital expenditures on the face of the cash flow statement and in the "Liquidity and Capital Resources" section below.

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Three Months Ended
March 31,
 
2016
 
2015
 
(in thousands)
GAAP cash flows provided by operating activities:
$
17,418

 
$
12,524

Less:
 
 
 
Purchases of property and equipment
(7,838
)
 
(4,584
)
Non-GAAP free cash flows
$
9,580

 
$
7,940


Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations is based upon our accompanying Condensed Consolidated Financial Statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates, assumptions and judgments that can have significant impact on the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. We base our estimates, assumptions and judgments on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. On a regular basis we evaluate our estimates, assumptions and judgments and make changes accordingly.
We believe that the estimates, assumptions and judgments involved in revenue recognition, deferred commissions, stock-based compensation expense, fair value of assets acquired and liabilities assumed in business combinations, impairment assessment of goodwill, intangible assets and other long-lived assets, loss contingency, and recognition and measurement of current and deferred income taxes have the greatest potential impact on our accompanying Condensed Consolidated Financial Statements, and consider these to be our critical accounting estimates. Historically, our estimates, assumptions and judgments relative to our critical accounting policies have not differed materially from actual results. The critical accounting estimates associated with these policies are described in our 2015 Annual Report on Form 10-K, under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” There have been no material changes to our significant accounting policies, except for commissions accounting (see below and Note 1 to the accompanying Condensed Consolidated Financial Statements), as compared to the significant accounting policies described in our 2015 Annual Report on Form 10-K for the year ended December 31, 2015.
Deferred Commissions
Deferred commissions are the direct and incremental selling costs that are associated with our customer contracts and consist of sales commissions paid to our direct sales force and referral fees paid to independent third-parties. The commissions are amortized to sales and marketing expense over the non-cancelable terms of the related contracts with our customers. The commission payments, which are paid in full the month after the customer's service commences, are a direct and incremental cost of the revenue arrangements. The deferred commission amounts are recoverable through the future revenue streams under the non-cancelable customer contracts. We believe this is the preferable method of accounting as the commission charges are so closely related to the revenue from the non-cancelable customer contracts that they should be recorded as an asset and charged to expense over the same period that the subscription revenue is recognized. The adoption of this accounting policy change has been applied retrospectively to all periods presented in this Quarterly Report on Form 10-Q, in which the cumulative effect of the change has been reflected as of the beginning of the first period presented. See Note 1 to the accompanying Condensed Financial Statements.
Components of Our Results of Operations
Revenue
We derive our revenue primarily through the license of various solutions and services on our security-as-a-service platform on a subscription basis, supplemented by the sales of training, professional services and hardware depending upon our customers' requirements.

Subscription. We license our platform and its associated solutions and services on a subscription basis. The fees are charged on a per user, per year basis. Subscriptions are typically one to three years in duration. We invoice our customers upon signing for the

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entire term of the contract. The invoiced amounts billed in advance are treated as deferred revenue on the balance sheet and are recognized ratably, in accordance with the appropriate revenue recognition guidelines, over the term of the contract. We also derive a portion of our subscription revenue from the license of our solutions to strategic partners. We bill these strategic partners monthly. We expect our subscription revenue will continue to grow and remain above 95% of our total revenue.

Hardware and services.     We provide hardware appliances as a convenience to our customers and as such it represents a small part of our business. Our solutions are designed to be implemented, configured and operated without the need for any training or professional services. For those customers that seek to develop deeper expertise in the use of our solutions or would like assistance with complex configurations or the importing of data, we offer various training and professional services. We typically invoice the customer for hardware at the time of shipment. We typically invoice customers for services at the time the order is placed and recognize this revenue ratably over the term of the contract. On occasion, customers may retain us for special projects such as archiving import and export services; these types of services are recognized upon completion of the project. We expect the overall proportion of revenue derived from hardware and service offerings to generally remain below 5% of our total revenue.

Cost of Revenue
Our cost of revenues consists of cost of subscription revenue and cost of hardware and services revenue. Personnel costs, which consist of salaries, benefits, bonuses, stock-based compensation, data center costs and hardware costs are the most significant components of our cost of revenues. We expect personnel costs to continue to increase in absolute dollars as we hire new employees to continue to grow our business.

Cost of Subscription Revenue. Cost of subscription revenue primarily includes personnel costs, consisting of salaries, benefits, bonuses, and stock-based compensation, for employees who provide support services to our customers and operate our data centers. Other costs include fees paid to contractors who supplement our support and data center personnel; expenses related to the use of third-party data centers in both the United States and internationally; depreciation of data center equipment; amortization of licensing fees and royalties paid for the use of third-party technology; amortization of internally developed intangible assets; and the amortization of intangible assets acquired through business combinations. Growth in subscription revenue generally consumes production resources, requiring us to gradually increase our cost of subscription revenue in absolute dollars as we expand our investment in data center equipment, the third-party data center space required to house this equipment, and the personnel needed to manage this higher level of activity.

Cost of Hardware and Services Revenue. Cost of hardware and services revenue includes personnel costs for employees who provide training and professional services to our customers as well as the cost of server hardware shipped to our customers that we procure from third parties and configure with our software solutions.

Operating Expenses
Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. Personnel costs, which consist of salaries, benefits, bonuses, and stock-based compensation, are the most significant component of our operating expenses. We expect personnel costs to continue to increase in absolute dollars as we hire new employees to continue to grow our business. Our headcount has increased 40% from December 31, 2014 to December 31, 2015. As a result of this growth in headcount, operating expenses have increased significantly over these periods. We expect personnel costs to continue to increase in absolute dollars as we hire new employees to continue to grow our business.

Research and Development. Research and development expenses include personnel costs, consulting services and depreciation. We believe that these investments have played an important role in broadening the capabilities of our platform over the course of our operating history, enhancing the relevance of our solutions in the market in general and helping us to retain our customers over time. We expect to continue to devote substantial resources to research and development in an effort to continuously improve our existing solutions as well as to develop new offerings. We believe that these investments are necessary to maintain and improve our competitive position. However, over the longer term, we intend to monitor these costs so as to decrease this spending as a percentage of total revenue. Our research efforts include both software developed for our internal use on behalf of our customers as well as software elements to be used by our customers in their own facilities. To date, our capitalized costs on software developed for internal use on behalf of our customers were not material. For the software developed for use on our customers’ premises, the costs associated with the development work between technological feasibility and the general availability has not been material and as such we have not capitalized any of these development costs to date.


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Sales and Marketing. Sales and marketing expenses include personnel costs, sales commissions, and other costs including travel and entertainment, marketing and promotional events, public relations and marketing activities. These costs also include amortization of intangible assets as a result of our past acquisitions. Due to our continued investment in growing our sales and marketing operations, both domestically and internationally, headcount increases were reflected in higher compensation expense consistent with our revenue growth. Our sales personnel are typically not immediately productive, and therefore the increase in sales and marketing expenses we incur when we add new sales representatives is not immediately offset by increased revenue and may not result in increased revenue over the long-term if these new sales people fail to become productive. The timing of our hiring of new sales personnel and the rate at which they generate incremental revenue will affect our future financial performance. We expect that sales and marketing expenses will continue to increase in absolute dollars and be among the most significant components of our operating expenses.

General and Administrative. General and administrative expenses consist of personnel costs, consulting services, audit fees, tax services, legal expenses and other general corporate items. As a result of our operational growth, we expect our general and administrative expenses to increase in absolute dollars in future periods as we continue to expand our operations and hire additional personnel.

Interest expense
Interest expense consists of interest income earned on our cash, cash equivalents and short-term investments, the interest expense related to our convertible senior notes and our capital lease payments.

Other Income (Expense), Net
Other income (expense), net, consists primarily of the net effect of foreign currency transaction gains and losses.

(Provision for) Benefit from Income Taxes
For 2013 and prior years, the (provision for) benefit from income taxes was related to state and foreign income taxes. As we have incurred operating losses in all periods to date and recorded a full valuation allowance against our deferred tax assets, we have not historically recorded a provision for federal income taxes. However, in 2015 we recognized $0.1 million deferred tax expense, and in 2014 we recognized a $0.8 million deferred tax benefit related to the release of U.S. valuation allowances as a result of business acquisitions. Realization of any of our deferred tax assets depends upon future earnings, the timing and amount of which are uncertain.  Utilization of our net operating losses and research and development credits may be subject to substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. Analyses have been conducted to determine whether an ownership change had occurred since inception. The analyses have indicated that although ownership changes have occurred in prior years, the net operating losses and research and development credits would not expire before utilization as a result of the ownership change. In the event we have subsequent changes in ownership, net operating losses and research and development credit carryovers could be limited and may expire unutilized as a result of the subsequent ownership change.

Results of Operations
The following table is a summary of our consolidated statements of operations and results of operations as a percentage of our total revenue for those periods.

34


 
Three Months Ended
March 31,
 
2016
 
2015
 
Amount
 
% of revenue
 
Amount
 
% of revenue
 
($ in thousands)
Revenue:
 
 
 
 
 
 
 
Subscription
$
77,397

 
98
 %
 
$
55,856

 
97
 %
Hardware and services
1,606

 
2

 
1,907

 
3

Total revenue
79,003

 
100

 
57,763

 
100

Cost of revenue:
 
 
 
 
 
 
 
Subscription
21,682

 
27

 
16,334

 
28

Hardware and services
3,142

 
4

 
2,954

 
5

Total cost of revenue
24,824

 
31

 
19,288

 
33

Gross profit
54,179

 
69

 
38,475

 
67

Operating expense:
 
 
 
 
 
 
 
Research and development
22,653

 
29

 
15,708

 
27

Sales and marketing
46,523

 
59

 
32,951

 
57

General and administrative
10,604

 
13

 
7,333

 
13

Total operating expense
79,780

 
101

 
55,992

 
97

Operating loss
(25,601
)
 
(32
)
 
(17,517
)
 
(30
)
Interest expense
(5,800
)
 
(8
)
 
(2,853
)
 
(5
)
Other income expense, net
2

 

 
(1,180
)
 
(2
)
Loss before provision for income taxes
(31,399
)
 
(40
)
 
(21,550
)
 
(37
)
Provision for income taxes
(257
)
 

 
(162
)
 

Net loss
$
(31,656
)
 
(40
)%
 
$
(21,712
)
 
(37
)%

Comparison of the three months ended March 31, 2016 and 2015 :
Revenue
 
Three Months Ended
March 31,
 
2016
 
2015
 
% Change
 
(in thousands)
 
 
Revenue
 
 
 
 
 
Subscription
$
77,397

 
$
55,856

 
39
 %
Hardware and services
1,606

 
1,907

 
(16
)
Total revenue
$
79,003

 
$
57,763

 
37
 %
Subscription revenue for the three months ended March 31, 2016 increased $21.5 million , or 39% , as compared to the corresponding period last year, primarily due to an $18.3 million increase in subscription revenue contributed from the United States market. To a lesser extent, for the same period, there was an increase of $3.2 million in revenue contributed from international locations. The increases were due to improved demand for our platform worldwide due to a shift in the overall threat landscape, the growth of business-to-business collaboration as well as the consumerization of IT which led to the increase in demand for data protection and governance solutions. Additionally, the revenue released from acquired deferred revenue

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related to historical acquisitions made was $0.9 million and $1.3 million for the three months ended March 31, 2016 and 2015, respectively.
Hardware and services revenue for the three months ended March 31, 2016 decreased $0.3 million , or 16% , as compared to the corresponding period last year due to lower revenue from hardware units sold due to product mix.
Cost of Revenue
 
Three Months Ended
March 31,
 
2016
 
2015
 
% Change
 
(in thousands)
 
 
Cost of revenue
 
 
 
 
 
Subscription
$
21,682

 
$
16,334

 
33
%
Hardware and services
3,142

 
2,954

 
6

Total cost of revenue
$
24,824

 
$
19,288

 
29
%
Cost of subscription revenue for the three months ended March 31, 2016 increased  $5.3 million , or  33% , as compared to the corresponding period last year, primarily due to an increase in operations-related expense of $3.1 million, due to increased headcount, depreciation expense as a result of higher capital expenditures to support our growth, and intangible amortization expense of developed technology from the acquisitions. Additionally, support-related expenses increased $1.1 million primarily due to higher headcount and consulting costs. Data center costs increased $1.1 million primarily due to subscription revenue growth in our cloud-based solutions.

Cost of hardware and services revenue for the three months ended March 31, 2016 increased $0.2 million , or 6% , as compared to the corresponding period last year, which was insignificant.
    

Operating Expenses
 
Three Months Ended
March 31,
 
2016
 
2015
 
% Change
 
(in thousands)
 
 
Research and development
$
22,653

 
$
15,708

 
44
%
Percent of total revenue
29
%
 
27
%
 
 
Research and development expenses increased $6.9 million , or 44% , for the three months ended March 31, 2016, as compared to the corresponding period last year, primarily due to personnel-related cost increase of $5.2 million from higher headcount. Additionally, corporate and facilities expense increased $0.5 million primarily due to expanded operations. Consulting costs increased $1.2 million due to expansion in outsourced services.
  
 
Three Months Ended
March 31,
 
2016
 
2015
 
% Change
 
(in thousands)
 
 
Sales and marketing
$
46,523

 
$
32,951

 
41
%
Percent of total revenue
59
%
 
57
%
 
 
    

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Table of Contents

Sales and marketing expenses increased $13.6 million , or 41% for the three months ended March 31, 2016, as compared to the corresponding period last year. The increase in headcount on a worldwide basis resulted in increased personnel-related and commissions expenses of $12.7 million, which included increases in stock-based compensation expense of $1.9 million. Corporate and facilities expenses increased $0.9 million due to higher headcount. Marketing expenses related to trade shows and traveling increased $1.2 million due to the increase in headcount and timing of the marketing events. The increase was offset by the $1.3 million decrease in lead generation and outside services.
 
 
Three Months Ended
March 31,
 
2016
 
2015
 
% Change
 
(in thousands)
 
 
General and administrative
$
10,604

 
$
7,333

 
45
%
Percent of total revenue
13
%
 
13
%
 
 
General and administrative expenses increased $3.3 million , or 45% for the three months ended March 31, 2016, as compared to the corresponding period last year. The increase was primarily due to an increase in personnel costs of $2.5 million and corporate expense of $0.3 million from higher headcount. Additionally, litigation expense increased $0.7 million due to ongoing litigation with Finjan. The increase was offset by $0.2 million decrease in acquisition expenses as there were no business acquisitions during the three months ended March 31, 2016.     

Interest Expense
 
Three Months Ended
March 31,
 
2016
 
2015
 
% Change
 
(in thousands)
 
 
Interest expense
$
(5,800
)
 
$
(2,853
)
 
(103
%)
The change in interest expense was due to accretion and coupon expense additions of $3.3 million for the three months ended March 31, 2016, due to the issuance of the 0.75% Notes in June 2015 (see Note 6 to the accompanying Condensed Consolidated Financial Statements). The increase was offset by $0.3 million increase in interest income from our cash equivalents and short-term investments.

Other Income (Expense), Net
 
Three Months Ended
March 31,
 
2016
 
2015
 
% Change
 
(in thousands)
 
 
Other income (expense), net
$
2

 
$
(1,180
)
 
100
%
Other income (expense), increased $1.2 million for the three months ended March 31, 2016, as compared to the corresponding period last year, primarily due to fluctuations in foreign currency exchange rates.

Provision for Income Taxes


37


 
Three Months Ended
March 31,
 
2016
 
2015
 
% Change
 
(in thousands)
 
 
Provision for income taxes
$
(257
)
 
$