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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2008
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File Number 001-33197
GUIDANCE SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
Delaware | 95-4661210 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |
215 North Marengo Avenue Pasadena, California 91101 | (626) 229-9191 | |
(Address of principal executive offices) | Registrant’s telephone number, including area code |
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $0.001 par value per share.
Securities registered pursuant to Section 12(g) of the Act:
None.
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 þ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company (as defined in Rule 12b-2 of the Exchange Act).
Large accelerated filer ¨ Accelerated filer þ Non-accelerated filer ¨ Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No þ
As of May 5, 2008, there were approximately 23,122,500 shares of the registrant’s Common Stock outstanding.
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GUIDANCE SOFTWARE, INC.
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2008
Page | ||||
Item 1. | ||||
Condensed Consolidated Balance Sheets at December 31, 2007 and March 31, 2008 (unaudited) | 1 | |||
2 | ||||
3 | ||||
Notes to the Condensed Consolidated Financial Statements (unaudited) | 4 | |||
Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 13 | ||
Item 3. | 24 | |||
Item 4. | 24 | |||
Item 1. | Legal Proceedings | 25 | ||
Item 1A. | Risk Factors | 25 | ||
Item 6. | Exhibits | 25 | ||
26 |
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Item 1. | Financial Statements |
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
(unaudited)
December 31, 2007 | March 31, 2008 | |||||||
ASSETS | ||||||||
Current assets: | ||||||||
Cash and cash equivalents | $ | 37,591 | $ | 36,203 | ||||
Trade receivables, net of allowance for doubtful accounts of $984 and $1,183, respectively | 21,093 | 23,419 | ||||||
Prepaid expenses, inventory and other current assets | 2,863 | 2,463 | ||||||
Deferred tax assets | 1,386 | 1,386 | ||||||
Total current assets | 62,933 | 63,471 | ||||||
Property and equipment, net | 12,515 | 12,277 | ||||||
Other assets | 489 | 493 | ||||||
Total assets | $ | 75,937 | $ | 76,241 | ||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||
Current liabilities: | ||||||||
Accounts payable | $ | 4,595 | $ | 4,053 | ||||
Accrued expenses | 6,421 | 6,208 | ||||||
Capital lease obligations | 586 | 449 | ||||||
Deferred revenues | 24,895 | 26,023 | ||||||
Total current liabilities | 36,497 | 36,733 | ||||||
Long-term liabilities: | ||||||||
Rent incentives | 3,053 | 2,944 | ||||||
Capital lease obligations | 185 | 116 | ||||||
Deferred revenues | 2,306 | 2,591 | ||||||
Total long-term liabilities | 5,544 | 5,651 | ||||||
Commitments and contingencies (Note 7) | ||||||||
Stockholders’ equity: | ||||||||
Preferred stock, $0.001 par value: 10,000,000 shares authorized; no shares issued or outstanding | — | — | ||||||
Common stock, $0.001 par value; 100,000,000 shares authorized; 23,010,000 and 23,112,000 shares issued and outstanding, respectively | 23 | 23 | ||||||
Additional paid-in capital | 46,516 | 49,152 | ||||||
Accumulated deficit | (12,643 | ) | (15,318 | ) | ||||
Total stockholders’ equity | 33,896 | 33,857 | ||||||
Total liabilities and stockholders’ equity | $ | 75,937 | $ | 76,241 | ||||
The accompanying notes are an integral part of these consolidated financial statements
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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
Three Months Ended March 31, | ||||||||
2007 | 2008 | |||||||
Revenues: | ||||||||
Product revenue | $ | 10,088 | $ | 10,922 | ||||
Services and maintenance revenue | 7,508 | 10,768 | ||||||
Total revenues | 17,596 | 21,690 | ||||||
Cost of revenues (1): | ||||||||
Cost of product revenue | 745 | 788 | ||||||
Cost of services and maintenance revenue | 4,513 | 5,647 | ||||||
Total cost of revenues | 5,258 | 6,435 | ||||||
Gross profit | 12,338 | 15,255 | ||||||
Operating expenses (1): | ||||||||
Selling and marketing | 8,692 | 9,734 | ||||||
Research and development | 2,048 | 3,087 | ||||||
General and administrative | 3,090 | 4,331 | ||||||
Depreciation and amortization | 699 | 1,051 | ||||||
Total operating expenses | 14,529 | 18,203 | ||||||
Operating loss | (2,191 | ) | (2,948 | ) | ||||
Other income and expense: | ||||||||
Interest income | 358 | 282 | ||||||
Interest expense | (32 | ) | (16 | ) | ||||
Other income, net | 34 | 35 | ||||||
Loss before income taxes | (1,831 | ) | (2,647 | ) | ||||
Income tax provision | 25 | 28 | ||||||
Net loss | $ | (1,856 | ) | $ | (2,675 | ) | ||
Net loss per share: | ||||||||
Basic | $ | (0.08 | ) | $ | (0.12 | ) | ||
Diluted | $ | (0.08 | ) | $ | (0.12 | ) | ||
Weighted average number of shares used in per share calculation: | ||||||||
Basic | 22,289 | 23,086 | ||||||
Diluted | 22,289 | 23,086 |
(1) | See Management’s Discussion and Analysis of Financial Condition and Results of Operations for the amount of share-based compensation included in the Condensed Consolidated Statements of Operations. |
The accompanying notes are an integral part of these consolidated financial statements
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Three Months Ended March 31, | ||||||||
2007 | 2008 | |||||||
Cash flows from operating activities: | ||||||||
Net loss | $ | (1,856 | ) | $ | (2,675 | ) | ||
Adjustments to reconcile net loss to net cash provided by (used in) operating activities: | ||||||||
Depreciation and amortization | 699 | 1,051 | ||||||
(Recovery of) provision for doubtful accounts | (49 | ) | 267 | |||||
Share-based compensation | 888 | 2,116 | ||||||
Loss on disposal of assets | 27 | 14 | ||||||
Changes in operating assets and liabilities: | ||||||||
Trade receivables | 1,167 | (2,593 | ) | |||||
Prepaid expenses, inventory and other assets | (17 | ) | 396 | |||||
Accounts payable | (1,937 | ) | (610 | ) | ||||
Accrued expenses | 446 | (733 | ) | |||||
Deferred revenue | 2,691 | 1,413 | ||||||
Net cash provided by (used in) operating activities | 2,059 | (1,354 | ) | |||||
Cash flows from investing activities: | ||||||||
Purchase of property and equipment | (1,376 | ) | (348 | ) | ||||
Purchase of marketable debt securities | (24,693 | ) | — | |||||
Sale of marketable debt securities | 24,703 | — | ||||||
Net cash used in investing activities | (1,366 | ) | (348 | ) | ||||
Cash flows from financing activities: | ||||||||
Proceeds from the exercise of stock options | 640 | 520 | ||||||
Principal payments on capital lease obligations | (258 | ) | (206 | ) | ||||
Cash paid for offering expenses | (241 | ) | — | |||||
Net cash provided by financing activities | 141 | 314 | ||||||
Net increase (decrease) in cash and cash equivalents | 834 | (1,388 | ) | |||||
Cash and cash equivalents, beginning of period | 8,041 | 37,591 | ||||||
Cash and cash equivalents, end of period | $ | 8,875 | $ | 36,203 | ||||
Supplemental disclosures of cash flow information: | ||||||||
Net cash paid during the period for: | ||||||||
Interest | $ | 22 | $ | 13 | ||||
Income taxes | $ | — | $ | 426 | ||||
Non-cash activities: | ||||||||
Capital lease obligations incurred to acquire assets | $ | 165 | $ | — | ||||
Purchase of equipment included in accounts payable and accrued expenses | $ | 1,484 | $ | 479 | ||||
Rent incentives | $ | 546 | $ | — | ||||
Recognition of uncertain tax liabilities | $ | 130 | $ | — |
The accompanying notes are an integral part of these consolidated financial statements
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note 1. Description of the Business and Summary of Significant Accounting Policies
General
Guidance Software, Inc. was incorporated in the state of California during 1997 and reincorporated in Delaware on December 11, 2006. Guidance and its subsidiaries are collectively referred to herein as “Guidance,” “we” or the “Company.” Headquartered in Pasadena, California, Guidance is a global provider of software solutions to conduct digital investigations. Our flagship product is EnCase® Enterprise, a comprehensive, network-enabled digital solution that enables corporations and government agencies to search, collect, preserve and analyze data across all of the servers, desktops and laptops that comprise their entire network from a single location. We also sell EnCase® Forensic, primarily for use by law enforcement and government agencies for collecting, preserving, analyzing and authenticating electronic computer forensic data for use in criminal and civil court proceedings. We complement our software offerings with a comprehensive array of professional and training services including technical support and maintenance services to help our customers implement our solutions, conduct investigations and train their IT professionals to effectively and efficiently use our software products.
Basis of Presentation
The accompanying condensed consolidated balance sheet as of March 31, 2008 and the condensed consolidated statements of operations and cash flows for the three months ended March 31, 2008 and 2007 are unaudited. These statements should be read in conjunction with the audited consolidated financial statements and related notes, together with management’s discussion and analysis of financial position and results of operations, contained in our Annual Report on Form 10-K for the year ended December 31, 2007, filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 17, 2008.
The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or (“GAAP”). In the opinion of our management, the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements in the Annual Report on Form 10-K for the year ended December 31, 2007 and include all adjustments necessary for the fair presentation of our financial position as of March 31, 2008 and our results of operations and cash flows for the three months ended March 31, 2008 and 2007. The condensed consolidated balance sheet as of December 31, 2007 has been derived from the December 31, 2007 audited financial statements. The interim financial information contained in this quarterly report is not necessarily indicative of the results to be expected for any other interim period or for the entire year.
The consolidated financial statements include the accounts of Guidance and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Use of Estimates and Assumptions
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate these estimates, including those related to bad debts, annual performance based bonus plan, income taxes, commitments, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.
Fair Value of Financial Instruments
The carrying amounts of cash equivalents, accounts receivable, and accounts payable approximate fair value because of the short-term maturities of these instruments. Based on borrowing rates currently available to us for borrowings with similar terms, the carrying values of our capital lease obligations also approximate fair value. Marketable debt securities are stated at fair value based on market quotes.
Concentrations of Credit Risk
Financial instruments that potentially subject us to significant concentrations of credit risk consist primarily of cash and cash equivalents, marketable debt securities, and accounts receivable. We restrict our investments in cash and cash equivalents to financial institutions and government or federal agency securities and obligations of corporations with high credit standing. At March 31, 2008, the majority of our cash balances were held at financial institutions located in California,
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which accounts are insured by the Federal Deposit Insurance Corporation up to $100,000. Uninsured balances aggregate approximately $35.9 million as of March 31, 2008. At March 31, 2008, all of our cash equivalents consisted of financial institution and corporate obligations. We periodically perform credit evaluations of our customers and maintain reserves for potential losses on our accounts receivable and do not believe we are subject to concentrations of credit risk with respect to such receivables.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.” SFAS 157 does not require new fair value measurements but rather defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. We adopted SFAS 157 in the first quarter of 2008 for financial assets and liabilities and are required to adopt FAS 157 in the first quarter of 2009 for nonfinancial assets and liabilities. Adoption of FAS 157 with respect to financial assets and liabilities did not have a material impact on our consolidated financial position and results of operations and we do not expect adoption of SFAS 157 with respect to nonfinancial assets and liabilities to have a material impact on our consolidated financial position and results of operations.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities—Including an amendment of FASB Statement No. 115.” SFAS 159 allows companies to elect fair-value measurement when an eligible financial asset or financial liability is initially recognized or when an event, such as a business combination, triggers a new basis of accounting for that financial asset or financial liability. SFAS 159 became effective for us on January 1, 2008, however we did not elect the fair value measurement provision for any of our financial assets or liabilities, so adoption of SFAS 159 had no effect on our consolidated financial position or results of operations.
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations,” which will significantly change the accounting for business combinations. Under SFAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS 141R will change the accounting treatment for certain specific items, including:
• | acquisition costs will be generally expensed as incurred; |
• | in-process research and development will be recorded at fair value as an indefinite-lived intangible asset at the acquisition date; |
• | restructuring costs associated with a business combination will be generally expensed subsequent to the acquisition date; and |
• | changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense. |
SFAS 141R also includes a substantial number of new disclosure requirements. We will be required to adopt SFAS 141R prospectively to any business combinations for which the acquisition date is on or after January 1, 2009. Earlier adoption is prohibited. SFAS 141R will only have an effect on our financial statements in the event that we enter into business combinations subsequent to that date.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — An Amendment of ARB No. 51.” SFAS 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the statement of operations. SFAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. SFAS 160 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. We will be required to adopt SFAS 160 effective January 1, 2009. Earlier adoption is prohibited. We do not have a noncontrolling interest in any subsidiaries. Accordingly, we do not anticipate that the initial application of SFAS No. 160 will have an impact on us.
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Note 2. Net (Loss) Income Per Share
We calculate net (loss) income per share in accordance with SFAS No. 128, “Earnings Per Share.” Under SFAS No. 128, basic net income per common share is calculated by dividing net income by the weighted-average number of common shares outstanding during the reporting period. Diluted net income per share is calculated based on the weighted average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares consist of the shares issuable upon the exercise of stock options and upon the vesting of nonvested stock awards under the treasury stock method. In net loss periods, basic net loss per share and diluted net loss per share are identical since the effect of potential common shares is anti-dilutive and therefore excluded. The following is a reconciliation of the numerators and denominators of the income (loss) per share computations for the periods presented (in thousands, except per share amounts):
Three Months Ended March 31, | ||||||||
2007 | 2008 | |||||||
Numerator: | ||||||||
Net loss | $ | (1,856 | ) | $ | (2,675 | ) | ||
Denominator: | ||||||||
Basic weighted average shares outstanding | 22,289 | 23,086 | ||||||
Effect of dilutive stock options and non-vested share awards | — | — | ||||||
Diluted weighted average shares outstanding | 22,289 | 23,086 | ||||||
Net loss per share: | ||||||||
Basic | $ | (0.08 | ) | $ | (0.12 | ) | ||
Diluted | $ | (0.08 | ) | $ | (0.12 | ) | ||
Anti-dilutive options | 1,283 | 565 | ||||||
Anti-dilutive non-vested share awards | — | — | ||||||
Note 3. Debt Obligations
We maintain a $3,000,000 revolving line of credit with a bank which expires on October 31, 2008. Borrowings under this line of credit would bear interest at a rate equal to the bank’s prime rate minus 0.75% or the bank’s LIBOR plus 1.50%, would be due on the expiration date of the facility and be collateralized by substantially all our assets. The facility requires us to maintain cash, cash equivalents, and marketable securities of not less than $10 million, not to allow a cumulative net loss (excluding non-cash share-based compensation) in excess of $4 million during any one fiscal year and limits additional indebtedness to $2,000,000. As of March 31, 2008, we were in compliance with the covenants associated with the revolving line of credit. At December 31, 2007 and March 31, 2008, no amounts were outstanding under the line.
Note 4. Equity Incentive Plan
In 2004, our Board of Directors and stockholders approved the 2004 Equity Incentive Plan (the “Plan”). A total of 2,062,000 shares of common stock was initially authorized and reserved for issuance under the Plan in the form of incentive and non-qualified stock options and nonvested share awards (commonly referred to as “restricted stock”). The Plan was amended in 2005 to increase the number of shares available for issuance to 3,977,000. On May 3, 2006, the Board of Directors and stockholders approved increases in the shares available for issuance under the Plan by an additional 1,127,000 shares on May 3, 2006, and an additional 828,000 shares on each of January 1, 2007, 2008 and 2009. We have proposed a resolution, to be voted on at our 2008 Annual Meeting of Stockholders, to accelerate the January 1, 2009 contribution of shares to July 1, 2008. Employees, officers and directors are eligible under the Plan, which is administered by the Board of Directors, who determines the terms and conditions of each grant. The terms of the options granted under the Plan are determined at the time of grant, and generally vest 25% annually over a four-year service period and typically must be exercised within 10 years from the date of grant.
In December 2007, we awarded our new Chief Executive Officer with 500,000 stock options that will vest in 25% increments in the event our common stock price increases to specified levels during his continued employment over the grant’s 10 year term. This grant depleted the authorized option pool. Accordingly, approximately 300,000 options were issued outside of the Plan. During the first quarter of 2008, we amended this grant, effectively cancelling the non-Plan options and reissuing them under the Plan. A December 2007 nonvested share award of 100,000 shares to our Chief Executive Officer was also restructured during the first quarter of 2008 to bring them under the terms of the Plan.
At March 31, 2008, 303,000 shares remain available for grant as options or nonvested share awards under the Plan.
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Stock Options
A summary of stock option activity follows:
Number of Options | Weighted Average Exercise Price | Range of Exercise Prices | |||||||
Outstanding, December 31, 2007 | 4,553,000 | $ | 9.11 | $ | 4.54 -14.32 | ||||
Granted | 247,000 | $ | 10.49 | $ | 10.49 | ||||
Exercised | (102,000 | ) | $ | 5.12 | $ | 4.54 -10.75 | |||
Canceled or forfeited | (225,000 | ) | $ | 10.93 | $ | 4.54 -14.32 | |||
Outstanding, March 31, 2008 | 4,473,000 | $ | 9.19 | $ | 4.54 -14.32 | ||||
A summary of nonvested options as of March 31, 2008, and the changes during the three months ended March 31, 2008 is presented below:
Number of Options | |||
Nonvested options as of December 31, 2007 | 3,525,000 | ||
Granted | 247,000 | ||
Vested | (585,000 | ) | |
Forfeited | (225,000 | ) | |
Nonvested options as of March 31, 2008 | 2,962,000 | ||
The following tables summarize information about stock options outstanding at March 31, 2008:
Options Outstanding | Options Exercisable | |||||||||||||||||||
Exercise Price | Number of Options | Weighted Average Remaining Contract Life (Years) | Weighted Average Exercise Price | Intrinsic Value | Number of Options | Weighted Average Remaining Contract Life (Years) | Weighted Average Exercise Price | Intrinsic Value | ||||||||||||
$ 4.54 – 5.34 | 1,454,000 | 6.6 | $ | 4.62 | $ | 6,303,000 | 1,118,000 | 6.5 | $ | 4.58 | $ | 4,889,000 | ||||||||
$ 6.17 – 7.64 | 454,000 | 7.8 | 6.41 | 1,154,000 | 208,000 | 7.8 | 6.36 | 539,000 | ||||||||||||
$ 10.49 – 11.90 | 1,304,000 | 9.0 | 11.08 | — | 148,000 | 8.4 | 11.07 | — | ||||||||||||
$ 12.80 – 14.32 | 1,261,000 | 9.6 | 13.50 | — | 37,000 | 8.9 | 12.94 | — | ||||||||||||
4,473,000 | 8.3 | $ | 9.19 | $ | 7,457,000 | 1,511,000 | 6.9 | $ | 5.66 | $ | 5,428,000 | |||||||||
Options Expected to Vest | ||||||||||
Exercise Price | Number of Options | Weighted Average Remaining Contract Life (Years) | Weighted Average Exercise Price | Intrinsic Value | ||||||
$ 4.54 – 5.34 | 292,000 | 6.7 | $ | 4.74 | $ | 1,230,000 | ||||
$ 6.17 – 7.64 | 213,000 | 7.8 | 6.45 | 533,000 | ||||||
$ 10.49 – 11.90 | 1,007,000 | 9.1 | 11.08 | — | ||||||
$ 12.80 – 14.32 | 1,131,000 | 9.6 | 13.48 | — | ||||||
2,643,000 | 8.9 | $ | 11.03 | $ | 1,763,000 | |||||
We define in-the-money options at March 31, 2008 as options that had exercise prices that were lower than the $8.95 fair market value of our common stock at that date. The aggregate intrinsic value of options outstanding at March 31, 2008 is calculated as the difference between the exercise price of the underlying options and the fair market value of our common
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stock for the 1,908,000 shares that were in-the-money at that date, of which 1,326,000 were exercisable. The total intrinsic value of the options exercised during the three months ended March 31, 2008 was $713,000, determined as of the date of exercise.
For options granted after January 1, 2006, the total fair value of options vested during the three months ended March 31, 2008 was $877,000; options awarded prior to January 1, 2006 were granted prior to our adoption of FAS 123R and did not have an estimable fair value.
Nonvested Share Awards
During 2007, we began issuing nonvested share awards (commonly referred to as “restricted stock”) to certain executives and employees under the Plan. Compensation expense for such awards, based on the fair market value of the awards on the grant date, is recorded during the vesting period. The first awards of nonvested share awards were made in February 2007, when approximately 40,000 shares were granted with three-month vesting periods. Later in 2007 and the quarter ended March 31, 2008, additional grants were awarded. Awards granted under the Plan generally vest 25% annually over a four-year period, however a 100,000 share award to our President and Chief Executive Officer vests 100% in December 2011. A summary of nonvested share awards activity follows:
Number of Shares | Weighted Average Fair Value | Range of Fair Values | ||||||
Outstanding, December 31, 2007 | 499,000 | $ | 14.02 | $ | 12.80 -14.32 | |||
Granted | 179,000 | 10.16 | 9.11 -10.49 | |||||
Vested and issued | — | — | — | |||||
Forfeited | — | — | — | |||||
Outstanding, March 31, 2008 | 678,000 | $ | 13.00 | $ | 9.11 -14.32 | |||
The following table summarizes information about nonvested share awards outstanding at March 31, 2008:
Nonvested Share Awards Outstanding | Nonvested Share Awards Expected to Vest | |||||||||
Fair Value | Number of Shares | Weighted Average Remaining Vesting Period (Years) | Number of Shares | Weighted Average Remaining Vesting Period (Years) | ||||||
$ 9.11 | 42,000 | 2.5 | 37,000 | 2.5 | ||||||
$ 10.49 | 137,000 | 2.4 | 119,000 | 2.4 | ||||||
$ 12.80 | 100,000 | 3.7 | 100,000 | 3.7 | ||||||
$ 14.32 | 399,000 | 2.1 | 347,000 | 2.1 | ||||||
678,000 | 2.4 | 603,000 | 2.4 | |||||||
No nonvested share awards vested during the three months ended March 31, 2008.
We experienced disqualifying dispositions of incentive stock options during the three months ended March 31, 2008. Disqualifying dispositions result in a tax deduction in our corporate tax return equal to the intrinsic value of the option at exercise. To the extent we have previously recorded share-based compensation expense related to disqualifying dispositions of incentive stock options, we record the benefit from the disqualifying dispositions as a reduction in our income tax provision.
As a result of the disqualifying dispositions of incentive stock options during the three months ended March 31, 2008, the $0.1 million tax benefit related to options that were granted prior to the adoption of SFAS No. 123R (“SFAS 123R”), “Share-Based Payment” (Note 5) was recorded as a reduction of our current year tax liability and an increase to additional paid-in capital. The tax benefit related to the exercise of options granted subsequent to the adoption so SFAS 123R was recorded as a reduction of current year tax expense and the tax liability. There were no material disqualifying dispositions during the three months ended March 31, 2007.
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Note 5. Share-Based Compensation
Effective January 1, 2006, we adopted SFAS No. 123R (“SFAS 123R”), “Share-Based Payment.” We adopted SFAS 123R using the prospective transition method and, accordingly, since adoption, we recognize share-based compensation expense for all share-based awards granted after January 1, 2006. Under that transition method, results for prior periods have not been restated.
With the exception of one option granted in December 2007 with market-based vesting conditions, discussed further below, the fair values of awards granted under the Plan were estimated at the date of grant using the Black-Scholes option pricing model and the following weighted average assumptions:
Three Months Ended March 31, | ||||||||
2007 | 2008 | |||||||
Risk-free interest rate | 4.5 | % | 3.3 | % | ||||
Dividend yield | — | % | — | % | ||||
Expected life (years) | 6.25 | 6.25 | ||||||
Volatility | 69.3 | % | 48.7 | % | ||||
Weighted average grant date fair value | $ | 8.62 | $ | 5.38 |
The SEC has issued Staff Accounting Bulletin (“SAB”) Topics No. 107 and No. 110 which provide guidance on the implementation of SFAS 123R. We applied the principles of SAB 107 in conjunction with adoption of SFAS 123R. The volatility of our common stock is estimated at the date of grant based on a weighted-average of the implied volatility of publicly traded 30-day to 270-day options on the common stock of a select peer group of similar companies (“Similar Companies”), the historical volatility of the common stock of Similar Companies and, beginning in late 2007, the historical volatility of our common stock, consistent with the requirements of SFAS 123R and SAB 107. The risk-free interest rate that was used in the Black-Scholes option valuation model is based on the implied yield in effect at the time of each option grant, based on U.S. Treasury zero-coupon issues with equivalent remaining terms. We use an expected dividend yield of zero in the Black-Scholes option valuation model, as we have no intention of paying any cash dividends on our common stock in the foreseeable future. SFAS 123R requires us to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. We amortize share-based compensation on a straight-line basis over the requisite service period of the awards, which is generally the vesting period. The expected term (life) of all stock option awards has been calculated using the “simplified method” as defined by SAB 107 and SAB 110 because, due to the limited time our common stock has been publicly traded, we lack sufficient historical data to provide a reasonable basis to estimate the expected term of these options.
In December 2007, we granted our President and Chief Executive Officer an option to purchase 500,000 shares of our common stock at the price of $12.80 per share which vests, in 25% increments, only upon attainment of specified market-based conditions tied to the market value of our common stock. Under the provisions of SFAS 123R, the fair value of share-based grants with a market vesting condition must be modeled and valued with a path-dependent valuation technique. Accordingly, we estimate the value of such awards using the Monte Carlo binomial simulation model. The primary assumptions used in the model are volatility, a risk-free interest rate, starting stock price, transferability restrictions and the terms of the award, as follows:
• | Risk-free interest rate of 3.98%; |
• | Dividend yield of zero; |
• | Expected option life of 10 years; and |
• | Volatility of the expected market price of our common stock over that term of 53.9%. |
Using these assumptions and inputs, we estimated that the weighted average grant date fair value of this award was $5.68 per option, with derived service periods ranging from 15 to 32 months for the four performance levels, and averaging 24 months. Under FAS 123R, the calculated $2.8 million fair value of this award must be recognized as expense over a weighted average period of approximately two years whether the market conditions are met or not so long as the grantee meets the service condition.
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The following table summarizes the share-based compensation expense we recorded in accordance with the provisions of FAS 123R:
Three Months Ended March 31, | ||||||
2007 | 2008 | |||||
(in thousands) | ||||||
Amortization of fair value of stock option grants | $ | 617 | $ | 1,641 | ||
Nonvested share awards | 271 | 475 | ||||
Share-based compensation expense | $ | 888 | $ | 2,116 | ||
As of March 31, 2008, there was approximately $22.9 million of total unrecognized compensation cost related to non-vested share-based compensation that is expected to be recognized over a weighted-average period of 2.8 years. We expect to record approximately $8.6 million in share-based compensation in 2008 related to options and nonvested share awards outstanding at March 31, 2008.
Note 6. Income Taxes
We file income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. We adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”), on January 1, 2007 and, accordingly, performed a comprehensive review of our uncertain tax positions as of that date. In this regard, an uncertain tax position represents our expected treatment of a tax position taken in a filed tax return, or planned to be taken in a future tax return, that has not been reflected in measuring income tax expense for financial reporting purposes. As a result of this review, we recorded uncertain tax positions by recognizing additional liabilities totaling $130,000 through a charge to accumulated deficit. During the year ended December 31, 2007, our liability for uncertain tax positions was reduced to $13,000 upon payment of additional taxes to a foreign tax jurisdiction and the balance remains unchanged at March 31, 2008. We do not expect there to be any material changes to the estimated amount of liability associated with our uncertain tax positions over the next twelve months. The tax years 2006 to 2007 remain subject to review by the taxing authorities in several jurisdictions.
In assessing the realizability of the net deferred tax assets, we consider whether it is more likely than not that some or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends upon either the generation of future taxable income during the periods in which those temporary differences become deductible or the carryback of losses to recover income taxes previously paid during the carryback period.
Note 7. Contingencies
Legal Matters
We are from time to time a party to legal proceedings that arise in the normal course of business. We are not currently involved in any litigation, the outcome of which would, in management’s judgment based on information currently available, have a material adverse effect on our results of operations or financial condition, nor is management aware of any such litigation threatened against us.
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Note 8. Segment Information
We have adopted SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” This standard requires segmentation based on our internal organization and reporting of revenue and other performance measures. Our segments are designed to allocate resources internally and provide a framework to determine management responsibility. Operating segments are defined as components of an enterprise about which discrete financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. We have four operating segments. The types of products and services provided by each segment are summarized below:
• | Products segment—includes EnCase® Enterprise Software, EnCase® Forensic Software, Premium License Support Program, and hardware sales. |
• | Professional services segment—is our division that performs consulting services and implementations. Consulting services include conducting investigations using our software products. |
• | Training segment—is our division that provides training classes in which we train our customers to effectively and efficiently use our software products. |
• | Maintenance segment—Maintenance related revenue and costs. |
We refer to the revenue generated by our professional services and training segments, collectively, as services revenue. We refer to the revenue generated by our training segment as training revenue. We refer to the revenue generated by our maintenance segment as maintenance revenue.
Currently, we do not separately allocate operating expenses to these segments, nor does we allocate specific assets to these segments. Therefore, the segment information reported includes only revenues, cost of revenues and gross profit. The following tables present the operations by each operating segment:
Three Months Ended March 31, 2007 | |||||||||||||||||
Product | Professional Services | Training | Maintenance & Other | Total | |||||||||||||
(in thousands) | |||||||||||||||||
Revenues | $ | 10,088 | $ | 2,694 | $ | 1,960 | $ | 2,854 | $ | 17,596 | |||||||
Cost of revenues | 745 | 2,753 | 1,333 | 427 | 5,258 | ||||||||||||
Gross profit | $ | 9,343 | $ | (59 | ) | $ | 627 | $ | 2,427 | 12,338 | |||||||
Operating expenses: | |||||||||||||||||
Selling and marketing | 8,692 | ||||||||||||||||
Research and development | 2,048 | ||||||||||||||||
General and administrative | 3,090 | ||||||||||||||||
Depreciation and amortization | 699 | ||||||||||||||||
Total operating expenses | 14,529 | ||||||||||||||||
Operating loss | (2,191 | ) | |||||||||||||||
Interest income | 358 | ||||||||||||||||
Interest expense | (32 | ) | |||||||||||||||
Other income, net | 34 | ||||||||||||||||
Loss before income taxes | $ | (1,831 | ) | ||||||||||||||
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Three Months Ended March 31, 2008 | ||||||||||||||||
Product | Professional Services | Training | Maintenance & Other | Total | ||||||||||||
(in thousands) | ||||||||||||||||
Revenues | $ | 10,922 | $ | 4,061 | $ | 2,546 | $ | 4,161 | $ | 21,690 | ||||||
Cost of revenues | 788 | 3,590 | 1,539 | 518 | 6,435 | |||||||||||
Gross profit | $ | 10,134 | $ | 471 | $ | 1,007 | $ | 3,643 | 15,255 | |||||||
Operating expenses: | ||||||||||||||||
Selling and marketing | 9,734 | |||||||||||||||
Research and development | 3,087 | |||||||||||||||
General and administrative | 4,331 | |||||||||||||||
Depreciation and amortization | 1,051 | |||||||||||||||
Total operating expenses | 18,203 | |||||||||||||||
Operating loss | (2,948 | ) | ||||||||||||||
Interest income | 282 | |||||||||||||||
Interest expense | (16 | ) | ||||||||||||||
Other income, net | 35 | |||||||||||||||
Loss before income taxes | $ | (2,647 | ) | |||||||||||||
Revenue, classified by the major geographic areas in which we operate, is as follows (in thousands):
Three Months Ended March 31, | ||||||
2007 | 2008 | |||||
Revenues | ||||||
United States. | $ | 13,431 | $ | 16,983 | ||
Europe | 2,306 | 2,964 | ||||
Asia | 870 | 1,225 | ||||
Other | 989 | 518 | ||||
$ | 17,596 | $ | 21,690 | |||
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Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
The following discussion of our financial condition and results of operations should be read together with the financial statements and related notes that are included elsewhere in this Quarterly Report. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in this Quarterly Report under “Risk Factors,” in our Annual Report on Form 10-K for the year ended December 31, 2007 under “Risk Factors” and in other parts of this Quarterly Report.
Overview
We develop and provide the leading software solutions for digital investigations, including EnCase® Enterprise, a network-enabled product primarily for large corporations and government agencies, and EnCase® Forensic, a desktop-based product primarily for law enforcement agencies. We were incorporated and commenced operations in 1997. From 1997 through 2002, we generated a substantial portion of our revenues from the sale of our EnCase® Forensic products and related services. We have experienced increases in our revenue as a result of the release of our EnCase® Enterprise products in late 2002, which expanded our customer base into corporate enterprises and federal government agencies. In addition, the releases of our EnCase® eDiscovery solution in late 2005 and EnCase® Information Assurance solution in late 2006 have increased our average transaction size. We anticipate that sales of our EnCase® Enterprise products and related services, in particular our EnCase® eDiscovery and EnCase® Information Assurance solutions, will comprise a substantial portion of our future revenues.
Factors Affecting Our Results of Operations
There are a number of trends that may affect our business and our industry. Some of these trends or other factors include:
• | Legislative and regulatory developments.Our digital investigation solutions allow law enforcement agencies, government organizations and corporations to conduct investigations within the legal and regulatory framework. Historically, the implementation of new laws and regulations surrounding digital investigations has helped create demand for our products. Future changes in applicable laws or regulations could enhance or detract from the desirability of our products. |
• | Information technology budgets.Deployment of our solutions may require a substantial capital expenditure by our customers. Budgets for information technology-related capital expenditures at corporations and all levels of government organizations are typically cyclical in nature, with generally higher budgets in times of improving economic conditions and lower budgets in times of economic slowdowns. |
• | Law enforcement agency budgets. We sell our EnCase® Forensic products and training services primarily to law enforcement agencies. Because of the limited nature of law enforcement budgets, funds are typically initially allocated toward solving issues perceived to be the most pressing. Sales of our products could be impacted by changes in the budgets of law enforcement agencies or in the relative priority assigned to digital law enforcement investigations. |
• | Prevalence and impact of hacking incidents and spread of malicious software. The increasing sophistication of hacking attacks on government and private networks and the global spread of malicious software, such as viruses, worms and rootkits, have increased the focus of corporations and large government organizations on digital investigations and other aspects of network security, which has, in turn, increased demand for our products. Future changes in the number and severity of such attacks or the spread of malicious software could have an effect on the demand for our products. |
• | Seasonality in revenues. We experience seasonality in our revenues, with the third and fourth quarters typically having the highest revenues for the year. We believe that this seasonality results primarily from our customers’ budgeting cycles. The federal government budget year ends in the third calendar quarter of the year and a majority of corporate budget years end in the fourth calendar quarter of the year. In addition, our customers also tend to make software purchases near the end of a particular quarter, which tends to make our revenues for a particular period unpredictable for a significant portion of that period. We expect that this seasonality within particular years and unpredictability within particular quarterly periods will continue for the foreseeable future. |
• | Amount of commercial litigation. Because commercial litigation often involves eDiscovery, an increase in commercial litigation could increase demand for our products and services, while a decrease in commercial litigation could decrease demand. |
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Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Our significant accounting policies are discussed in Note 1 to our financial statements. The application of GAAP requires us to make estimates, judgments and assumptions that affect the reported amounts of our revenues, expenses, assets and liabilities, and related disclosure of contingent assets and liabilities. We base our estimates, judgments and assumptions on historical experience and on various other factors that are believed to be reasonable based upon information available to us at the time these estimates are made. Historically, our critical accounting estimates have not differed materially from actual results; however, changes in these accounting estimates are reasonably likely to occur from period to period. Although we evaluate these estimates, judgments and assumptions on a regular basis and make changes accordingly, actual results could differ significantly from those anticipated based on our estimates and assumptions. To the extent there are significant differences between these estimates and actual results, our future results of operations and financial condition could be materially affected.
We believe that the estimates, judgments and assumptions involved in the accounting policies described below require the most subjective judgment and have the greatest potential impact on our financial statements, so we consider these to be our critical accounting policies. Senior management has reviewed the development and selection of these critical accounting policies and estimates, and their related disclosure in this report, with the Audit Committee of our Board of Directors.
Revenue Recognition
We derive revenue from licenses of our software and sales of related services, which include post-contract customer support, or maintenance, consulting and training. We recognize revenue in accordance with GAAP as prescribed for the software industry, which are substantially governed by AICPA Statement of Position No. 97-2 (“SOP 97-2”), “Software Revenue Recognition,” as amended and interpreted. While these pronouncements govern the basis for revenue recognition, in applying our revenue recognition policy we must determine which portions of our revenue should be recognized currently and which portions, if any, should be deferred. In order to determine current and deferred revenue, we make judgments and estimates with regard to future deliverable products and services and the appropriate pricing for those products and services. In general, we recognize revenue when persuasive evidence of an arrangement exists, we have delivered the product or performed the service, the fee is fixed or determinable and collectibility is probable, as follows:
• | Persuasive evidence of an arrangement. If we either enter into contracts or receive written purchase orders issued by a customer that legally bind us and the customer, we consider that as evidence of an arrangement. |
• | Delivery. We deem delivery of products to have occurred when the title and risk of ownership have passed to the buyer. Services revenue is recognized as services are performed. |
• | Fixed or determinable fee. We consider the fee to be fixed or determinable if the fee is not subject to refund or adjustment and the payment terms are within normal established practices. If the fee is not fixed or determinable, we recognize the revenue as amounts become due and payable, provided all other revenue recognition criteria have been met. |
• | Collection is deemed probable. We conduct a credit review for all significant transactions at the time of the arrangement to determine the credit-worthiness of the customer. Collection is deemed probable if we have a reasonable basis to expect that the customer will pay amounts under the arrangement as payments become due. |
However, determining whether and when some of these criteria have been satisfied often involves assumptions and judgments that can have a significant impact on the timing and amount of revenue reported. For example, for multiple element arrangements we must make assumptions and judgments in order to allocate the total purchase price (irrespective of invoiced allocations) among the various elements we deliver, to determine whether undelivered services are essential to the functionality of the delivered products and services, to determine whether vendor-specific evidence (“VSOE”) of fair value exists for each undelivered element and to determine whether and when each element has been delivered. The VSOE of fair value for all elements of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for software license updates and product support services, is additionally measured by the renewal rate offered to the customer. If we were to change our pricing practices or any of our other assumptions or judgments in the future, our future revenue recognition could differ significantly from our historical results.
Amounts for fees collected or invoiced and due relating to arrangements when revenue cannot be recognized are reflected on our balance sheet as deferred revenue and recognized when the product is delivered or over the period in which the service is performed, in accordance with our revenue recognition policy for such element. If we cannot objectively determine the fair value of any undelivered element included in bundled software and service arrangements, we defer revenue until all elements are delivered and services have been performed, or until fair value can objectively be determined for any remaining undelivered elements. When the fair value of a delivered element has not been established, we use the residual
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method to record revenue if the fair value of all undelivered elements is determinable. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements and is recognized as revenue.
Product Revenue. The timing of product revenue recognition is dependent on the nature of the product sold. Product arrangements comprising multiple deliverables, including software and hardware, are generally categorized into one of the following:
• | EnCase® Enterprise, Encase® eDiscovery, EnCase® Information Assurance and EnCase®Automated Incident Response Solution (“AIRS”). License revenue associated with these arrangements, exclusive of amounts allocated to maintenance and other undelivered elements for which we have vendor-specific objective evidence (“VSOE”) of fair value, is recognized upon delivery, provided that all other criteria for revenue recognition have been met. |
• | EnCase® Forensic. License revenue from corporate customers, exclusive of amounts allocated to maintenance, for which we have VSOE of fair value, is recognized upon delivery, provided that all other criteria for revenue recognition have been met. Because maintenance is included at no additional cost in governmental Forensic arrangements, VSOE of fair value for the maintenance element for governmental customers is indeterminable, so we allocate governmental Forensic product, services and maintenance revenue ratably over the longer of the contractual maintenance period (12 months) or the implied maintenance period (12-25 months) based on estimated fair values of the various components. |
• | Premium License Support Program Solutions. The Premium License Support Program is a subscription arrangement entitling customers to receive unspecified future products and post-contract customer support for a period of several years. Revenue resulting from Premium License Support Program arrangements is recognized ratably over the contractual period beginning with the delivery of the first product. |
• | Neutrino™. Our mobile device investigative solution is sold to Forensic customers with a related subscription covering future adapters for newly issued cell phones. Revenue is recognized over the related subscription period. For Enterprise customers, Neutrino revenue is recognized upon delivery, provided that all other criteria for revenue recognition have been met. Standard maintenance is charged to entitle customers to future cell phone adapters on an if-and-when available basis. |
• | Hardware. Revenue associated with the sale of hardware is recognized upon shipment to the customer, provided that all other criteria for revenue recognition have been met. |
Services and Maintenance Revenue. Services and maintenance revenue consists of professional services, training, and maintenance. Revenue from such services is recognized as the services are provided. We refer to revenue related to technical product support and software updates on a when-and-if available basis as maintenance revenue, which is recognized ratably over the applicable contractual period. We determine the amount of maintenance revenue to be deferred through reference to substantive maintenance renewal provisions contained in each arrangement. We consider substantive maintenance provisions to be provisions where the cost of the maintenance renewal, stated in the contract with our customer as a percentage of the product fee, is comparable to the normal pricing for maintenance-only renewals. Substantially all of our customers purchase maintenance support when they acquire new software licenses and substantially all renew their maintenance support contracts annually or otherwise.
Training revenues are either recognized on a per-class basis upon a participant’s attendance or, for those customers who have subscribed to our Annual Training Passport program, revenue is recognized ratably over the annual period.
Share-Based Compensation
We adopted SFAS 123R using the prospective transition method and, accordingly, since adoption, we recognize share-based compensation expense for all share-based awards granted after January 1, 2006. Under that transition method, results for prior periods have not been restated.
With the exception of one option granted in December 2007 with market-based vesting conditions, which is discussed further below, we use the Black-Scholes option pricing model to determine the grant date fair value of share-based payments and recognize that cost, net of an estimated forfeiture rate, as compensation expense on a straight-line basis over the vesting period. The determination of the grant date fair value of share-based awards using that model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include the estimated number of years that we expect employees to hold their stock options (the option “term”) and our expected stock price volatility, risk-free interest rates and dividends to be paid on our stock over that term.
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The expected term (life) of stock option awards has been calculated using the “simplified method” as afforded by Staff Accounting Bulletins (“SAB”) Topic No. 107 and 110 because we lack sufficient historical data to provide a reasonable basis to estimate the expected term. We lack this historical data because of two factors: first, our 2004 Equity Incentive Plan (the “Plan”) was adopted in 2004 and we do not have a sufficient history of exercises and forfeitures over the typical 10-year life of our awards to predict future option holder behavior, which is critical in estimating an expected term for our options, and, second, we believe that our December 2006 initial public offering has likely changed the historical patterns that were experienced during the brief period of time from the Plan’s adoption to our initial public offering. The volatility of our common stock is estimated at the date of grant based on a weighted-average of the implied volatility of publicly traded 30-day to 270-day options on the common stock of a select peer group of similar companies (“Similar Companies”), the historical volatility of the common stock of Similar Companies and, beginning in late 2007, the historical volatility of our common stock, consistent with the requirements of SFAS 123R and SAB 107. The risk-free interest rate used in option valuation is based on the implied yield in effect at the time of each option grant, based on U.S. Treasury zero-coupon issues with equivalent expected terms. We use a dividend yield of zero in the Black-Scholes model, as we have no intention to pay any cash dividends on our common stock in the foreseeable future. SFAS 123R also requires that we estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. Quarterly changes in the estimated forfeiture rate can potentially have a significant effect on reported share-based compensation, as the cumulative effect of adjusting the forfeiture rate for all expense amortization after January 1, 2006 is recognized in the period the forfeiture estimate is changed.
In December 2007, we granted our Chief Executive Officer an option to purchase 500,000 shares of our common stock that vests, in 25% increments, only upon attainment of specified market-based conditions tied to the market value of our common stock and we may continue to award such market-based vesting options from time to time in the future. Under the provisions of SFAS 123R, the fair value of share-based grants with a market vesting condition must be modeled and valued with a path-dependent valuation technique. Accordingly, we estimate the value of such awards using the Monte Carlo binomial simulation model. The primary assumptions used in the model are volatility, a risk-free interest rate, starting stock price, transferability restrictions and the terms of the award, as more fully described in Note 5 to our condensed consolidated financial statements. Using these assumptions and inputs, in valuing the December 2007 grant, we simulated 25,000 possible price paths for our common stock over a ten-year period. For each trial, if the market conditions were met, the fair value of the option was then estimated using the Black-Scholes model; if the market condition was not met, the options were assigned zero value. The fair value of this award was then calculated as the average net present value across the simulation trials and a derived service period was calculated for achievement of each of the four market conditions. Under FAS 123R, the calculated $2.8 million fair value of this award must be recognized as expense over a weighted average period of approximately two years whether the market conditions are met or not so long as the grantee meets the service condition.
If we change the terms of our employee share-based compensation programs, refine future assumptions, such as experiencing forfeiture rates that differ from our estimates, or if we change to other acceptable valuation models, the stock-based compensation expense that we record in future periods may differ significantly from historical trends and could materially affect our results of operations.
The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded put and call options that have no vesting restrictions and are fully transferable, characteristics not present in our stock option grants. Existing valuation models, including the Black-Scholes and Monte Carlo models, may not provide reliable measures of the fair values of our share-based compensation. Consequently, there is a risk that our estimates of the grant date fair value of share-based compensation awards may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those grants in the future. Certain stock options may be forfeited or expire and result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, values may be realized from these instruments that are significantly higher than the fair values originally estimated on the grant date and reported in our financial statements. There currently is no market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models.
As of March 31, 2008, there was approximately $22.9 million of total unrecognized compensation cost related to non-vested stock-based compensation that is expected to be recognized over a weighted-average period of 2.8 years for grants subsequent to January 1, 2006. See Notes 4 and 5 of our condensed consolidated financial statements for further information regarding share-based compensation.
Allowance for Doubtful Accounts
We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The allowance is established through a provision for bad debt expense. We determine the adequacy of this allowance by evaluating individual customer accounts receivable, through consideration of the customer’s financial condition, credit history and current economic conditions. In addition, we analyze our historical credit loss history and apply
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these loss rates to our current accounts receivable balances to verify the reasonableness of our allowance. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required in the future, which would result in increased general and administrative expense.
Accounting for Taxes
In preparing our consolidated financial statements, we estimate our income tax liability in each of the foreign and domestic jurisdictions in which we operate by estimating our actual current tax exposure and assessing temporary differences resulting from differing treatment of items for tax and financial statement purposes. Our judgments, assumptions and estimates relative to the current provision for income tax take into account current tax laws, our interpretation of current tax laws and possible outcomes of audits conducted by foreign and domestic tax authorities. We have established reserves for income taxes to address potential exposures involving tax positions that could be challenged by tax authorities. Although we believe our judgments, assumptions and estimates are reasonable, changes in tax laws or our interpretation of tax laws and the resolution of any future tax audits could significantly impact the amounts provided for income taxes in our consolidated financial statements.
We calculate our current and deferred tax provisions based on estimates and assumptions that could differ from the actual results reflected in income tax returns filed during the subsequent year. Adjustments based on filed returns are generally recorded in the period when the tax returns are filed and the global tax implications are known and could significantly impact the amounts provided for income taxes. Tax law and rate changes are reflected in the income tax provision in the period in which such changes are enacted.
As a result of the termination of our S Corporation status in December 2006, we recorded deferred tax assets, which were fully offset by a valuation allowance. Subsequently, additional deferred tax assets generated have also been offset by partial valuation allowances. Management’s judgment is required in assessing the realizability of these and future deferred tax assets. In performing these assessments, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of our net deferred tax assets is dependent upon our generating sufficient taxable income in future years in appropriate tax jurisdictions to realize a tax benefit from the reversal of temporary differences and net operating loss carryforwards. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Management will continue to evaluate the realizability of the deferred tax assets and related valuation allowances. If our assessment of the deferred tax assets or the corresponding valuation allowance were to change, we would record the related adjustment as a component of the income tax provision or benefit during the period in which we make that determination.
Commitments and Contingencies
We are subject to certain legal proceedings, as well as demands, claims and threatened litigation that arise in the normal course of our business. We periodically evaluate all pending or threatened contingencies and commitments, if any, that are reasonably likely to have a material adverse effect on our operations or financial position. We assess the probability of an adverse outcome and determine if it is remote, reasonably possible or probable as defined in accordance with the provisions of SFAS No. 5, “Accounting for Contingencies.” If management determines that it is probable that an asset had been impaired or a liability had been incurred at the date of our financial statements, and the amount of the loss, or the range of probable loss can be reasonably estimated, we record an accrued liability and an expense for the estimated loss. If no accrual is made for a loss contingency because one or both of the conditions pursuant to SFAS No. 5 are not met, but the probability of an adverse outcome is at least reasonably possible, we would disclose the nature of the contingency, if material, and provide an estimate of the possible loss or range of loss, or state that such an estimate cannot be made.
Significant judgment is required in both the determination of probability and the determination of whether an exposure is reasonably estimable. Because of uncertainties related to these matters, any accruals recorded are based on the best information available at the time. As additional information becomes available, we would reassess the potential liability related to our pending claims and litigation and may revise our estimates favorably or unfavorably. Potential legal liabilities and the revision of estimates of potential legal liabilities could have a material impact on our financial position and results of operations.
Prior S Corporation Status
From our incorporation through September 1998, we were treated as a “C Corporation” under Subchapter C of the Code. In October 1998, we elected to be treated for federal income tax purposes as an “S Corporation” under Subchapter S of the Code. In addition, we also elected or may have been otherwise treated as an S Corporation for certain state tax purposes. We filed an election to revoke our S Corporation status on December 11, 2006. From and after the termination of our S Corporation status,
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we have been treated for federal and state income tax purposes as a C Corporation under Subchapter C of the Code and, as a result, we are subject to state and federal corporate income taxes.
We have entered into a tax matters agreement with our existing pre-IPO S Corporation stockholders to which we have agreed, among other things, to indemnify and hold harmless our existing pre-IPO S Corporation stockholders in certain circumstances for increases in their tax liability for the periods during which we were an S Corporation.
Results of Operations
The following table sets forth selected statements of operations data for each of the periods indicated expressed as a percentage of total revenues:
Three Months Ended March 31, | ||||||
2007 | 2008 | |||||
Revenues: | ||||||
Product revenue | 57.3 | % | 50.4 | % | ||
Services and maintenance revenue | 42.7 | 49.6 | ||||
Total revenues | 100.0 | 100.0 | ||||
Cost of revenues: | ||||||
Cost of product revenue | 4.2 | 3.6 | ||||
Cost of services and maintenance revenue | 25.6 | 26.1 | ||||
Total cost of revenues | 29.8 | 29.7 | ||||
Gross profit | 70.2 | 70.3 | ||||
Operating expenses: | ||||||
Selling and marketing | 49.4 | 44.9 | ||||
Research and development | 11.6 | 14.2 | ||||
General and administrative | 17.6 | 20.0 | ||||
Depreciation and amortization | 4.0 | 4.8 | ||||
Total operating expenses | 82.6 | 83.9 | ||||
Operating loss | (12.4 | ) | (13.6 | ) | ||
Other income and expense: | ||||||
Interest income | 2.0 | 1.3 | ||||
Interest expense | (0.2 | ) | (0.1 | ) | ||
Other income, net | 0.2 | 0.2 | ||||
Loss before income taxes | (10.4 | ) | (12.2 | ) | ||
Income tax provision | 0.1 | 0.1 | ||||
Net loss | (10.5 | )% | (12.3 | )% | ||
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The following table sets forth share-based compensation expense (in thousands) recorded in each of the respective periods:
Three Months Ended March 31, | ||||||
2007 | 2008 | |||||
Non-Cash Share-Based Compensation Data(1): | ||||||
Cost of product revenue | $ | 23 | $ | 17 | ||
Cost of services and maintenance revenue | 164 | 441 | ||||
Selling and marketing | 243 | 694 | ||||
Research and development | 131 | 349 | ||||
General and administrative | 327 | 615 | ||||
Total non-cash share-based compensation | $ | 888 | $ | 2,116 | ||
(1) | Non-cash share-based compensation recorded in the three month periods ended March 31, 2007 and 2008 relates to stock options and nonvested share awards granted to employees measured under the fair value method. See Notes 4 and 5 to the condensed consolidated financial statements. |
Comparison of Results of Operations for the Three Months Ended March 31, 2007 and 2008
Revenues
Three Months Ended March 31, | |||||||||
(Dollars in millions) | 2007 | Increase | 2008 | ||||||
Product revenues: | |||||||||
Encase® Enterprise (1) | $ | 7.4 | 2 | % | $ | 7.6 | |||
Encase® Forensic (2) | 2.3 | 22 | % | 2.8 | |||||
Other | 0.4 | 42 | % | 0.5 | |||||
Total product revenues | 10.1 | 8 | % | 10.9 | |||||
Services and maintenance revenues: | |||||||||
Professional services | 2.7 | 51 | % | 4.1 | |||||
Training | 2.0 | 30 | % | 2.5 | |||||
Maintenance and other | 2.8 | 46 | % | 4.2 | |||||
Total services and maintenance revenues | 7.5 | 43 | % | 10.8 | |||||
Total revenues | $ | 17.6 | 23 | % | $ | 21.7 | |||
(1) | Includes perpetual licenses related to our eDiscovery and Information Assurance add-on products. |
(2) | Includes revenues related to our Premium License Support Program. |
We generate product revenue principally from sales of our EnCase® Enterprise and EnCase® Forensic products. A substantial portion of the EnCase® Enterprise and EnCase® Forensic license agreements we enter into include perpetual license terms. In conjunction with our EnCase® Forensic software, we also sell our Premium License Support Program product, which is sold on a subscription basis for a term of one or three years. In addition, we sell our NeutrinoTM mobile forensic device and certain other forensic hardware which we include in “Other” product revenue. The first two quarters of each fiscal year are typically our period of lowest product sales due to the seasonal budgetary cycles of our customers. The third quarter is typically the strongest sales quarter to our federal government customers. Typically, sales to our corporate customers are highest in the fourth quarter.
Product revenues increased by $0.8 million (8%) in first quarter 2008 over 2007, with that growth driven primarily by an increase in Encase® Forensic licenses and subscriptions. Total sales revenues from our EnCase® Enterprise products increased, year over year, with sales of add-on modules higher, and sales of the EnCase® Enterprise platform lower, than in first quarter 2007. During first quarter 2008, we sold 16 EnCase® eDiscovery, EnCase® Information Assurance and AIRS add-on modules as compared to 14 in the first quarter of 2007. Increases in product revenues were aided modestly by an
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increase in selling and marketing personnel, as the number of sales and marketing personnel that we employ increased from approximately 155 at March 31, 2007 to approximately 160 at March 31, 2008. As previously reported, we closed a large, nearly $1.0 million, license transaction on the last business day of the first quarter of 2007, which increased that quarter’s results higher than our historical seasonal pattern would have indicated.
Services and maintenance revenues increased $3.3 million (43%) in the first quarter of 2008, with our professional services and maintenance segments both producing revenue increases of $1.4 million over the 2007 quarter. The professional services revenue growth has been driven by larger eDiscovery services engagements. The number of professional services personnel has increased from approximately 55 at March 31, 2007 to approximately 65 at March 31, 2008. The continuing growth in maintenance revenues is the result of an on-going overall increase in our installed product base and a high annual renewal rate by customers desiring continuing maintenance support on our products. Training services revenue increased $0.5 million in first quarter 2008 as the number of customers we train has increased, due both to growth in our installed product base and the greater availability of our training courses, with a new training location near Chicago and additional availability through authorized training partners.
Cost of Revenues
Three Months Ended March 31, | |||||||||||
(Dollars in millions) | 2007 | Increase | 2008 | ||||||||
Cost of product revenues | $ | 0.8 | 6 | % | $ | 0.8 | |||||
Cost of services and maintenance revenues: | |||||||||||
Professional services | 2.8 | 30 | % | 3.6 | |||||||
Training | 1.3 | 16 | % | 1.5 | |||||||
Maintenance and other | 0.4 | 21 | % | 0.5 | |||||||
Total cost of services and maintenance revenues | 4.5 | 25 | % | 5.6 | |||||||
Total cost of revenues | $ | 5.3 | 22 | % | $ | 6.4 | |||||
Share-based compensation included above: | |||||||||||
Cost of product revenues | $ | — | $ | — | |||||||
Cost of services and maintenance revenues | $ | 0.2 | $ | 0.4 | |||||||
Gross Margin Percentage | |||||||||||
Products | 92.6 | % | 92.8 | % | |||||||
Services and maintenance | 39.8 | % | 47.6 | % | |||||||
Total | 70.2 | % | 70.3 | % | |||||||
Cost of software product revenue consists principally of the cost of producing and distributing our software, including the cost of compact discs, packaging, shipping, customs duties, and, to a lesser extent, compensation and related overhead expenses. While these costs are primarily variable with respect to sales volumes, they remain very low in relation to the revenues generated. Our gross margins can be affected by product mix, as our EnCase® Enterprise products are generally higher margin products than our EnCase® Forensic product, which is, in turn, higher margin than our hardware products.
The costs of professional services and training revenue, on the other hand, are largely comprised of employee compensation, including share-based compensation, costs and related overhead expenses, travel and facilities costs. The cost of maintenance revenue consists primarily of commissions paid to our third party service provider for contract renewals and includes employee compensation cost for customer technical support.
Cost of product revenues increased 6% in first quarter 2008, in line with the 8% increase in total product revenues over the 2007 quarter. Product gross margin increased slightly to 92.8% in first quarter 2008 from 92.6% in the 2007 quarter.
Total cost of services and maintenance revenue increased $1.1 million, or 25%, in first quarter 2008, on an overall increase in services and maintenance revenue of 43% over first quarter 2007. Since first quarter 2007, we increased our team of professional services consulting personnel by ten and opened several new facilities, which contributed to increased total services and maintenance compensation expense of $0.7 million (including a $0.2 million increase in share-based compensation) and higher facilities and recruiting costs. In addition, travel expense related to consulting and training increased $0.1 million due to increased activity and expenses and commissions paid to our third-party maintenance vendor also increased by $0.1 million, which is in line with the growth in maintenance revenue in first quarter 2008. Overall, the
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services and maintenance gross margin improved to 47.6% in first quarter 2008 compared to 39.8% in the 2007 quarter. Individually, the gross margins of our segments improved from first quarter 2007 to first quarter 2008 as follows: professional services segment, from (2.2%) to 11.6%; training segment, from 32.0% to 39.6%; maintenance segment, from 85.0% to 87.6%.
Selling and Marketing
Three Months Ended March 31, | |||||||||||
(Dollars in millions) | 2007 | Increase | 2008 | ||||||||
Selling and marketing expenses | $ | 8.7 | 12 | % | $ | 9.7 | |||||
As a percentage of revenue | 49.4 | % | 44.9 | % | |||||||
Share-based compensation included above | $ | 0.2 | $ | 0.7 | |||||||
Selling and marketing expenses consist primarily of base and incentive (sales commissions and share-based) compensation and related overhead expenses for employees engaged in selling and marketing. Selling and marketing expenses also include expenses relating to advertising, brand building, marketing and trade show events (net of amounts received from sponsors and participants), product management, travel and allocated overhead.
Although we expense our sales commissions at the time the related sale is invoiced to the client, revenues from our EnCase® Enterprise term licenses, EnCase® Forensic product, Premium License Support Program, NeutrinoTM, the Annual Training Passport, consulting, maintenance and implementation are recognized over the relevant performance or license period. Accordingly, we generally experience a delay between increased selling and marketing expenses and the recognition of a portion of the corresponding revenue. The number of sales and marketing personnel that we employ was approximately 155 and 160 at March 31, 2007 and 2008, respectively.
Selling and marketing expenses in first quarter 2008 increased $1.0 million over 2007, of which $0.5 million consisted of share-based compensation, however, these costs as a percentage of revenue decreased from 49.4% in 2007 to 44.9% in 2008. Total compensation expense largely accounted for the increase. Higher costs for events and promotions, recruiting and facilities costs were offset by lower travel and entertainment, bad debt expense and other miscellaneous costs.
Research and Development
Three Months Ended March 31, | |||||||||||
(Dollars in millions) | 2007 | Increase | 2008 | ||||||||
Research and development expenses | $ | 2.0 | 51 | % | $ | 3.1 | |||||
As a percentage of revenue | 11.6 | % | 14.2 | % | |||||||
Share-based compensation included above | $ | 0.1 | $ | 0.3 | |||||||
Research and development expenses consist primarily of compensation, including share-based compensation, and related overhead expenses for research and development personnel, including quality assurance and testing. In order to develop new product offerings, continue developing existing products and improve quality assurance, we increased the number of research and development personnel that we employ from 53 at March 31, 2007 to 62 at March 31, 2008.
Research and development expenses increased $1.1 million, or 51%, in the first quarter of 2008 over the 2007 quarter. The higher expenses were driven by increases of $0.3 million (32%) in base compensation, $0.2 million in share-based compensation, $0.4 million in benefits, recruiting and other employee-related and facilities costs and $0.1 million in consulting costs.
General and Administrative
Three Months Ended March 31, | |||||||||||
(Dollars in millions) | 2007 | Increase | 2008 | ||||||||
General and administrative expenses | $ | 3.1 | 40 | % | $ | 4.3 | |||||
As a percentage of revenue | 17.6 | % | 20.0 | % | |||||||
Share-based compensation included above | $ | 0.3 | $ | 0.6 | |||||||
General and administrative expenses consist of compensation, including share-based compensation, and related overhead expenses for personnel engaged in the accounting, legal, information systems, human resources and other administrative functions. In addition, general and administrative expense includes professional services fees, including fees from auditors and attorneys, other corporate expenses and related overhead. The number of general and administrative
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personnel that we employ was 58 and 68 at March 31, 2007 and 2008, respectively. The increased headcount results largely from the need for additional qualified personnel and professional services to meet the compliance requirements of a public company.
General and administrative expenses in first quarter 2008 increased $1.2 million, or 40%, over the 2007 quarter. Contributing to the increased expenses, base compensation expense (including bonuses) increased $0.3 million, share-based compensation increased $0.3 million, audit fees and professional fees associated with consultation on Sarbanes-Oxley Section 404 increased $0.5 million, bad debt expense increased $0.3 million and costs associated with a new ERP implementation were $0.2 million.
Depreciation and Amortization
Three Months Ended March 31, | |||||||||||
(Dollars in millions) | 2007 | Increase | 2008 | ||||||||
Depreciation and amortization expense | $ | 0.7 | 50 | % | $ | 1.1 | |||||
As a percentage of revenue | 4.0 | % | 4.8 | % | |||||||
Depreciation and amortization expenses consist of depreciation and amortization of our leasehold improvements, furniture and computer hardware and software. Depreciation and amortization expense in first quarter 2008 increased $0.4 million, or 50%, over the 2007 quarter, primarily due to the 2007 investment of approximately $8.6 million in the openings or expansions of our facilities and the investment in leasehold improvements, networks and phone equipment to permit several of our remote offices to safely access our corporate network. We expect that depreciation and amortization will continue to increase in 2008 and 2009.
Interest Income
Interest income decreased to $0.3 million in the three months ended March 31, 2008, compared to $0.4 million in the 2007 period, with the decrease resulting largely from lower market interest rates.
Income Tax Provision
The income tax provision for the first quarter of 2008 was $28,000 as compared to $25,000 provision for the same period one year prior. The increase is primarily attributable to estimated taxes due to the federal government.
Liquidity and Capital Resources
Since inception, we have largely financed our operations from our cash flow from operations. In December 2006, we issued and sold 3,250,000 primary shares of our common stock at $11.50 per share, for net proceeds of $34.8 million in our initial public offering. As of March 31, 2008, we had $36.2 million in cash and cash equivalents. We believe that our cash flow from operations and our cash and cash equivalents are sufficient to fund our working capital and capital expenditure requirements for at least the next 12 months.
We generate cash from operations primarily from cash collections related to the sale of our products and services. Net cash used by operating activities was $1.4 million for the three months ended March 31, 2008 compared with net cash provided by operations of $2.1 million in the three months ended March 31, 2007. The decrease in cash provided by operations principally reflects a decrease in cash collections from sales of products and services, which reflects somewhat slower payment practices by our customers. The first and fourth quarters of our fiscal year are typically our strongest quarters for cash collections, a consequence of much higher sales volumes typically experienced in the third and fourth quarters, however one of our largest fourth quarter 2007 sales remained outstanding at March 31, 2008, although it has since been collected.
Net cash used by investing activities was $0.3 million in the first quarter of 2008 for additions to property and equipment. In the first quarter of 2007, capital expenditures of $1.4 million accounted for the net use of cash by investing activities, with sales and purchases of marketable securities largely offsetting.
Net cash provided by financing activities was $0.3 million for the first quarter of 2008 compared with $0.1 million for the 2007 quarter. The increase in cash provided by financing activities was due to proceeds from the exercise of stock options. In each of the periods, we paid down capital lease obligations and, in 2007, we paid certain remaining costs of our initial public stock offering.
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We maintain a $3.0 million line of credit with a bank. This line of credit terminates on October 31, 2008. At March 31, 2008, there were no amounts outstanding against this line. The line requires that we maintain certain financial covenants. At March 31, 2008, we were in compliance with the covenants associated with the revolving line of credit.
At March 31, 2008, our outstanding contractual cash commitments were largely limited to our non-cancelable lease obligations, primarily relating to real estate. As part of our Annual Report on Form 10-K, we previously reported in Part II, Management’s Discussion and Analysis of Financial Condition and Results of Operations, that our contractual obligation for these non-cancelable lease obligations as of December 31, 2007 were approximately $23.9 million, of which $4.1 million was due during 2008. We currently have no other material cash commitments, except our normal recurring trade payables, expense accruals and leases, all of which are currently expected to be funded through existing working capital and future cash flows from operations.
Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our selling and marketing activities, the timing and extent of research and development spending to support product development and enhancement efforts, costs associated with expansion into new territories or markets, the timing of the introduction of new products and services and the enhancement of existing products and the continuing market acceptance of our products and services. To the extent that our short-term investments and existing cash, the availability under our line of credit and cash from operations are insufficient to fund our future activities and planned growth, we may need to raise additional funds through public or private equity or debt financings. Although we are currently not a party to any agreement or letter of intent with respect to potential investments in, or acquisitions of, complementary businesses, products or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional debt or equity financing. Additional funds may not be available on terms favorable to us or at all. Furthermore, although we cannot accurately anticipate the effect of inflation or foreign exchange markets on our operations, we do not believe these external economic forces have had, or are likely in the foreseeable future to have, a material impact on our results of operations.
At March 31, 2008, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, special-purpose, or variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we did not engage in trading activities involving non-exchange traded contracts. As a result, we are not exposed to any financing, liquidity, market or credit risks that could arise if we had engaged in such relationships. We do not have material relationships and transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties except as disclosed in this report.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.” SFAS 157 does not require new fair value measurements but rather defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. We adopted SFAS 157 in the first quarter of 2008 for financial assets and liabilities and are required to adopt FAS 157 in the first quarter of 2009 for nonfinancial assets and liabilities. Adoption of FAS 157 with respect to financial assets and liabilities did not have a material impact on our consolidated financial position and results of operations and we do not expect adoption of SFAS 157 with respect to nonfinancial assets and liabilities to have a material impact on our consolidated financial position and results of operations.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities—Including an amendment of FASB Statement No. 115.” SFAS 159 allows companies to elect fair-value measurement when an eligible financial asset or financial liability is initially recognized or when an event, such as a business combination, triggers a new basis of accounting for that financial asset or financial liability. SFAS 159 became effective for us on January 1, 2008, however we did not elect the fair value measurement provision for any of our financial assets or liabilities, so adoption of SFAS 159 had no effect on our consolidated financial position or results of operations.
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations,” which will significantly change the accounting for business combinations. Under SFAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS 141R will change the accounting treatment for certain specific items, including:
• | acquisition costs will be generally expensed as incurred; |
• | in-process research and development will be recorded at fair value as an indefinite-lived intangible asset at the acquisition date; |
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• | restructuring costs associated with a business combination will be generally expensed subsequent to the acquisition date; and |
• | changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense. |
SFAS 141R also includes a substantial number of new disclosure requirements. We will be required to adopt SFAS 141R prospectively to any business combinations for which the acquisition date is on or after January 1, 2009. Earlier adoption is prohibited. SFAS 141R will only have an effect on our financial statements in the event that we enter into business combinations subsequent to that date.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — An Amendment of ARB No. 51” (“SFAS 160”). SFAS 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the statement of operations. SFAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. SFAS 160 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. We will be required to adopt SFAS 160 effective January 1, 2009. Earlier adoption is prohibited. We do not have a noncontrolling interest in any subsidiaries. Accordingly, we do not anticipate that the initial application of SFAS No. 160 will have an impact on us.
Item 3. | Quantitative and Qualitative Disclosure about Market Risk |
Although we currently bill for our products and services mostly in U.S. dollars, our financial results could be affected by factors such as changes in foreign currency rates or weak economic conditions in foreign markets. A strengthening of the dollar could make our products and services less competitive in foreign markets and therefore could reduce our revenues. We are billed by and pay substantially all of our vendors in U.S. dollars. In the future, an increased portion of our revenues and costs may be denominated in foreign currencies. To date, exchange rate fluctuations have had little impact on our operating results. We do not enter into derivative instrument transactions for trading or speculative purposes.
Fixed income securities are subject to interest rate risk. The fair value of our investment portfolio would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due mainly to the short-term nature of the major portion of our investment portfolio. At March 31, 2008, all of our cash and cash equivalents consisted of federal agency and corporate obligations and deposits with financial institutions.
Item 4. | Controls and Procedures |
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the objectives of the control system and, accordingly, management must apply considerable judgment in evaluating the cost-benefit relationship of possible controls and procedures. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.
As required by Rule 13a-15(b) under the Exchange Act, we conducted an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon the foregoing evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that as of March 31, 2008, these disclosure controls and procedures were effective.
There were no changes in our internal control over financial reporting during the quarter ended March 31, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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Item 1. | Legal Proceedings |
From time to time, we may become involved in various lawsuits and legal proceedings that arise in the ordinary course of business. Litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business. We are not currently aware of any such legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse effect on our business, financial condition or operating results.
Item 1A. | Risk Factors |
There have been no material changes to the risk factors as presented in our Annual Report on Form 10-K for the year ended December 31, 2007, filed with the Securities and Exchange Commission on March 17, 2008.
Item 6. | Exhibits |
Exhibit | Description of Documents | |
31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
32.1† | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |
32.2† | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
† | These certifications are being furnished solely to accompany this quarterly report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934 and are not to be incorporated by reference into any filing of Guidance Software, Inc., whether made before or after the date hereof, regardless of any general incorporation language in such filing. |
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Guidance Software, Inc. | ||
By: | /s/ Frank J. Sansone | |
Frank J. Sansone | ||
Chief Financial Officer | ||
(Principal Financial Officer) |
Dated: May 12, 2008
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