UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 20122014

OR

For the transition period from                      to                     

Commission file number: 000-27687

BSQUARE CORPORATION

(Exact name of registrant as specified in its charter)

110 110^th Avenue NE, Suite 200,300, Bellevue, Washington 98004

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code: (425) 519-5900

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

NONE

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act.    Yes  ¨    No  x

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

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  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x¨

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

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

The aggregate market value of common stock held by non-affiliates of the registrant as of June 30, 20122014 was approximately $26,000,000$35,049,000 based on the closing price of $2.99$3.20 per share of the registrant’s common stock as listed on the NASDAQ Global Select Market.

The number of shares of common stock outstanding as of January 31, 2013: 11,104,9852015: 11,769,452

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive proxy statement to be delivered to shareholders in connection with the 20132015 annual meeting of shareholders are incorporated by reference into Part III of this Annual Report on Form 10-K.

BSQUARE CORPORATION

FORM 10-K

TABLE OF CONTENTS

PART I

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K including any information incorporated by reference, contains forward-looking statements"forward-looking statements" within the meaning of Section 27Athe safe-harbor provisions of the U.S. Private Securities Litigation Reform Act of 1933,1995. Forward-looking statements can often be identified by words such as: "expect," "believe," "estimate," "plan," "strategy," "future," "potential," "continue," "may," "should," "will," and similar references to future periods. Examples include, among others, statements about: expected operating results, such as amended, (the “Securities Act”),revenue growth and Section 21Eearnings; anticipated levels of capital expenditures; future market conditions; our belief that we have sufficient liquidity to fund our business operations for at least the next 12 months; expectations of the Securities Exchange Acteffect on our financial condition of 1934, as amended, (the “Exchange Act”). In some cases, you can identify forward-lookingclaims, litigation, contingent liabilities and supplier audits; and strategies for customer retention, growth, product and service development, and market position.

Forward-looking statements by terms such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “forecast,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue,” or the negative of these terms or other comparable terminology, which when used are meant to signify the statement as forward-looking. These forward-looking statements include, butneither historical facts nor assurances about future performance. Instead they are not limited to, statements about our plans, objectives,only predictions, based on current beliefs, expectations and intentionsassumptions about the future of our business and other statements that are not historical facts. These forward-lookingfuture conditions. Forward-looking statements are not guarantees of future performance and involvesubject to known and unknown risks, uncertainties and situationschanges in circumstances that are difficult to predict and that may causemany of which are outside of our own, or our industry’s, actual results to be materially different from the future results that are expressed or implied by these statements. Accordingly, actualcontrol. Actual events and results may differ materially from those anticipated or expressedmaterially. Therefore, you should not rely on any of these forward-looking statements.

Any forward-looking statement made by us in such statements as a result of a variety of factors, including those set forth under Item 1A, “Risk Factors.” Such forward-looking statements include, but are not limitedthis report is based only on information available to statements with respect to the following:

Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date made.of this report. Except as may be required by law, we undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future eventsdevelopments or otherwise. Readers, however, should carefully review the

Our forward-looking statements can be affected by inaccurate assumptions we might make or by known or unknown risks, uncertainties and other factors. We discuss many of these risks, uncertainties and other factors set forth in this Annual Report on Form 10-K in greater detail under the Item 1A—“Risk Factors.” We caution readers that our business and other reports or documents that we file from timefinancial performance are subject to time with the Securitiessubstantial risks and Exchange Commission (“SEC”).uncertainties.

BUSINESS

Overview

As used in this Annual Report on Form 10-K, “we,” “us”, “our”, “the Company” and “the Company”“Bsquare” refer to BSQUARE Corporation. We primarily resell software from Microsoft Corporation (“Microsoft”) and provide software solutions and related engineering services to companies that develop smart, connected systems. A smart, connected system is a dedicated purpose computing device that typically has a display, runs an operating system (e.g., Microsoft^® Windows^® CE or Google Android)Android^TM platform) and is usually connected to a network or data cloud via a

wired or wireless connection. Examples of smart, connected systems include set-top boxes, home gateways, point-of-sale terminals, kiosks, voting machines, gaming platforms, tablets, handheld data collection devices, personal media players, smart phones, smart vending machines and in-vehicle telematics and entertainment devices. We focus on smart, connected systems that utilize various Microsoft Windows Embedded and Windows Mobile operating systems specifically Windows Embedded Compact, Windows Embedded Standard 7 and 8, Windows Mobile™, Windows Phone 8 and Windows Embedded 8 Handheld as well as devices running other popular operating systems such as Android, Linux, and QNX.

We have been providing software solutions to thefor smart, connected systems marketplace since our inception. Our customers include world class original equipment manufacturers (“OEMs”), original design manufacturers (“ODMs”) and corporate enterprises (“Enterprises”), as well as silicon vendors (“SVs”) and peripheral vendors which purchase our software solutions for purposes of facilitating processor and peripheral sales to the aforementioned customer categories.sales. In the case of enterprises,Enterprises, our customers include those whichthat develop, market and distribute smart, devicesconnected systems on their own behalf as well as those that purchase devicessystems from OEMs or ODMs and require additional device software, integration and/or testing. The software solutions we provide are utilized and deployed throughout various phases of our customers’ device life cycle, including design, development, customization, quality assurance and deployment.

Increasingly, we intend to focus on developing and offering our own products such as DataV^TM to address the emerging Internet of Things (“IoT”) market, which is the interconnection of uniquely identifiable embedded computing devices within the existing internet infrastructure. Similarly, we intend to focus on increasing the amount of our own products and know-how, including in our MobileV^TM product, a complete hardware and software reference solution for OEMs building durable and rugged handhelds and industrial tablets.

We were incorporated in the State of Washington in July 1994. Our principal office is located at 110 110th Avenue NE, Suite 200,300, Bellevue, Washington 98004, and our telephone number is (425) 519-5900.

Industry Background

The increasing opportunity for connectivity and exchange of data coupled with the rise of cloud storage and cloud computing infrastructure is driving new applications for smart, connected systems of all kinds.

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The smart, connected systems industry is characterized by a wide variety of software and hardware configurations and end-user applications, often designed to address a specific vertical market. To accommodate these diverse characteristics in a cost-effective manner, OEMs, ODMs and ODMsEnterprises require operating systems and software that can support a diverse set of hardware requirements and connect to a wide variety of networks, systems, peripherals, content and applications.

The smart, connected systems marketplace is being influenced by the following factors:

Software Solutions and Related Engineering Services for Smart Device MakersConnected Systems

Our customers include world class OEMs and ODMs, enterprises, mobile network operators,Enterprises, SVs and peripheral vendors which are developing smart devicesconnected systems or assisting others in doing so. Representative customer engagements in 20122014 included the following:

The software we deliver to our customers as part of our smart deviceconnected software solutions takes three forms. The first is our own proprietary software products, the second is best-of-class third-party software products and the last is custom software delivered through our engineering services teams. The majority of the software we sell is from Microsoft. Due to the complexity of embedded software, the integration of our own proprietary software, and/or third-party software products and customer software on customers’ devices often requires us to provide additional engineering services addressing systems integration, customization and/or optimization as well as quality assurance testing. Our goal is to increase the breadth and depth of our software product and engineering service offerings to smart deviceour customers to enhance our position as an overall smart deviceconnected software solutions provider.

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Software revenue for the last two fiscal years was as follows (in thousands):

Third-Party Software Products

We have distribution agreements with multiple third-party software vendors. Our ability to resell these third-party software products, whether stand-alone or in conjunction with our own proprietary software and engineering service offerings, provides our customers with a significant solution source for their project needs. Our primary third-party software offerings include the following:

The sale of Microsoft operating systems has accounted for substantially all of our third-party software revenue historically, including 95% of third-party software revenue in 2014 and 90% of third-party software revenue in 2013.

Engineering Service Offerings

We offer a variety of engineering services to our customers including:

Customers engage us for engineering services due to our extensive device software development and testing experience and because of our deep experience with embedded and mobile operating systems. We believe that engaging us on a new device design

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typically results in shorter development cycles and reduced time-to-market, lower overall costs to complete projects, and enhanced product robustness and features, which a customer may otherwise have been unable to achieve.

Service revenue for the last two fiscal years was as follows (in thousands):

Service revenue related to Coca-Cola was $4.6 million, or 24% of 2014 service revenue and $3.2 million, or 17% or service revenue in 2013. Service revenue related to the MyFord Touch program was $2.8 million, or 14% of service revenue, in 2014 and $4.5 million, or 24% of service revenue, in 2013.

Proprietary Software Products

Our primary proprietary software offerings being actively sold or developed include:

·

HTML5 Rendering Engine—Our award-winning HTML5 Rendering Engine is based on the open-source WebKit platform which is maintained by a number of leading internet and device companies. Using WebKit, device makers can create portable applications and user interfaces for their devices using the industry-standard HTML5 markup language. We ported WebKit to the latest versions of Microsoft’s Windows Embedded Compact Operating System and sell our porting layer to customers along with engineering services to implement our WebKit port on their devices;

Third-Party Software Products

We have license and distribution agreements with multiple third-party software vendors. Our ability to resell these third-party software products, whether stand-alone or in conjunction with our own proprietary software and engineering service offerings, provides our customers with a significant solution source for their smart device project needs. Our primary third-party software offerings include the following:

Software revenue for the last two fiscal years was as follows (in thousands):

The sale of Microsoft operating systems has accounted for substantially all of our third-party software revenue historically, including 94% of third-party software revenue in 2012 and 93% of third-party software revenue in 2011.

Engineering Service Offerings

We offer a variety of engineering services to our customers including:

Customers utilize our engineering services due to our extensive device software development and testing experience and because of our deep experience with embedded and mobile operating systems. We believe that engaging us on a new device design typically results in shorter development cycles and reduced time-to-market, lower overall costs to complete projects, and enhanced product robustness and features, which a customer may have been unable to achieve through other means.

Service revenue for the last two fiscal years was as follows (in thousands):

Service revenue related to the MyFord Touch program was $6.4 million, or 25% of service revenue, in 2012 and $9.7 million, or 34% of service revenue, in 2011.

Strategy

Our strategy is to continue to enhance our position as a leading provider of device software solutions and related engineering services for smart connected systems, ultimately becoming the go-to solutions provider for our customers and potential customers around the globe. To advance this strategy, we intend to continue to focus on the following areas:following:

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Relationship with Microsoft and Impact on our Smart DeviceConnected Solutions Business

We have a long-standing relationship with Microsoft and this relationship is critical to the continuing success of our business. Our credentials as a Microsoft partner include:

We work closely with Microsoft executives, developers, product managers and sales personnel. We leverage these relationships in a variety of ways, including:

See Item 1A, “Risk Factors,” for more information regarding our relationship with Microsoft.

Customers

Customers ofpurchasing third-party software and our software solutions and engineering services include leading OEMs, ODMs, Enterprises, SVs and peripheral vendors and other enterprises seeking to leverage the software we provide them, be it our own proprietary software, third-party software or custom software developed via our engineering services, to develop high-quality, full-featured smart devicesconnected systems that meet the requirements of numerous end-markets. Representative customers include Ford, Coca-Cola, Qualcomm Inc., TycoFuture Electronics, Ltd.,Elo Touch Solutions, Honeywell International, Inc., Canon, Inc.,IGT, Microsoft, Motorola Solutions,Mitsubishi Electric Corporation, Panasonic, Elektrobit, Bally and Research In Motion Ltd.several industrial handset companies.

The MyFord Touch program, under which we provided services to Ford in 2011 and Microsoft in 2012, accounted for $6.4 million, or 6% of total revenue, in 2012, and $9.7 million, or 10% of total revenue, in 2011. No other customer accounted for 10% or more of total revenue in 2011 and there were no customers that accounted for more than 10% of total revenue in 2012. Revenue generated from the MyFord Touch program has been declining primarily due to completion of the main MyFord Touch project in August 2011 and a resulting decline in the number of our resources working on the program.

Sales and Marketing

We market our software solutions and engineering services predominantly utilizing a direct sales model. We have sales personnel throughout the United States and in various countries in AsiaTaiwan, the United Kingdom and Europe.Japan. Historically, we have not made significant use of resellers, channel partners, representative agents or other indirect channels.

Key elements of our sales and marketing strategy include direct marketing, content marketing, trade shows, event marketing, public relations, analyst relations, social media properties, customer and strategic alliance partner co-marketing programs and a comprehensive website. We rely significantly on lead referral and other marketing support programs from strategic partners.

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Research and Development

Our research and development personnel are responsible for the design, development and release of our proprietary software products. Members of our research and development staff work closely with our sales and marketing departments, as well as with our customers and potential customers, to better understand market needs and requirements. We perform our research and development primarily utilizing engineering staff located in and outside the United States. Research and development expense was $3.6$1.7 million and $3.8$2.8 million in 20122014 and 2011,2013, respectively.

Competition

The market for devicesmart connected systems software and services is extremely competitive. We face competition from the following:

Some of our competitors focus on only one aspect of our business or offer complementary products which can be integrated with our products. As we develop and bring to market new software products and service offerings, particularly offerings focused on specific industries and/or focused on devices utilizing non-Microsoft Windows Embedded operating systems, we may begin competing with companies with which we have not previously competed. Further, as we expand the geographic markets into which we sell our software solutions and related services, or increase our penetration therein, we may expect to increasingly compete with companies with which we have not previously competed. It is also possible that new competitors will enter the market or that our competitors will form alliances, including alliances with Microsoft, that may enable them to rapidly increase their market share.

Microsoft has not agreed to any exclusive arrangement with us, nor has it agreed not to compete with us. Microsoft may decide to bring more of the core embedded development services and expertise that we provide in-house, possibly resulting in reduced software and service revenue opportunities for us. The barrier to entering the market as a provider of Microsoft-based smart deviceconnected systems software and services is low. In addition, Microsoft has created marketing programs to encourage systems integrators to work on Windows Embedded and Windows Mobile operating system software and services. These systems integrators are given substantially the same access by Microsoft to the Microsoft technology as we are. New competitors may have lower overhead than we do and may be able to undercut our pricing. We expect that competition will increase as other established and emerging companies enter the connected device market, and as new products and technologies are introduced.

International Operations

Our international operations outside of North America consistedconsist principally of operations in Taipei, Taiwan Beijing China and Trowbridge, England. Our presence in Trowbridge England resulted from the acquisition of MPC Data Limited in September 2011.

We have minora sales and sales support presencesoffice in other countries in Asia and Europe as well.

Tokyo, Japan. Because our OEM Distribution Agreement with Microsoft for the sale of Microsoft Windows Embedded operating systems (e.g. Windows Embedded Compact) has been, until relatively recently, restricted to North America, including Mexico, the majority of our revenue continues to be generated from North America. In 2012,2014, revenue generated from customers located outside of North America was 29%10% of total revenue, compared to 23%

13% in 2011.2013. The increasedecrease in non-North American revenue in 20122014 was primarily attributable to higher service revenue in Europe driven by the September 2011 acquisitionlower sales of MPC as well as an increase inWindows Mobile operating systems, lower service revenue and third partylower proprietary software sales in Asia.

See Item 1A, “Risk Factors,” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for more information regarding our international operations.

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Personnel

The following highlightsindicates the total number of employeesheadcount by area:

As of December 31, 2012, we were also utilizing the services of 19 contractors, primarily for engineering services, compared to 46 at December 31, 2011. Of the total headcount of 260197 at December 31, 2012, 1452014, 112 were located in North America, 47 were located in Taiwan, 42 were located36 in the United Kingdom and 19 were located2 in China with the remainder located in other countries in Asia and Europe.Japan. As conditions necessitate, engineering service employees perform research and development activities and vice versa. WeIn October 2013, we effected three headcount reductions during 2012 necessitated by business conditions. The first occurred in the first quarter and primarily affected sales and engineering services. The second occurred in the third quarter and affected research and product development and the last occurred in the fourth quarter and primarily affected sales and engineering services. The fourth quartera headcount reduction was the largestthat impacted approximately 20% of the three, impacting 20 full-time personnel in total.our worldwide workforce.

Intellectual Property and Other Proprietary Rights

In general, we attemptstrive to protect our intellectual property rights through patent, copyright, trademark and trade secret laws and through contractual arrangements. However, we cannot be certain that our efforts will be effective to prevent the misappropriation of our intellectual property, or to prevent the development and design by others of products or technologies similar to, or competitive with, those developed by us.

Additionally, because a significant portion of our revenue relates to the sale of third-party software products, we also rely on our partners, particularly Microsoft, to appropriately protect their own intellectual property.

We currentlyAs of December 31, 2014 we have eight issued United States (“US”) patents and one pending US patent in the United States, and weapplication. We also have a number of registered trademarks in various jurisdictions. We will continue to pursue appropriate protections for our intellectual property.

See Item 1A, “Risk Factors,” for more information regarding our intellectual property and other proprietary rights.

Available Information

We are a reporting company and file annual, quarterly and current reports and other information with the SEC. You may read and copy any materials weelectronically file with the SEC at the SEC’s Public Reference Room at

100 F Street, NE, Washington, DC 20549. You also may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxySecurities and information statements, and other information we file electronically with the SEC athttp://www.sec.gov.

Our Internet website is located at www.bsquare.com. We make available, free of charge, through the investor relations section of our website, under “SEC Filings,” all our filings, includingExchange Commission (“SEC”) our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. We make available on our website at www.bsquare.com, free of charge, copies of these reports, as soon as reasonably practicable after electronically filing such material is filedreports with, or furnishedfurnishing them to, the SEC.Securities and Exchange Commission. The information contained in, or that can be accessed through, our website is not part of, and is not incorporated into, this Annual Report on Form 10-K.

Directors and Executive Officers of the Registrant

The following table sets forth certain information with respect to our directors and executive officers as of January 31, 2013:2015:

As discussed under Item 1 of Part I, “Business—Cautionary Note Regarding Forward-Looking Statements,” our actual results could differ materially from those expressed in our forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed below. Additional risks and uncertainties not presently known to us, or that

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we currently deem immaterial, may also impair our business operations. If any of the following risks occur, our business, financial condition, operating results, cash flows and the trading price of our common stock could be materially adversely affected.

Microsoft-Related Risk Factors

Due to the fact that we have historically providedprovide software and services to customers building devices utilizing Microsoft’s Windows Embedded and Windows Mobile operating systems, as well as the fact that a significant portion of our revenue is derived from the sale of Microsoft Windows Embedded and Windows Mobile operating systems, Microsoft has a significant direct and indirect influence on our business. The following Microsoft-related risk factors may negatively impact our business and operating results.

If we do not maintain our OEM Distribution Agreements with Microsoft or if Microsoft de-emphasizes or divests itself from these areas of its business, our revenue would decrease and our business would be adversely affected.

We have OEM Distribution Agreements (“ODA“s)ODAs”) for Software Products for Embedded Systems with Microsoft, which enable us to sell various Microsoft Windows Embedded operating systems to our customers in

the United States, Canada, the Caribbean (excluding Cuba), Mexico, the European Union and the European Free Trade Association. These ODAs are effective through June 30, 2013.2016. We have also entered into other ODAs with Microsoft pursuant to which we are licensed to sell Microsoft Windows Mobile operating systems to customers in North America, South America, Central America (excluding Cuba), Japan, Taiwan, Europe, the Middle East, and Africa. The ODAs to sell Windows Mobile operating systems are effective through June 2014 with the exception of EMEA which expired on December 31, 2012 but which we expect to be renewed shortly. 30, 2015.

We generated $67.0$70.2 million and $58.4$64.0 million of revenue in 20122014 and 2011,2013, respectively, through our sales of Microsoft operating systems and expect this revenue stream to continue in 2013 although our rights to distribute Windows Mobile operating systems in Korea ended on October 31, 2012. We sold $4.5 million of Windows Mobile operating systems in Korea in 2012 and $4.6 million in 2011.2015. If any of the ODAs are terminated by Microsoft (which Microsoft can do unilaterally) or not renewed, or if Microsoft decides to no longer invest in or to divest itself from these areas of its business, our software revenue and resulting gross profit could decrease significantly and our operating results would be negatively impacted. Future renewals, if any, could be on less favorable terms, which could also negatively impact our business and operating results.

Microsoft can change pricing under the ODAs at any time, and unless we are able to either pass through price increases to our customers or sign our customers to 12-month purchasing commitments, which lowers the price we pay to Microsoft, our revenue, gross profit and operating results would be negatively impacted. Further, Microsoft currently offers a rebate program in conjunction with our ODA activities in which we earn money for achieving certain predefined objectives. If Microsoft were to eliminate or negatively modify the rebate program, our gross profit and operating results would be negatively impacted. We earnedqualified for rebate credits from Microsoft of $888,000$1.0 million and $746,000$1.2 million in 20122014 and 2011, respectively.2013, respectively, a portion of which is accounted for as a reduction in cost of sales and a portion as a reduction in marketing expense if and when qualified expenditures are made.

Microsoft has audited our records under the ODAs in the past and will likely audit our records again in the future and any negative audit results could result in additional charges and/or the termination of the ODAs.

There are provisions in the ODAs that require us to maintain certain internal records and processes for auditing and other reasons. Non-compliance with these and other requirements could result in the termination of the ODAs. Microsoft has concluded audits of our records pertaining to the ODAODAs in 2009 and 2006, neither of which had material findings. It is possible that future audits could result in charges due to any material findings that are found. The provisions also include terms that may make us contractually liable for payment of royalties to Microsoft in the event that certificates of authenticity are lost, damaged or stolen.

If we are invoiced by Microsoft for a pricing adjustments under OVRP arrangements and we are unable to pass through the charge to our customers, our operating results and cash flow would be negatively impacted.

In conjunction with our activities under the ODAs with Microsoft, we enter into OEM Volume Royalty Program (“OVRP”) commitments with Microsoft. Under these OVRPs, we are provided with volume pricing on a customer-by-customer basis assuming certain minimum unit volumes are met. The OVRP terms are 12 months. In the event we don’t meet the committed minimum unit volumes, we are obligated to pay the difference between the committed per-unit volume rate and the actual per-unit rate we achieved based upon actual units purchased. The OVRP arrangements do not equate to a minimum purchase commitment but rather the arrangements are a volume pricing arrangement based upon actual volume purchased. In substantially all instances, we have reciprocal agreements with our customers such that we will receive per-unit price adjustments, similar to the amounts we would subsequently owe to Microsoft if such OVRP volumes are not met. While our history with OVRP arrangements has shown that very few result in a price adjustment and, for those that have, we have been able to pass through the price adjustment to our customer, in the event the customer is unwilling or unable to pay us, our operating results and cash flow would be negatively impacted.

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If we do not maintain our favorable relationship with Microsoft, we will have difficulty marketing and selling our software and services and may not receive developer releases of Microsoft Windows Embedded and Windows Mobile operating systems. As a result, our revenue and operating results could suffer.

We maintain a strategic marketing relationship with Microsoft. If our relationship with Microsoft deteriorates for any reason, includingsuch as an increased focus by us on customers building devices utilizing non-Microsoft operating systems, our efforts to market and sell our software and services to OEMs and othersour customers could be adversely affected and our business could be harmed. Microsoft has significant influence over the development plans and buying decisions of OEMs and otherscustomers utilizing the various Microsoft Windows Embedded and Windows Mobile operating systems for smart devices and these targeted platforms are a significant focus for us.systems. Microsoft provides customer referrals to us. Moreover, Microsoft controls the marketing campaigns related to its operating systems. Microsoft’s marketing activities including trade shows, direct mail campaigns and print advertising, are important to the continued promotion and market acceptance of Microsoft Windows Embedded and Windows Mobile operating systems and, consequently, to our sale of Windows-based software and services. We must maintain a favorable relationship with Microsoft to continue to participate in joint marketing activities with them, which includes participating in “partner pavilions” at trade shows, listing our services on Microsoft’s website, and receiving customer referrals. In the event thatIf we are unable to continue our joint marketing efforts with Microsoft, or fail to receive referrals from them, we would be required to devote significant additional resources and incur additional expenses to market our software products and services directly to potential customers. In addition, we depend on Microsoft for developer releases of new versions of, and upgrades to, its Windows Embedded and Windows Mobile software in order to facilitate timely development and delivery of our own software and services. If we are unable to maintain our favorable relationship with Microsoft and no longer continue receiving such new versions and updates, our revenue could decline significantly, and/or our costs could increase significantly, thereby negatively impacting our operating results.

Unexpected delays or announcement of delays by Microsoft related to product releases of Windows Embedded Windows 8 Embedded or Windows Embedded 8 HandheldMobile operating systems could adversely affect our revenue and operating results.

Unexpected delays or announcement of delays in Microsoft’s delivery schedule for new versions of the variousWindows Embedded or Windows Mobile operating systems for Windows Embedded and Windows Mobile devices could cause us to delay our product introductions or impede our ability to sell our products and services and/or to complete customer projects on a timely basis. Such delays or announcements of delays by Microsoft could also cause our customers to delay or cancel their project development activities or product introductions, which could negatively impact our revenue and operating results.

If Microsoft adds features to its Windows operating systems or develops products that directly compete with products and services we provide, our revenue and operating results could be negatively impacted.

As the developer of various operating systems for Windows Embedded and Windows Mobile devices,operating systems, Microsoft could add features which eliminate or reduce our customers’ need for our software and services, or Microsoft could develop standalone products and services that compete with the products and services we provide to our customers. The ability of our customers, or potential customers, to obtain products and services directly from Microsoft that compete with our products and services could negatively impact our revenue and operating results. Even if the standard features of future Microsoft operating system software were more limited than our offerings, a significant number of our customers, and potential customers, might elect to accept more limited functionality in lieu of purchasing additional software from us or delay the purchase of our products and services while they perform a comparison of Microsoft’s competing offerings. Moreover, the resulting competitive pressures could lead to price reductions for our offerings and reduce our revenue and gross profit accordingly and our operating results could be negatively impacted.

Our business and results of operations would be adversely impacted if Microsoft decided to provide some, or all, of its Windows Embedded or Windows Mobile operating systems which we currently resell, free of charge to customers.

Microsoft has recently announced programs to offer certain consumer Windows phone and tablet-based operating systems to customers free of charge, subject to certain limitations. While we do not distribute these operating systems today under our ODA with Microsoft, if Microsoft were to pursue a similar strategy and offer operating systems that we do currently distribute free of charge, our business and results of operations would be adversely impacted.

Microsoft will be introducing the Windows 10 operating system software in the near future, and Microsoft’s pricing and support for this new operating system could directly impact our revenue and margins.

In January 2015, Microsoft announced a new operating system, Windows 10, but has not indicated when the software will be available to customers. Microsoft indicated that Windows 10 will be delivered as a service which may alter the traditional business model used to sell Microsoft licenses as a software product. As a reseller of Microsoft Windows Embedded and Windows Mobile operating systems, changes Microsoft’s business model may adversely impact our revenue and gross profit and our operating results could be negatively impacted.

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If the markets for Windows Embedded and/or Windows 8 for Embedded, Windows Phone 8 and Windows Embedded 8 HandheldMobile operating systems fail to develop further, develop more slowly than expected, or decline, our business and operating results may be materially harmed.

Because a significant portion of our revenue to date has been generated by software and services targeted at customers and devices utilizing the various Microsoft Windows Embedded and Windows Mobile operating systems, if the markets for these systems or platforms fail to develop further, or develop more slowly than expected, or decline, our business and operating results could be negatively impacted. Market acceptance of Microsoft Windows Embedded and Windows Mobile operating systems will depend on many factors, including:

MyFord Touch-Related Risk Factors

If we do not obtain additional work on the MyFord Touch program, through our new statement of work with Microsoft or elsewhere in the future, our future revenue and gross profit would decrease and our operating results would be adversely affected.

We began working on the MyFord Touch infotainment project with Ford in the second quarter of 2008 and have been workingcontinue to work on the program since then although the main program was completed in August 2010.program. Since inception of the program through December 31, 2011, our contractual relationship was with Ford. Effective January 1, 2012, our contractual relationship for the MyFord Touch program shifted from Ford to Microsoft, as Microsoft has become the primary vendor to Ford for this program. In 2014 the relationship added Elektrobit Automotive. In December 2014, Ford introduced Sync 3, the next generation MyFord Touch program that is scheduled to be deployed on cars in 2016 and will be based on QNX software from Blackberry instead of software from Microsoft.

Revenue from Fordthe MyFord Touch program comprised $6.4$2.8 million, or 6%3%, of our total revenue in 2012.2014, and $4.5 million, or 5%, of our total revenue in 2013. We currently expect this project work to continue in 2013 under our new statement of work with Microsoft2015 but expect revenue from the MyFord Touch program to be lower, albeit still significant in 2013,2015, than it was in 20122013 due to the lower level of personnel resources utilized on the program. Our new statementstatements of work with Microsoft and Ford currently runsrun through June 30, 2013.2015, and with Elektrobit through December 31, 2015. While we expect to be actively involved in futurecurrent generation MyFord Touch projects with Microsoft, Ford and FordElektrobit through 2015 and beyond, June 30, 2013, ifwe expect our role on MyFord Touch iswill be scaled back or eliminated beyond that pointbecause of the transition to QNX software for the next generation Sync 3 and our revenue and resulting gross profit would suffer and negatively impact our operating results.

General Business-Related Risk Factors

Our marketplace is extremely competitive, which may result in price reductions, lower gross profit margins and loss of market share.

The market for ourdevice software products and related services is extremely competitive. Increased competition may result in lower revenue, price reductions, lower gross profit and margin and loss of customers and market share, which could negatively impact our operating results. We face competition from:from the following:

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Some of our competitors focus on only one aspect of our business or offer complementary products which can be integrated with our products. As we develop and bring to market new software products and service offerings, particularly offerings focused on specific industries and/or focused on devices utilizing non-Windows Embedded operating systems, we may begin competing with companies with which we have not previously competed. Further, as we expand the geographic markets into which we sell our software solutions and related services, or increase our penetration therein, we may expect to increasingly compete with companies with which we have not previously competed. It is also possible that new competitors will enter the market or that our competitors will form alliances, including alliances with Microsoft, that may enable them to rapidly increase their market share. Microsoft has not agreed to any exclusive arrangement with us, nor has it agreed not to compete with us. Microsoft may decide to bring more of the core embedded development services and expertise that we provide in-house, possibly resulting in reduced software and service revenue opportunities for us. The barrier to entering the market as a provider of Windows-basedMicrosoft-based smart deviceconnected system software and services is low. In addition, Microsoft has created marketing programs to encourage systems integrators to work on Microsoft Windows Embedded and Windows Mobile operating system software and services. These systems integrators are given substantially the same access by Microsoft to the WindowsMicrosoft technology as we are. New competitors may have lower overhead than we do and may be able to undercut our pricing. We expect that competition will increase as other established and emerging companies enter the smartconnected device market, and as new products and technologies are introduced.

Management turnover creates uncertainties and could harm our business.

We had significant changes in executive leadership during 2013 and 2014 and more could occur. Jerry D. Chase was appointed as President and Chief Executive Officer of the Company in February 2014. Mr. Chase joined our Board of Directors in July 2013 and had served as our interim Chief Executive Officer since September 23, 2013, after Brian Crowley stepped down as President and Chief Executive Officer and from the Board of Directors. In October 2013, John Traynor, Senior Vice President, Products left the company as part of our restructuring. In addition, Mike Stipe, Senior Vice President, Worldwide Sales and Marketing departed in December 2013. Mark D. Whiteside has taken on the role of Vice President, Solutions and Scott B. Caldwell has taken on the role as Vice President, Worldwide OEM Sales. Scott Mahan resigned as Chief Financial Officer in August 2014 and was replaced by Martin L. Heimbigner in November 2014.

Changes to strategic or operating goals, which can often times occur with the appointment of new executives, can create uncertainty, may negatively impact our ability to execute quickly and effectively, and may ultimately be unsuccessful. In addition, executive leadership transition periods are often difficult as the new executives gain detailed knowledge of our operations, and friction can result from changes in strategy and management style. Management turnover inherently causes some loss of institutional knowledge, which can negatively affect strategy and execution. Until we integrate new personnel, and unless they are able to succeed in their positions, we may be unable to successfully manage and grow our business, and our financial condition and profitability may suffer.

Further, to the extent we experience additional management turnover, competition for top management is high and it may take months to find a candidate that meets our requirements. If we are unable to attract and retain qualified management personnel, our business could suffer.

Our ability to maintain or grow our proprietary software revenue is contingent on our ability to bring to market competitive, unique offerings that keep pace with technological changes and needs. If we are not successful in doing so, our business would be negatively impacted.

Proprietary software product revenue provides us with much higher gross profit margins than we typically receive from third-party software products and our engineering service offerings and provide other advantages as well. Increasing the number and amount of proprietary products we sell is an important part of our growth strategy. Our ability to maintain and increase the revenue contribution from proprietary software products is contingent on our ability to enhance the features and functionality of our current proprietary products as well as

to devise, develop and introduce new products. There can be no assurance that we will be able to maintain or expand the number of proprietary products that we sell, and our failure to do so could negatively impact revenue and our operating results.

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We may experience delays in our efforts to develop new products and services, and these delays could cause us to miss market opportunities which could negatively impact our revenue and operating results.

The market for our software and services evolves rapidly. As a result, the life cycles of our products and services are difficult to estimate. To be successful, we believe we must continue to enhance our current offerings and provide new software and service offerings with attractive features, prices and terms that appeal to our customers. We have experienced delays in new software and service offering introductions in the past and may do so again in the future. Our revenue and operating results may be negatively impacted if we delay releases of new products, product enhancements and/or new services offerings, or if we fail to accurately anticipate our customers’ needs or technical trends and are unable to introduce new products and service offerings into the market successfully. In addition, our customers may defer or forego purchases of our products and/or services if we, Microsoft, our competitors or major hardware, systems or software vendors introduce or announce new products.

Our future success depends upon our customers’ ability to successfully sell their products incorporating our technology, and to continue buying our services.

Even if a customer selects us to provide software and services, the customer may not ultimately market and sell its product successfully. A cancellation or change in plans by a customer, whether from lack of market acceptance of its products or otherwise, could cause us to lose revenue that we had anticipated and our revenue and operating results would suffer. Also, our revenue and operating results could suffer if a significant customer reduces or delays orders during our sales cycle or chooses not to release products that contain our technology.

If the market for smart, connected systems evolves based on technologies that we do not support, our revenue may not grow as anticipated, if at all, and our business would be harmed.

The technologies used in smart, connected systems change very rapidly and it is often difficult to forseeforesee and predict which application processors, operating systems, connectivity, testing and application development technologies will gain a foothold in device development. As a smaller company we can invest our resources in a limited number of technologies and as such must make forward investments in developing products and capabilities to support the technologies that we choose. If we make investments in technologies that do not gain traction in device development, our profit potential is uncertain and our revenue may not develop as anticipated. We are dependent upon the broad acceptance and adoption by businesses and consumers of a wide variety of device technologies, which will depend on many factors, including:

The success and profitability of our service offerings are contingent on our ability to differentiate these offerings adequately in the marketplace, which is, in turn, contingent on our ability to retain our engineering personnel and defend our billing rate structure against those of our competitors, including those using significant lower-cost offshore resources. If we are unable to do so successfully, our business could be harmed.

We are a leader in providing engineering services to customers developing smart device customers.devices. Our market differentiation is created through several factors, including our experience with a variety of smart deviceconnected system platforms and

applications. Our

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differentiation is contingent, in part, on our ability to attract and retain employees with this expertise, a significant portion of which are currently based in the United States. To the extent we are unable to retain critical engineering services talent and/or our competition is able to deliver the same services by using significant lower-cost offshore resources, our service revenue and operating results could be negatively impacted.

The success and profitability of our service engagements are contingent upon our ability to scope and bid engagements and deliver our services profitably. If we are unable to do so, our service revenue service gross profit margin and operating results could be negatively impacted.

Various factors may cause the total cost of service projects to exceed the original estimate provided to the customer or the contractual maximum in the case of fixed price contracts, including specification changes, customer deliverable delays, inadequate scoping and inefficient service delivery. If we are unable to adequately scope, bid and deliver on service engagements successfully, our service revenue, service gross margin and operating results could be negatively impacted. In addition, depending on the cause of an overrun for a given customer and project, we may also decide to provide pricing concessions to that customer which could negatively impact our service revenue, service gross profit and operating results.

We periodically enter into engineering service agreements in which we have agreedagree to perform our engineering service work for lower up-front fees, or for no fees, in exchange for future royalties or per unit fees. There is no guarantee that these arrangements will produce the strategic or economic returns as anticipated.

We have entered into contracts that involve reducing or eliminating up-front engineering service fees in return for a per-device/chip royalty or fee that is earned as our customers ship their devices or chips are shipped by our customers, and we may enter into more such agreements in the future. Because we are delaying revenue past the point where our services are performed, there is a risk that our customers may cancel their projects or that their devices or chips may not be successful in the market, which could negatively impact our revenue and operating results.

Cooperation and support from silicon vendors is critical for the success of our products and related services that are developed for their particular silicon architecture. Such cooperation cannot be assured.

We have developed, and continue to develop, software and service offerings based on certain silicon architectures (e.g. the TI OMAP architecture).architectures. Due to the nature of the industry we serve and the products we develop, it is necessary for us to make certain assumptions regarding which silicon vendors will be successful in the various markets we serve and upon which we are making investments. It is therefore important that there is ongoing support from the SVs in the marketplace for these silicon architectures. There can be no assurance that TI, Qualcomm, Freescale, Intel or any of the other SVs will continue to pursue and support the markets that we have been targeting. If the SVs do not support our efforts going forward, our revenue and operating results could be negatively impacted.

The long sales cycle of our products and services makes our revenue susceptible to fluctuations.

Our sales cycle is typicallycan run three to ninetwelve months because the expense and complexity of the software and service offerings we sell generally require a lengthy customer approval process and may be subject to a number of significant risks over which we have little or no control, including:

In addition, to successfully sell our software and engineering service offerings, we must frequently educate our potential customers about the full benefits of our software and services, which can require significant time. If our sales cycle further lengthens unexpectedly, it could adversely affect the timing of our revenue, which could cause our quarterly results to fluctuate.

Erosion of the financial condition of our customers could adversely affect our business.

Our business could be adversely affected if the financial condition of our customers erodes because such erosion could reduce demand from those customers for our software and engineering services. This could also cause them to terminate their relationships with us, and/or could increase the risk that such customers default on their payment obligations to us. Additionally, while we believe that our allowance for doubtful accounts is adequate, economic trends may cause more companies to default or cease operations, in which case our allowances may not cover actual losses, which could adversely affect our operating results.

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Our business and operations would be adversely impacted in the event of a failure or interruption of our information technology infrastructure.

The proper functioning of our information technology infrastructure is critical to the efficient operation and management of our business. Our technology infrastructure is vulnerable to cyber attacks,cyber-attacks, computer viruses, worms and other malicious software programs, physical and electronic break-ins, sabotage and similar disruptions from unauthorized tampering with our computer systems. We believe that we have adopted appropriate measures to mitigate potential risks to our technology infrastructure and our operations from these information technology-related and other potential disruptions. However, given the unpredictability of the timing, nature and scope of such disruptions, we could potentially be subject to downtimes, operational delays, other detrimental impacts on our operations or ability to provide products and services to our customers, the compromising of confidential or otherwise protected information, destruction or corruption of data, security breaches, other manipulation or improper use of our systems and networks, financial losses from remedial actions, loss of business or potential liability, and/or damage to our reputation, any of which could have a material adverse effect on our cash flows, competitive position, financial condition or results of operations.

We may be subject to product liability claims that could result in significant costs.

Our software license and service agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims with the notable exception of the portion of the MyFord Touch project contracted with Ford.claims. It is possible, however, that these provisions may be ineffective under the laws of certain jurisdictions or that our customers may not agree to these limitations. Although we have not experienced any product liability claims to date, the sale and support of our products and services may be subject to such claims in the future. There is a risk that any such claims or liabilities may exceed, or fall outside, the scope of our insurance coverage, and we may be unable to retain adequate liability insurance in the future. A product liability claim brought against us, whether successful or not, could negatively impact our business and operating results.

Our business and results of operations would be adversely impacted in the event that we incur business losses that are not covered by or exceed our existing business insurance coverage.

We are insured against certain business risks and liabilities under our corporate insurance policies. However to the extent that we incur losses in connection with our business that are not covered by our existing insurance policies or that exceed our existing policy coverage, our business and results of operations would be adversely impacted.

Negative business conditions, changes in useful lives, and other factors may negatively affect the carrying value of the intangible assets and goodwill we have acquired.

In the fourth quarter of 2008, we purchased certain assets of TestQuest including acquired technology and other intangible assets with a total gross carrying value of $1.9 million, and which had a carrying value of $142,000 as of December 31, 2012. During the fourth quarter of 2011, we assessed that the net carrying value of the remaining intangible assets associated with acquired technology from TestQuest was impaired due to slow sales of the product that incorporates this technology. As such, in that quarter we recognized an impairment charge of $518,000 as software cost of revenue which negatively impacted our gross profit and operating results. In the third quarter of 2011, we acquired MPC Data, LimitedLtd. including certain intangible assets with a carrying value of $1.2 million$660,000 and goodwill of $3.7 million as of December 31, 2012.2014. Although we expect to generate cash from the intangible assets in the future, and do not foresee any impairment of our goodwill, it is possible that we may be required to reassess the carrying value of these assets in the future if certain negative business conditions occur such as negative results of our business associated with our intangible assets or a low stock price. Any reduction in the carrying value of these intangible assets or goodwill would result in an impairment

charge that would negatively impact our operating results. Further, business conditions and other factors may also require us to reassess the useful lives associated with intangible assets.

Past acquisitions have proven difficult to integrate, and recent or future acquisitions, if any, could disrupt our business, dilute shareholder value and negatively affect our operating results.

We have acquired the technologies, assets and/or operations of other companies in the past and may acquire or make investments in companies, products, services and technologies in the future as part of our growth strategy. If we fail to properly evaluate, integrate and execute on our acquisitions and investments, our business and prospects may be seriously harmed. To successfully complete an acquisition, we must properly evaluate the technology, market and management team, accurately forecast the financial impact of the transaction, including accounting charges and transaction expenses, integrate and retain personnel, combine potentially different corporate cultures and effectively integrate products and research and development, sales, marketing and support operations. If we fail to do any of these, we may suffer losses and impair relationships with our employees, customers and strategic partners. Additionally, management may be distracted from day-to-day operations. We also may be unable to maintain uniform standards, controls, procedures and policies, which are especially critical in light of requirements under the Sarbanes-Oxley Act of 2002 and other corporate governance requirements, and significant demands may be placed on our management and our operations, information services and financial, legal and marketing resources. Finally, acquired businesses sometimes result in unexpected liabilities and contingencies, which may involve compliance with foreign laws, payment of taxes, labor negotiations or other unknown costs and expenses, which could be significant.

We may not be able to raise additional capital if required to support our business.

If we need to raise additional operating capital, we may find that our access to equity and debt capital markets is limited or blocked entirely. In the past, our stock has traded at low volumes and overall investor confidence in the stock market could falter. This

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could make it difficult or impossible to sell additional shares on the public markets. In addition, it may be difficult and costly to obtain debt financing and we may be unable to borrow additional funds at acceptable cost, or at all, should the need arise. If we are unable to raise capital as necessary, it may adversely affect our ability to invest in products or fund operations, which would materially harm our business and negatively affect operating results.

Taxing jurisdictions in the United States are becoming more aggressive with tax legislation and tax collection, particularly states facing significant budget deficits, which could expose us to additional tax liability that we have not been subject to in the past.

We make sales in many jurisdictions across the United States, most of which we do not have nexus in and, therefore, are not subject to sales, franchise, income and other state and local taxes. Particularly in light of state revenue deficits, taxing jurisdictions have become more aggressive in defining nexus, among other things, which could result in us achieving nexus, or potentially achieving nexus in significantly more tax jurisdictions. If this occurs and unless we are able to pass through this cost to our customers, our tax expense will increase which will negatively affect our results of operations. Further, because state and local tax laws are becoming increasingly complex, our cost to monitor our state and local tax compliance will increase which will negatively affect our results of operations. Additionally, there can be no assurance that we do not currently have unknown tax exposure in a state or local tax jurisdiction because of recent tax law changes which we are unaware of and the resulting liability could be significant and would negatively affect our results of operations.

There may be restrictions on the use of our net operating loss and tax credit carryforwards due to a tax law “ownership change.”

Section 382 of the U.S. Internal Revenue Code restricts the ability of a corporation that undergoes an ownership change to use net operating loss and tax credit carryforwards. At December 31, 2012,2014, we had

approximately $57$59.7 million of federal and $3.4 million of state net operating loss carryforwards and $2.5$2.7 million of tax credit carryforwards. Under the applicable tax rules, an ownership change occurs if greater than five percent shareholders of an issuer’s outstanding common stock collectively increase their ownership percentage by more than 50 percentage points over a rolling three-year period. We have performed analyses of possible ownership changes which included consideration of a third-party study, and do not believe that an ownership change (asas defined by this Section)Section 382 has occurred. However, if a tax law ownership change has occurred of which we are not aware, or if a tax law ownership change occurs in the future, we may have to adjust the valuation of our deferred tax assets, and could be at risk of having to pay income taxes notwithstanding the existence of our sizable carryforwards. Further, to the extent that we have utilized our carryforwards from prior years, the existence of a previous tax law ownership change that we did not account for could result in liability for back taxes, interest, and penalties. If we are unable to utilize our carryforwards and/or if we previously utilized carryforwards to which we were not entitled, it would negatively impact our business, financial condition and operating results.

Non-compliance with our lease agreement could have a material adverse impact on our financial position.

Under the terms of our corporate headquarters lease signed in February 2004, if we default under the lease, the landlord has the ability to demand cash payments forgiven in 2004. The amount of the forgiven payments for which the landlord has the ability to demand repayment was $400,000 at December 31, 2012, and decreases on a straight-line basis over the length of our ten-year headquarters lease which expires in August 2014. Any breach of or non-compliance with this lease agreement could negatively impact our business, financial condition and operating results.

Intellectual Property-Related Risk Factors

Our software and service offerings could infringe the intellectual property rights of third parties, which could expose us to additional costs and litigation and could adversely affect our ability to sell our products and services or cause shipment delays or stoppages.

It is difficult to determine whether our software and engineering services infringe third-party intellectual property rights, particularly in a rapidly evolving technological environment in which technologies often overlap and where there may be numerous patent applications pending, many of which are confidential when filed. If we were to discover that one of our software or service offerings, or a product based on one of our reference designs, violated a third-party’s proprietary rights, we may not be able to obtain a license on commercially reasonable terms, or at all, to continue offering that product or service. Similarly, third parties may claim that our current or future software products and services infringe their proprietary rights, regardless of whether such claims have merit. Any such claims could increase our costs and negatively impact our business and operating results. In certain cases, we have been unable to obtain indemnification against claims that third-party technology incorporated into our software products and services infringe the proprietary rights of others. However, any indemnification we do obtain may be limited in scope or amount. Even if we receive broad third-party indemnification, these entities may not have the financial capability to indemnify us in the event of infringement. In addition, in some circumstances we are required to indemnify our customers for claims made against them that are based on our software products or services. There can be no assurance that infringement or invalidity claims related to the software products and services we provide, or arising from the incorporation by us of third-party technology, and claims for indemnification from our customers resulting from such claims, will not be asserted or prosecuted against us. Some of our competitors have, or are affiliated, with companies with substantially greater resources than we have, and these competitors may be able to sustain the costs of complex intellectual property litigation to a greater degree and for longer periods of time than we could. In addition, we expect that software developers will be increasingly subject to infringement claims as the number of products and competitors in the software industry grows, and as the functionality of products in different industry segments increasingly overlap. Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources in addition to potential product redevelopment costs and delays. Furthermore, if we were unsuccessful in resolving a patent or other intellectual property infringement action claim against us, we

may be prohibited from developing or commercializing certain of our technologies and products, or

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delivering services based on the infringing technology, unless we obtain a license from the holder of the patent or other intellectual property rights. There can be no assurance that we would be able to obtain any such license on commercially favorable terms, or at all. If such license is not obtained, we would be required to cease these related business operations, which could negatively impact our business, revenue and operating results.

If we fail to adequately protect our intellectual property rights, competitors may be able to use our technology or trademarks, which could weaken our competitive position, reduce our revenue and increase our costs.

If we fail to adequately protect our intellectual property, our competitive position could be weakened and our revenue and operating results adversely affected. We rely primarily on confidentiality procedures and contractual provisions as well as a combination of patent, copyright, trade secret and trademark laws, to protect our intellectual property. These laws and procedures provide only limited protection. It is possible that another party could obtain patents that block our use of some, or all, of our software and services. If that occurred, we would need to obtain a license from the patent holder or design around those patents. The patent holder may or may not choose to make a license available to us at all, or on acceptable terms. Similarly, it may not be possible to design around a blocking patent. In general, there can be no assurance that our efforts to protect our intellectual property rights through patent, copyright, trade secret and trademark laws will be effective to prevent misappropriation of our technology, or to prevent the development and design by others of products or technologies similar to or competitive with those developed by us.

We frequently license the source code of our software products and the source code results of our services to customers. There can be no assurance that customers with access to our source code will comply with the license terms or that we will discover any violations of the license terms or, in the event of discovery of violations, that we will be able to successfully enforce the license terms and/or recover the economic value lost from such violations. To license some of our software products, we rely in part on “shrinkwrap”“shrink-wrap” and “clickwrap”“click wrap” licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. As with other software, our software products are susceptible to unauthorized copying and uses that may go undetected, and policing such unauthorized use is difficult. A significant portion of our marks include the word “BSQUARE.” Other companies use forms of “BSQUARE” in their marks alone, or in combination with other words, and we cannot prevent all such third-party uses. We license certain trademark rights to third parties. Such licensees may not abide by our compliance and quality control guidelines with respect to such trademark rights. Any of these outcomes could negatively impact our brand, dilute its recognition in the marketplace, or confuse potential customers, all of which could harm our business.

The computer software market is characterized by frequent and substantial intellectual property litigation, which is often complex and expensive, and involves a significant diversion of resources and uncertainty of outcome. Litigation may be necessary in the future to enforce our intellectual property or to defend against a claim of infringement or invalidity. Litigation could result in substantial costs and the diversion of resources and could negatively impact our business and operating results.

Our software or hardware products or the third-party hardware or software integrated with our products or delivered as part of our service offerings may suffer from defects or errors that could impair our ability to sell our products and services.

Software and hardware components as complex as those needed for smart devicesconnected systems frequently contain errors or defects, especially when first introduced or when new versions are released. We have had to delay commercial release of certain versions of our products until problems were corrected and, in some cases, have provided product enhancements to correct errors in released products. Some of our contracts require us to repair or replace products that fail to work. To the extent that we repair or replace products our expenses may increase. In addition, it is possible that by the time defects are fixed, the market opportunity may decline which may result in

lost revenue. Moreover, to the extent that we provide increasingly comprehensive products and services, particularly those focused on hardware, and rely on third-party manufacturers and suppliers to manufacture these products, we will be dependent on the ability of third-party manufacturers to correct, identify and prevent manufacturing errors. Errors that are discovered after commercial release could result in loss of revenue or delay in market acceptance, diversion of development resources, damage to our reputation and increased service and warranty costs, all of which could negatively impact our business and operating results.

If we are unable to license key software from third parties, our business could be harmed.

We sometimes integrate third-party software with our proprietary software and engineering service offerings or sell such third-party software offerings on a standalone basis (e.g. Microsoft Windows Embedded operating systems under our ODA with Microsoft). If our relationships with these third-party software vendors were to deteriorate, or be eliminated in their entirety, we might be unable to obtain licenses on commercially reasonable terms, if at all. In the event that we are unable to obtain these third-party software offerings, we would be required to develop this technology internally, assuming it was economically or technically feasible, or seek similar software offerings from other third parties assuming there were competing offerings in the marketplace, which could delay or limit our ability to introduce enhancements or new products, or to continue to sell existing products and engineering services, thereby negatively impacting our revenue and operating results.

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Governance-Related Risk Factors

It might be difficult for a third-party to acquire us even if doing so would be beneficial to our shareholders.

Certain provisions of our articles of incorporation, bylaws and Washington law may discourage, delay or prevent a change in the control of us or a change in our management, even if doing so would be beneficial to our shareholders. Our Board of Directors has the authority under our amended and restated articles of incorporation to issue preferred stock with rights superior to the rights of the holders of common stock. As a result, preferred stock could be issued quickly and easily with terms calculated to delay or prevent a change in control of our company or make removal of our management more difficult. In addition, our Board of Directors is divided into three classes. The directors in each class serve for three-year terms, one class being elected each year by our shareholders. This system of electing and removing directors may discourage a third party from making a tender offer or otherwise attempting to obtain control of our company because it generally makes it more difficult for shareholders to replace a majority of our directors. In addition, Chapter 19 of the Washington Business Corporation Act generally prohibits a “target corporation” from engaging in certain significant business transactions with a defined “acquiring person” for a period of five years after the acquisition, unless the transaction or acquisition of shares is approved by a majority of the members of the target corporation’s Board of Directors prior to the time of acquisition. This provision may have the effect of delaying, deterring or preventing a change in control of our company. The existence of these anti-takeover provisions could limit the price that investors might be willing to pay in the future for shares of our common stock.

International Operations-Related Risk Factors

Our international operations expose us to greater intellectual property, management, collections, regulatory and other risks.

Customers outside of North America generated 29%10% of our total revenue in 20122014 and 23%13% in 2011. We have expanded rapidly, particularly during 2011, including establishing presences in Korea and China and our MPC acquisition in September 2011 which significantly increased our presence in Europe.2013. We currently have sizable operations outside of North America in Taiwan China and the United Kingdom and also have a limitedminor sales and/orand support presence in Japan, SouthJapan. In 2013, we closed our operations in Korea, China and Germany. Our international activities and operations and our current expansion plans expose us to a number of risks, including the following:

These risks could have a material adverse effect on the financial and managerial resources required to operate our foreign offices, as well as on our future international revenue, which could negatively impact our business and operating results.

As we increase the amount of software development conducted in non-U.S. locations, potential delays and quality issues may impact our ability to timely deliver our software and services, potentially impacting our revenue and profitability.

We conduct development activities in non-U.S. locations, primarily China, Taiwan, and the United Kingdom, to take advantage of the high-quality, low-cost software development resources found in those countries. To date, we have limited experience in managing large scale software development outside the United States. Expanding our international software development inherently increases the complexity of managing these programs and may result in delays in introducing new products to market, or delays in completing service projects for our customers, which in turn may adversely impact the revenue we recognize from related software products and services and could also adversely impact the profitability of service engagements employing offshore resources, thereby negatively affecting our operating results.

As our customers seek more cost-effective locations to develop and manufacture their products, particularly overseas locations, our ability to continue to sell these customers our software products and services could be limited, which could negatively impact our revenue and operating results.

Due to competitive and other pressures, some of our customers have moved, and others may seek to move, the development and manufacturing of their smart, devicesconnected systems to overseas locations, which may limit our ability to sell these customers our software and services. As an example, under our ODA with Microsoft, we are currently only able to sell Microsoft Windows Embedded operating systems primarilyto our customers in North America, the United KingdomStates, Canada, the Caribbean (excluding Cuba), Mexico, the European Union and Germany.the European Free Trade Association. If our customers, or potential customers, move their manufacturing overseas we may be restricted from reselling Microsoft Windows Embedded operating systems to these customers or we would be less competitive, which could negatively impact our revenue and operating results.

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Not Applicable.applicable.

OurAs of December 31, 2014, our corporate headquarters are located in 43,40024,061 square feet of leased space in a single location in Bellevue, Washington. The underlying lease expiresterm ends in 2014.May 2020.

In North America, we also lease office space in San Diego, California; Boston, Massachusetts; and Akron, Ohio. We lease office space overseas in Beijing, China, Seoul, Korea, Tokyo, Japan,Japan; Taipei, Taiwan, Munich, GermanyTaiwan; and Trowbridge, United Kingdom. Our facilities have sufficient capacity to support our current operational needs as well as short-term growth plans.

None.

Not Applicable.

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PART II

Market Information

Our common stock is traded on the NASDAQ Global Select Market under the symbol “BSQR.” The following table sets forth the high and low closing prices for our common stock for the periods indicated, as reported by the NASDAQ Global Select Market.

Holders

As of January 31, 2013,2015, there were 132123 holders of record of our common stock. Because many shares of our common stock are held by brokers and other institutions on behalf of shareholders, we are unable to determine the total number of shareholders represented by these holders of record.

Dividends

We have never paid cash dividends on our common stock. We currently intend to retain any future earnings to fund future development and growth and, therefore, do not anticipate paying any consistent cash dividends in the foreseeable future. Our Board of Directors has, however, periodically considered implementing a share repurchase program and/or a special one-time cash dividend.

Not Applicable.

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The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes. This Management’s Discussion and Analysis of Financial Condition and Results of Operations may contain some statements and information which are not historical facts but are forward-looking statements. For a discussion of these forward-looking statements, and of important factors that could cause results to differ materially from the forward-looking statements contained in this report, see Item 1 of Part I, “Business—Cautionary Note Regarding Forward-Looking Statements,” and Item 1A of Part I, “Risk Factors.”

Overview

We provide software solutions and related engineering services to companies that develop smart, connected systems. A smart, connected system is a dedicated purpose computing device that typically has a display, runs an operating system (e.g., Microsoft^® Windows^® Embedded Compact) and is usually connected to a network or data cloud via a wired or wireless connection. Examples of smart, connected systems include set-top boxes, home gateways, point-of-sale terminals, kiosks, voting machines, gaming platforms, tablets, handheld data collection devices, personal media players, smart phones, smart vending machines, in-vehicle telematics and entertainment devices. We primarily focus on smart, connected systems that utilize various Microsoft Windows Embedded and Windows Mobile operating systems specifically Windows Embedded Compact, Windows Embedded Standard 7 and 8, Windows Mobile™, Windows Phone 8 and Windows Embedded 8 Handheld as well as devices running other popular operating systems such as Android, Linux and QNX.

We have been providing software solutions to thefor smart, connected device marketplacesystems since our inception. Our customers include world class original equipment manufacturers (“OEMs”), original design manufacturers (“ODMs”)OEMs, ODMs and enterprises,Enterprises, as well as silicon vendors (“SVs”)SVs and peripheral vendors which purchase our software solutions for purposes of facilitating processor and peripheral sales to the aforementioned customer categories.sales. In the case of enterprises,Enterprises, our customers include those which develop, market and distribute smart, devicesconnected systems on their own behalf as well as those that purchase devicessystems from OEMs or ODMs and require additional device software, integration and/or testing. The software solutions we provide are utilized and deployed throughout various phases of our customers’ device life cycle, including design, development, customization, quality assurance and deployment.

Building on the traditional focus of our business noted above, increasingly we intend to focus on developing and offering our own products such as DataV to address the emerging IoT market. Similarly, we intend to focus on increasing the amount of our own intellectual property and know-how including in our MobileV product, a complete hardware and software reference solution for OEMs building durable and rugged handhelds and industrial tablets.

Critical Accounting Judgments

Revenue Recognition

We recognize revenue from software and engineering service sales when the following four revenue recognition criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the selling price is fixed or determinable; and collectability is reasonably assured. Contracts and customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents and time records are generally used to verify delivery. We assess whether the selling price is fixed or determinable based on the contract and/or customer purchase order and payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectability based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history. Periodically, we will begin work on engineering service engagements prior to having a signed contract and, in some cases, the contract is signed in a quarter after which service delivery costs are incurred. We do not defer costs associated with such engagements before we have received a signed contract.

We recognize software revenue upon shipment provided that no significant obligations remain on our part, substantive acceptance conditions, if any, have been met and the other revenue recognition criteria have been met. Service revenue from time and materials contracts, and training service agreements, is recognized as services are performed. Fixed-price service agreements, and certain time and materials service agreements with capped fee structures, are accounted for using the percentage-of-completion method.method assuming reasonable estimates of completion can be made. We use the percentage-of-completion method of accounting because we believe it is the most accurate method to recognize revenue based

on the nature and scope of these engineering service contracts; we believe it is a better measure of periodic income results than other methods and better matches revenue recognized with the costs incurred. Percentage of completion is measured based primarily on input measures such as hours incurred to date compared to total estimated hours to complete, with consideration given to output measures, such as contract milestones, when applicable. Significant judgment is required when estimating total hours and progress to completion on these arrangements which determines the amount of revenue we recognize as well as whether a loss is recognized if one is expected to be incurred for the remainder of the project. Revisions to hour and cost estimates are incorporated in the period in which the facts that give rise to the revision become known.

In certain situations when it is impractical for us to reliably estimate either specific amounts or ranges of contract revenues and costs, and where we anticipate that we will not incur a loss, a zero profit model is used for revenue recognition. Equal amounts of revenue and cost are recognized during the contract period, and profit is recognized when the project is completed and accepted. This

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method was used in 2013 and 2014 for two engineering service contracts in Japan. The contracts were completed and accepted in the second and fourth quarters of 2014 and the profit from these contracts was recognized in 2014.

We also enter into arrangements in which a customer purchases a combination of software licenses, engineering services and post-contract customer support and/or maintenance (“PCS”). As a result, contract interpretation is sometimes required to determine the appropriate accounting, including how the price should be allocated among the deliverable elements if there are multiple elements. PCS may include rights to upgrades, when and if available, telephone support, updates and enhancements. When vendor specific objective evidence (“VSOE”) of fair value exists for all elements in a multiple element arrangement, revenue is allocated to each element based on the relative fair value of each of the elements. VSOE of fair value is established by the price charged when the same element is sold separately. Accordingly, the judgments involved in assessing the fair values of various elements of an agreement can impact the recognition of revenue in each period. Changes in the allocation of the sales price between deliverables might impact the timing of revenue recognition, but would not change the total revenue recognized on the contract. When elements such as software and engineering services are contained in a single arrangement, or in related arrangements with the same customer, we allocate revenue to each element based on its relative fair value, provided that such element meets the criteria for treatment as a separate unit of accounting. In the absence of fair value for a delivered element, revenue is first allocated to the fair value of the undelivered elements and then allocated to the residual delivered elements. In the absence of fair value for an undelivered element, the arrangement is accounted for as a single unit of accounting, resulting in a delay of revenue recognition for the delivered elements until the undelivered elements are fulfilled.

When engineering services and royalties are contained in a single arrangement, we recognize revenue from engineering services as earned in accordance with the criteria above even though the effective rate per hour may be lower than typical because the customer is contractually obligated to pay royalties on their device shipments. We recognize royalty revenue, classified as software revenue, when the royalty report from the customer is received or when such royalties are contractually guaranteed and the other revenue recognition criteria are met, particularly that collectability is reasonably assured.

There are two items involving revenue recognition that require us to make more difficult and subjective judgments: the determination of VSOE of fair value in multiple element arrangements and the estimation of percentage of completion on fixed-price service contracts. Historically, we have entered into very few multiple-element arrangements other than those involving the sale of PCS related to our TestQuest automated testing tools. We establish VSOE of fair value for TestQuest PCS based on the price when PCS is sold separately. VSOE of TestQuest PCS has been well established in the past as these products have been sold on a stand-alone basis for a number of years even prior to our acquisition of TestQuest assets in November 2008.

We measure our estimate of completion on fixed-price contracts, which in turn determines the amount of revenue we recognize, based primarily on actual hours incurred to date and our estimate of remaining hours necessary to complete the contract. The process of estimating the remaining hours on a contract involves detailed estimates of remaining hours by the engineers and project managers involved with the project, factoring in such variables as the remaining tasks, the complexity of the tasks, the contracted quality of the software to be provided, the customer’s estimated delivery date, integration of third-party software and quality thereof and other factors. Every fixed-price contract requires various approvals within our company, including our Chief Executive Officer if significant. This approval process takes into consideration a number of factors including the complexity of engineering. Historically, our estimation processes related to fixed-price contracts have been accurate based on the information known at the time of the reporting of our results. However, percentage-of-completion estimates require

significant judgment. As of December 31, 2012,2014, we were delivering engineering services under 6seven fixed-price service contracts. The percentage of completion calculations on these contracts represents management’s best estimates based on the facts and circumstances as of the filing of this report. If there are changes to the underlying facts and circumstances, revisions to the percentage-of-completion calculations will be recorded in the period the changes are noted. IfFor illustrative purposes only, if we were 10% under in our estimates of completion on every fixed-bid contract active on December 31, 2012,2014, our revenue would behave been over-stated by $180,000approximately $358,000 for 2012.2014.

Intangible Assets and Goodwill

We evaluate our intangible assets for indications of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Our intangible assets were acquired through business acquisitions. Our intangible assets consist of acquired technology, customer relationships, trade names and trademarks, and non-compete agreements.relationships. Factors that could trigger an impairment analysis include significant under-performance relative to historical or projected future operating results, significant changes in the manner of our use of the acquired assets or the strategy for our overall business or significant negative industry or economic trends. If this evaluation indicates that the value of the intangible asset may be impaired, we make an assessment of the recoverability of the net carrying value of the asset over its remaining useful life. If this assessment indicates that the intangible asset is not recoverable, based on the estimated undiscounted future cash flows of the technology over the remaining useful life, we reduce the net carrying value of the related intangible asset to fair value. Any such impairment charge could be significant and could have a material adverse effect on our reported financial results. During the fourth quarter of 2011, we recognized an impairment charge of $518,000 related to technology acquired from TestQuest in 2008.

We evaluate goodwill for impairment annually or more frequently when an event occurs or circumstances change that indicate that the carrying value may not be recoverable. Our annual testing date is December 31. We test goodwill for impairment by

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performing a qualitative assessment to determine whether it is more likely than not that the fair value of the reporting unit is less than the carrying amount. If it is more likely than not that the fair value of the reporting unit is greater than the carrying amount, further testing of impairment is not performed. If it is more likely than not that the fair value of the reporting unit is less than the carrying amount, we perform a quantitative two-step impairment test.

Stock-Based Compensation

Our stock-based compensation expense for stock options is estimated at the grant date based on the stock award’s fair value as calculated by the Black-Scholes-Merton (“BSM”) option-pricing model and is recognized as expense over the requisite service period. The BSM model requires various highly judgmental assumptions including expected volatility and option life. If any of the assumptions used in the BSM model change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period. Restricted stock units (“RSUs”) and restricted stock awards (“RSAs”) are measured based on the fair market values of the underlying stock on the dates of grant as determined based on the number of shares granted and the quoted price of our common stock on the date of grant. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. We estimate the forfeiture rate based on historical experience.experience and expected future activity. To the extent our actual forfeiture rate is different from our estimates, stock-based compensation expense is adjusted accordingly.

Incentive Compensation

We make certain estimates, judgments and assumptions regarding the likelihood of attainment, and the level thereof, of bonuses payable under our annual incentive compensation programs. We accrue bonuses and recognize the resulting expense when the bonus is judged to be reasonably likely to be earned as of year-end and is estimable. The amount accrued, and expense recognized, is the estimated portion of the bonus earned on a year-to-date basis less any amounts previously accrued. These estimates, judgments and assumptions are made quarterly based on available information and take into consideration our year-to-date actual results and expected

results for the remainder of the year. Because we consider estimated future results in assessing the likelihood of attainment, significant judgment is required. If actual results differ materially from our estimates, the amount of bonus expense recorded in a particular quarter could be significantly over or under estimated.

Taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate income taxes in each of the countries and other jurisdictions in which we operate. This process involves estimating our current tax expense together with assessing temporary differences resulting from the differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. Net operating losses and tax credits, to the extent not already utilized to offset taxable income or income taxes, also give rise to deferred tax assets. We must then assess the likelihood that any deferred tax assets will be realized from future taxable income, and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. Significant judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our deferred tax assets. We estimate the valuation allowance related to our deferred tax assets on a quarterly basis.

Our sales may be subject to other taxes, particularly withholding taxes, due to our sales to customers in countries other than the United States. The tax regulations governing withholding taxes are complex, causing us to have to make assumptions about the appropriate tax treatment. Further, we make sales in many jurisdictions across the United States, where tax regulations are varied and at times complex. We must therefore continue to analyze our state tax exposure and determine what the appropriate tax treatments are, and make estimates for sales, franchise, income and other state taxes.

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Results of Operations

The following table presents certain financial data as a percentage of total revenue for the periods indicated. Our historical operating results are not necessarily indicative of the results for any future period.

Comparison of the Years Ended December 31, 20122014 and 20112013

Acquisition of MPC Data Limited

On September 11, 2011 we completed the acquisition of MPC Data Limited (“MPC”), a United Kingdom-based provider of embedded software engineering services. The acquisition is part of our overall growth strategy and is designed to capitalize on the growing market for smart, connected systems by expanding both the breadth of services offered and the geographies that we serve. As the acquisition took place late in the third quarter of 2011, the impact on our results of operations for 2011 was relatively insignificant for the year in total. Where applicable, the MPC-related impacts have been noted in the following commentary.

Revenue

Our revenue is generated from the sale of software, both our own proprietary software and third-party software that we resell, and the sale of engineering services. Total revenue was $101.4increased $3.8 million, or 4%, to $95.9 million in 2012 and was $96.82014 from $92.1 million in 2011. An2013. This increase was driven by higher sales of Windows Embedded operating systems, and an increase in sales of Microsoft Windows Embedded and Windows Mobile operating systems drove the increase,engineering services revenue, partially offset partially by a decline in serviceproprietary software revenue. One customer, Future Electronics, Inc. accounted for 12% of total revenues in 2014. No other customers accounted for 10% or more of total revenue in either 2014 or 2013.

Revenue from our customers outside of North America increased $7.4decreased $1.7 million, or 33%14%, to $29.5$10.0 million in 2012,2014, from $22.1$11.7 million in 2011.2013. Revenue from our customers outside of North America represented 29%10% of our total revenue in 2012,2014, compared to 23%13% in 2011.2013. The increasedecrease in non-North American revenue in 20122014 was primarily attributable to higher service revenuelower sales of Windows Mobile operating systems in Europe driven by the September 2011 acquisition of MPC as well as an increase in serviceAsia, lower engineering services revenue and third partylower proprietary software sales in Asia.Asia.

Software revenue

Software revenue consists of sales of third-party software and revenue realized from our own proprietary software products, which include software license sales, royalties from our software products, sales of software development kits, support and maintenance revenue, and royalties from certain engineering service contracts. Software revenue for 20122014 and 20112013 was as follows (dollars in thousands):

The vast majority of our third-party software revenue is comprised of sales of Microsoft Windows Embedded software and Windows Mobile operating systems. Third-party software salesrevenue increased $8.4$3.0 million, or 13%4%, in 20122014 compared to the prior year. The

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increase in third-party software revenue was driven primarily by an increase in Microsoft Windows Embedded software sales as well two significant sales of our new MobileV products totaling $1.0 million, partially offset by decreases in Windows Mobile sales as well as sales of Adobe Flash which had a significant sale in Q4 2013.

Proprietary software revenue decreased $0.2 million, or 8%, in 2014 compared to 2013. This was driven by the continued decline in sales of legacy products.

Service revenue

Service revenue for 2014 and 2013 was as follows (dollars in thousands):

Service revenue increased $1.0 million, or 5%, in 2014 compared to the prior year. This increase was due to higher sales of both Microsoft Windows Embedded and Windows Mobile operating systems which increased $8.6 million. Sales of Microsoft Windows Embedded operating systems increased $5.0 million or 11% in 2012 as compared to the prior year driven by expansion into the EMEA region as well as significant increases in sales to some of our existing customer base. Sales of Microsoft Windows Mobile operating systems increased $3.6 million or 26% driven primarilyservice revenue generated in both Asia and EMEA offset partially by the addition of a new customer in North America. Our rights to distribute Windows Mobile operating systems in Korea ended on October 31, 2012. We sold $4.5 million of Windows Mobile operating systems in Korea in 2012 and $4.6 million in 2011.

Proprietary software revenue decreased $897,000, or 16%, in 2012 compared to 2011 due primarily to the fact that the sale of Qualcomm development platforms were classified as proprietary software revenue for the first three quarters of 2011, whereas in 2012 and for the fourth quarter of 2011, they were classified as third-party software sales. Proprietary software revenue in 2011 included $929,000 of Qualcomm development platform sales classified as proprietary software revenue.

Service revenue

Service revenue for 2012 and 2011 was as follows (dollars in thousands):

Service revenue decreased $3.0 million, or 10%, in 2012 as compared to the prior year. This decrease was due to a $6.7 million decline in North America service revenue offset in part by a $2.5 million increase in Europe service revenue resulting from the MPC acquisition in September 2011 and a $1.1 millionrevenue. The increase in Asia service revenuewas driven by growththe completion of two large handheld programs. Both programs were accounted for under the zero profit percentage of completion accounting method in Japan duewhich we recognized revenue during the project equal to our cost and recognize the remaining revenue, equal to the signinggross profit on the program, at completion. One of several significant OEM customers.the programs was completed during the three months ended June 30, 2014 while the other was completed during the three months ended December 31, 2014. The declinedecrease in North America service revenue was due todriven largely by a $3.3$1.7 million decline indecrease associated with the MyFord Touch-related service revenue as described below whileTouch Program offset partially by increases from our existing customer base and the remainder was attributable to two large customers in 2011 which contributed $3.2 million in service revenue compared to no similarly large projects in 2012.acquisition of new customers.

Microsoft Corporation (“Microsoft”) became our largest engineering services customer during the first quarter of 2012, replacing Ford Motor Company (“Ford”), as Microsoft replaced Ford as the invoiced customer on the MyFord Touch program. We continue to work on the MyFord Touch, a project we began with Ford during the second quarter of 2008; however, we now conduct these services through an agreement with Microsoft. During the initial project with Ford, we provided hardware design and implementation, platform level software development, application level software development, quality assurance services and systems integration services. The project has transitioned since the initial project such that we are now primarily focused on developing and integrating new user applications for the MyFord Touch, enhancing existing applications and customizing the MyFord Touch platform for additional vehicle models. The MyFord Touch program contributed $6.4$2.8 million in service revenue in 20122014 compared to $9.7$4.5 million in 20112013, representing a decline of $3.3$1.7 million or 34%38%. The decrease is attributable to a reduction in the number of engineers working on the MyFord Touch project as the amount of work on the increasingly mature platform has declined. In December 2014, Ford introduced Sync 3, the next generation MyFord Touch program that is scheduled to be deployed on cars in 2016 and will be based on QNX software from Blackberry instead of software from Microsoft. While we expect to be actively involved in current generation MyFord Touch projects with Microsoft, Ford and Elektrobit through 2015 and beyond, we expect our role on MyFord Touch will be scaled back or eliminated because of the transition to QNX software for the next generation Sync 3 and our revenue and resulting gross profit will decline accordingly.

Gross profit and gross margin

Cost of revenue related to software revenue consists primarily of the cost of third-party software products payable to third-party vendors.vendors and support costs associated with our proprietary software products. Cost of revenue related to service revenue consists primarily of salaries and benefits, contractor costs and re-billable expenses, related facilities and depreciation costs, and amortization of certain intangible assets related to acquisitions.

Gross profit on the sale of third-party software products wasis also positively affectedimpacted by rebate credits of $888,000 in 2012 and $746,000 in 2011we receive from Microsoft which wefor embedded software sales earned through the achievement of defined objectives.

Under this rebate program, we recognized $298,000 of rebate credits in 2014 and $744,000 in 2013, which were treated as reductions in cost of sales. Additionally, during 2014 we qualified for $685,000 in rebate credits which will be accounted for as a reduction in marketing expense if and when qualified expenditures are made.

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The following table outlines software, services and total gross profit (dollars in thousands):

Software gross profit and gross margin

Software gross profit increaseddecreased by $1.5$1.2 million, or 12%9%, in 2012,2014 compared to 2011,2013, while software gross margin was 19%decreased by three percentage points from 18% in both years. The gross profit increase was driven by higher sales of Microsoft Windows Embedded and Windows Mobile operating systems which accounted for a $1.6 million increase2013 to 15% in software gross profit. 2014.

Third-party software gross margin was 14% in 2014, compared to 16% in 2012 compared to 15%2013 driven primarily by a heavier concentration of sales of the lower margin product line of Microsoft Embedded software and lower rebates in 2011.2014, as well as a large Adobe Flash sale in the fourth quarter of 2013. Proprietary software gross margin was 78%75% in 20122014 compared to 65%66% in 2011 with2013. Although proprietary software revenue decreased by 8%, margins improved as a result of a decrease in the improvement attributablerelatively fixed software cost of sales due in part to a $518,000 impairment charge related to acquired TestQuest technology which negatively affectedthe cost reductions in the fourth quarter of 2011.2013.

Service gross profit and gross margin

Service gross profit decreased by $1.9increased $2.7 million, or 31%132%, in 2012 as2014 compared to 2011, while2013 driven by a $1.0 million increase in service revenue combined with a $1.7 million decrease in service cost of sales. Service gross margin decreased by fivewas 24% in 2014, a 13 percentage points to 17%point increase from 11% in 2012, from 22% in 2011.2013. The declinedecrease in service gross profitcost of sales was largely driven primarily by the decrease in engineering service revenue of $3.0 million. Service costs decreased by $1.1 million or 5% in 2012 compared to 2011. While cost per available hour decreased by approximately 10% primarily as a result of mix of resources internationally, it was more than offset by a declinean improvement in utilization ratemade possible by our cost reduction effort in the fourth quarter of 12% and a decline in realized rate per hour of 2%. During 2012, we made adjustments to reduce service related expenses2013 to better align our service cost base with anticipated revenue which included the closure of our futureBeijing, China delivery center.

Service gross profit also benefited from the recognition of $478,000 of gross profit on the previously mentioned service revenue expectations.project completed in Japan in the second quarter of 2014 as well as the $598,000 of gross profit on the other previously mentioned service project completed in Japan in the fourth quarter of 2014. These two completed projects, with recognized profit in 2014, added approximately 2% to the reported 2014 gross margin with a similar reduction in 2013 margins.

Operating expenses

Selling, general and administrative

Selling, general and administrative expenses consist primarily of salaries and related benefits, commissions and bonuses for our sales, marketing and administrative personnel and related facilities and depreciation costs, as well as professional services fees (e.g., consulting, legal, audit and audit)tax). Selling, general and administrative expenses decreased $2.4$3.0 million, or 14%20%, to $14.3$12.4 million in 2012,2014, from $16.7$15.4 million in 2011. Sales expense declined $2.7 million in 2012 compared to 2011, while marketing and general and administrative expense increased slightly.2013. The decrease in sales expense was driven by a $1.6 million decline in headcount-related expenses, including incentive compensation and travel, due to reductions which occurred during 2012, a portion of which were backfilledour cost reduction effort in the fourth quarter of 2012 or may be backfilled in 2013. Further, sales-related stock compensation expense decreased $975,000 in 2012 compared to 2011 due largely to2013 as well as severance and related costs associated with the departure of our previousformer Chief Executive Officer in September 2013 and the departure of our former Senior Vice President of Worldwide Sales and Marketing in 2012 which resulted in a significant forfeiture of unvested stock options in the third quarter of 2012.December 2013. Selling, general and administrative expenses represented 14%13% of our total revenue in 20122014 compared to 17% of revenue in 2011.2013.

Research and development

Research and development expenses consist primarily of salaries and benefits for software development and quality assurance personnel, contractor and consultant costs and related facilities and depreciation costs. Research and development expenses decreased $234,000,$1.1 million, or 6%39%, to $3.6$1.7 million in 2012,2014, from $3.8$2.8 million in

2011. 2013. The declinedecrease was driven largely by lower wage expenseour cost reduction efforts in the second halffourth quarter of 2012 associated primarily with reductions in headcount associated with our TestQuest development efforts.2013. Research and development expenses represented 4%2% of total revenue in both 20122014 and 2011.

Other income, net3% in 2013.

Other income (expense), net

Other income (expense) consists of interest income on our cash and investments, gains and losses we may recognize on our investments, gains or losses on foreign exchange transactions interest income on our cash, cash equivalents and investments and other items. Other incomeNet other expense was $103,000$101,000 in 20122014 compared to $422,000net other income of $40,000 in 2011,2013, representing a declinedecrease of $319,000.$141,000. This decreasechange was driven primarily by losses on foreign currency transactions in 2014 compared to gains on such transactions in 2013.

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Income taxes

Income tax expense was $38,000 in 2014, based on income before income taxes of $2.4 million. Our effective tax rate in 2014 was 1.6%, which is below the statutory rate of 34%, primarily due to a $104,000 realized gainthe full valuation allowance on the sale of an auction rate security (“ARS”) investment in 2011 and the settlement of a lawsuit with our former broker dealer of our ARS investments which resulted in a gain of $213,000 in 2011, compared to no such similar items in 2012.

U.S. deferred tax assets. Income tax

Our income tax expense was $366,000$2.2 million in 2012 compared2013, based on loss before income taxes of $3.1 million. Although we recognized a loss before income taxes in 2013, we did not recognize a tax benefit due to an income tax benefitcharge in the third quarter of $166,0002013. We determined that it was not more likely than not that we would generate sufficient future taxable income to use our U.S. deferred tax assets. As a result, we increased our deferred tax asset valuation allowance by $2.2 million. Deferred tax assets relative to our foreign jurisdictions were not affected.

The factors we considered in 2011,recording a changefull valuation allowance on our US deferred tax assets included, among other things, our recent history of $532,000.losses and the uncertainty regarding generation of future taxable income.

Restructuring

During the fourth quarter of 2013, we effected a restructuring that included a workforce reduction and the closure of our offices in Beijing, China and Munich, Germany. The increase in expenseworkforce reduction impacted approximately 20% of our worldwide workforce. The restructuring was drivenintended to better align our organizational structure with our strategic focus. The staff reductions and office closures were substantially completed by the profitabilityend of the fourth quarter of 2013 with some activities, including completing certain legal entity closures, continuing into early 2015.

The results of this restructuring and associated asset impairment were recorded within loss from operations on our United States parent company Consolidated Statement of Operations and Comprehensive Income (Loss). See Note 12: 2013 Restructuring in 2012.our Notes to Consolidated Financial Statements for further information.

Liquidity and Capital Resources

As of December 31, 2012,2014, we had $20.6$26.6 million of cash, cash equivalents, short-term investments and restricted cash, compared to $19.0$21.1 million at December 31, 2011. The increase was driven by our net income2013. Of these amounts, $13.1 million and non-cash expenses offset in part by negative working capital changes.$13.5 million were classified as cash and cash equivalents at December 31, 2014 and December 31, 2013, respectively,

Restricted cash is classified as long term and was $875,000$250,000 at both December 31, 20122014 and 2011.2013. This cash is restricted under the terms of our headquarters operating lease which will continue to secure that obligation through its expiration in 2014.2020. Our working capital was $20.6$23.7 million at December 31, 2012,2014, compared to $18.0$19.8 million at December 31, 2011.2013.

Net cash provided by operating activities was $2.5$5.3 million in 20122014, driven by our net income of $916,000$2.3 million, positive net working capital changes of $1.4 million and non cashnon-cash expenses of $2.2 million, offset in part by net negative working capital changes.$1.6 million. Net cash provided by operating activities was $1.1 million$619,000 in 20112013, driven by $3.1positive net working capital changes of $2.1 million ofand non-cash expenses and a $518,000 impairment charge onof $3.8 million, offset by our intangible assets associated with TestQuest acquired technology offset, in part, by net negative working capital changes.loss of $5.3 million.

Net cash used by investing activities was $1.2$6.3 million in 2012 driven2014, due primarily by capital expenditures. Net cash used by investing activities was $3.6 million in 2011 driven by the acquisitionto purchases of MPC for $4.8 million in cash, net of cash acquired and $785,000 of capital expenditures, offset in part by netshort-term investments exceeding proceeds from maturities of short-term investments. investments by approximately $6.0 million and fixed asset purchases of $0.3 million. Investing activities provided net cash of $3.0 million in 2013, due primarily to net proceeds of short-term investments of $2.5 million and a $625,000 reduction in restricted cash under the terms of our corporate headquarters lease amendment executed in August 2013.

Financing activities generated cash of $205,000$666,000 in 20122014 and $424,000$51,000 in 20112013 as a result of employees’the exercise of employee stock options.

We believe that our existing cash, cash equivalents, short-term investments and long-term investments will be sufficient to meet our needs for working capital and capital expenditures for at least the next 12 months.

Cash Commitments

We have the following future or potential cash commitments:

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Not Applicable.

27

BSQUARE CORPORATION

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders

BSQUARE Corporation

We have audited the accompanying consolidated balance sheets of BSQUARE Corporation (the “Corporation”) as of December 31, 20122014 and 20112013, and the related consolidated statements of operations and comprehensive income (loss), shareholders’ equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the auditsaudit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Corporation is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Corporation’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of BSQUARE Corporation as of December 31, 20122014 and 2011,2013, and the consolidated results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

/s/ Moss Adams LLP

Seattle, Washington

February 22, 2013

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BSQUARE CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

See notes to consolidated financial statements.

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BSQUARE CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)

(In thousands, except per share amounts)