Form 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

 

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

For the fiscal year ended: December 31, 2012

Commission file number: 001-34358

SOLARWINDS, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   73-1559348
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification Number)

3711 S. MoPac Expressway

Austin, Texas

  78746
(address of principal executive offices)   (zip code)

Registrant’s telephone number, including area code: (512) 682-9300

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

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Common Stock, $0.001 par value   New York Stock Exchange

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

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

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    x

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

 

Large accelerated filer  x   Accelerated filer  ¨   Non-accelerated filer  ¨   Smaller reporting company  ¨
    (Do not check if a 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  x

Based on the closing price of the registrant’s common stock on the last business day of the registrant’s most recently completed second fiscal quarter, which was June 29, 2012, the aggregate market value of its shares held by non-affiliates on that date was approximately $2,679,073,162.

On February 14, 2013, 74,966,659 shares of common stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Part III of this Annual Report on Form 10-K incorporates certain information by reference from the definitive proxy statement for the registrant’s 2013 Annual Meeting of Stockholders to be filed within 120 days of the registrant’s fiscal year ended December 31, 2012 (the “Proxy Statement”). Except with respect to information specifically incorporated by reference in this Form 10-K, the Proxy Statement is not deemed to be filed as part of this Form 10-K.


Table of Contents
          Page No.  
   PART I   

Item 1.

  

Business

     1   

Item 1A.

  

Risk Factors

     9   

Item 1B.

  

Unresolved Staff Comments

     24   

Item 2.

  

Properties

     24   

Item 3.

  

Legal Proceedings

     24   

Item 4.

  

Mine Safety Disclosures

     25   
   PART II   

Item 5.

  

Market  for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     26   

Item 6.

  

Selected Consolidated Financial Data

     28   

Item 7.

  

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

     30   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

     51   

Item 8.

  

Financial Statements and Supplementary Data

     52   

Item 9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

     53   

Item 9A.

  

Controls and Procedures

     53   

Item 9B.

  

Other Information

     54   
   PART III   

Item 10.

  

Directors, Executive Officers and Corporate Governance

     55   

Item 11.

  

Executive Compensation

     55   

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     55   

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

     55   

Item 14.

  

Principal Accountant Fees and Services

     55   
   PART IV   

Item 15.

  

Exhibits and Financial Statement Schedules

     56   


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Safe Harbor Cautionary Statement

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995. Such statements may be signified by terms such as “anticipates,” “believes,” “seeks,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “projects,” “may,” “should,” “will,” “would,” “could” or similar expressions and the negatives of those terms. In this report, forward-looking statements include statements regarding our financial projections, future financial performance and plans and objectives for future operations including, without limitation, the following:

 

   

Our plan to continue to focus on growth opportunities within our existing customer base and IT infrastructure management markets through increased brand awareness and product depth and breadth, through expansion into adjacent areas of IT infrastructure management and by expanding our business globally;

 

   

Our objective to extend our market presence by providing IT professionals with easy-to-use and affordable enterprise-class software that solves their specific needs;

 

   

Our belief that the IT infrastructure management markets throughout North America and the rest of the world remain significantly under-penetrated and represent a significant opportunity to continue our growth;

 

   

Our intention to penetrate under-penetrated markets further by leveraging our customer base and end-user community and by using our strategic marketing programs to identify and obtain new customers;

 

   

Our belief that a substantial opportunity exists for sales of our software in the Europe, Middle East and Africa region, the Asian-Pacific region and the Latin American region and our intention to increase our sales, marketing and support operations in these regions;

 

   

Our anticipation of continuing our international expansion to further market, sell and develop our products;

 

   

Our plan to continue to scale and develop our existing group of international distributors and resellers;

 

   

Our plan to continue our strategy of delivering powerful, easy-to-use and affordable software while leveraging the web as the primary method to reach potential customers in the new markets we enter;

 

   

Our intention to cross-sell and up-sell existing products into our growing customer base;

 

   

Our intention to seek to expand, and generate loyalty from, our customer base and our end-user community by providing a variety of free tools for IT professionals, by hosting our online community website, thwack, and through other marketing programs;

 

   

Our belief that our customers are highly satisfied users of our products and that there is a significant opportunity for follow-on sales of both incremental capacity and additional products and modules to our existing customers;

 

   

Our expectation to continue to pursue product-oriented acquisitions that will enable us to utilize our go-to-market strategy and enter new markets or new segments of our existing markets by bringing new product offerings to market more quickly than we can develop them;

 

   

Our plan to continue to develop new software products and modules that enhance and expand our current offerings;

 

   

Our intention to continue to expand our product offerings into new areas of software in which we can provide differentiated, easy-to-use enterprise-class software products that are marketed and sold directly to end-users;

 

   

Our expectation to continue to invest in our research and development activities by hiring engineers in our international locations;

 

   

Our intention to continue to build our customer base and end-user community through marketing of relevant web-based content and online communications;


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Our expectation to continue to add additional channel partners as we expand geographically;

 

   

Our expectation to continue to experience some seasonality in our new license sales and, consequently, our cash collections;

 

   

Our expectation that competition will continue to increase both from existing competitors and new market entrants;

 

   

Our management’s intention to continue to exclude in their projections the potential revenue associated with certain transactions with U.S. federal government entities that are associated with projects involving larger end user technology implementations that typically involve multiple companies, resellers and/or service providers, or what we refer to as project-based transactions, which are difficult to predict;

 

   

Our management’s intention to state possible outcomes as high and low ranges when providing information regarding our financial outlook, which will be intended to provide a sensitivity analysis as variables are changed but will not be intended to represent that actual results could not fall outside of the suggested ranges;

 

   

Our expectation to incur significant additional expenses in expanding our sales personnel and our international operations in order to convert leads into sales of our products;

 

   

Our expectation to continue making similar acquisitions to those we made in 2012 and possibly larger acquisitions as part of our growth strategy;

 

   

Our intention to make additional investments in systems, facilities and personnel and to continue to expand our operations to support anticipated future growth in our business;

 

   

Our plan to continue to expand our sales force both domestically and internationally;

 

   

Our expectation to continue to expand our international operations for the foreseeable future;

 

   

Our intention to increase our expenditures on brand promotion;

 

   

Our expectation to utilize additional systems and service providers that may be essential to managing our business as we expand our operations;

 

   

Our expectation that the income tax benefit related to the 2012 R&E tax credit will be reflected in our results of operations for the quarter ended March 31, 2013 and will reduce our effective tax rate for the quarter and to a lesser extent the effective annual tax rate;

 

   

Our intention to either invest our non-U.S. earnings permanently in foreign operations or to remit these earnings to our U.S. entities in a tax-free manner;

 

   

Our intention to continue to pursue strategic acquisitions and potentially pay for such acquisitions, in part or in full, through the issuance of additional equity;

 

   

Our expectation that all of our future earnings will be used for the operation and growth of our business and that no dividends will be paid on shares of our common stock in the foreseeable future;

 

   

Our belief that our current facilities and planned expansion facilities may not be adequate for the foreseeable future and additional space may be required;

 

   

Our assessments and beliefs regarding the future outcome of pending legal proceedings and the liability, if any, that we may incur as a result of those proceedings;

 

   

Our belief that strategic product acquisitions and product releases that we made in 2011 and 2012 will be important to our long-term growth;

 

   

Our expectation that we will continue to look for acquisitions similar to those we have completed in the past and will be more aggressive in looking at new markets in the future to supplement our internal product development efforts;

 

   

Our belief that certain strategic investments we made in our business in 2012 will be an important foundation for our long-term growth;


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Our expectation to grow our business by focusing on initiatives such as acquisitions of products that will expand our network management and systems and application offerings or potentially acquisitions of products in new markets, increasing our presence in several key geographic markets, expanding our web presence, brand awareness and improving our communication with prospects and our current customers, domestically and internationally, and international expansion company-wide at lower cost locations;

 

   

Our expectation to continue to generate solid growth while delivering strong operating income and increase our cash flows from operating activities in 2013 with our disciplined approach to investing in our business combined with the large market opportunity;

 

   

Our assumption that we will be able to deliver ongoing value to our customers and maintain a long-term financial relationship with the users of our IT management products;

 

   

Our expectation that core product transaction volume growth will be the primary driver of our new license growth;

 

   

Our belief that IT-related trends and the limitations of existing offerings present a significant market opportunity for our products;

 

   

Our expectation that our revenue will continue to grow as we capitalize on IT-related trends and other market opportunities and target license revenue growth of 20% over the next three to five years;

 

   

Our belief that although difficult economic conditions in certain geographic regions may adversely affect the sales of our products, such conditions could also offer us an opportunity to market and sell our products to mid-size businesses and enterprise customers at compelling prices compared to the prices of some competing products;

 

   

Our expectation that the U.S. federal government will continue to be a significant market opportunity and our belief that the ease of deployment, power and scalability of our products gives us a competitive advantage to sell to various agencies and departments of the U.S. federal government;

 

   

Our expectation that we will continue to experience inconsistency in the buying pattern of the U.S. federal government for larger transactions with our products;

 

   

Our belief that many of our larger transactions with the U.S. federal government are dependent on specific projects that may or may not be continued at the same scale in the future due to budgetary cuts or other reasons, and the reduction or cancellation of specific projects such as these may change the buying patterns of the U.S. federal government and could result in our sales to the U.S. government being less than expected;

 

   

Our belief that maintenance revenue is an important source of our future revenue and expectation that maintenance revenue will continue to increase in absolute dollars in future periods;

 

   

Our expectation that our cost of revenue will increase in absolute dollars and fluctuate as a percentage of revenue as we acquire additional companies and as we increase our headcount to support new customers and product offerings;

 

   

Our expectation that our operating expenses will continue to increase in absolute dollars as we make long-term investments in our business both domestically and internationally;

 

   

Our expectation to continue to target our corporate margin structure as we acquire additional companies and integrate the businesses although our operating expenses in future periods may increase in absolute dollars and fluctuate as a percentage of revenue as a result of such acquisitions;

 

   

Our intention to continue to grant equity awards to our current executives and employees and those who join us in the future through acquisitions or otherwise, which will result in additional stock-based compensation expense;

 

   

Our expectation to continue to hire sales personnel in the United States and in our international sales offices at a rate consistent with our expected new license sales growth;

 

   

Our expectation to continue to invest in our websites, online user community site and marketing programs to drive customer downloads and support our new product launches;


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Our expectation to continue to invest in our research development activities by hiring engineers in our international locations, which will allow us to continue our research and development growth strategy internationally;

 

   

Our expectation that we will incur higher administrative costs in future periods as our business continues to grow both organically and through acquisitions;

 

   

Our expectation that our international income, as a percentage of total income, will increase resulting in a corresponding decline in our effective income tax rate;

 

   

Our plan to grant restricted stock units as the primary form of equity awards to our employees in 2013 and to continue to grant restricted stock units and stock options to our executives and board of directors in 2013;

 

   

Our expectation that our international cash and cash equivalents will continue to increase as a percentage of our consolidated cash and cash equivalents;

 

   

Our intention that the earnings generated by our international operations will be invested indefinitely in those operations and our expectation that we will not repatriate those earnings to our domestic operations;

 

   

Our expectation that capital expenditures in fiscal year 2013 will be approximately $6.0 to $8.0 million and primarily include equipment, software, leasehold improvements and furniture related to the expected growth of our corporate headquarters in Austin, Texas and our international research development centers in the Czech Republic and India; and

 

   

Our belief that our existing cash and cash equivalents and our cash flows from operating activities will be sufficient to fund our operations and our capital expenditures for at least the next 12 months.

Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially and adversely different from any future results, performance or achievements expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed under the heading “Risk Factors” in this report and in other documents we file with the Securities and Exchange Commission (“SEC”). Given these risks and uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our management’s beliefs and assumptions only as of the date of this report. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially and adversely from those anticipated in these forward-looking statements, even if new information becomes available in the future.


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PART I

 

ITEM 1. BUSINESS

Overview

SolarWinds, Inc. and its subsidiaries (“SolarWinds,” the “Company,” “we,” “us” or “our”) design, develop, market, sell and support enterprise-class information technology, or IT, infrastructure management software to IT professionals in organizations of all sizes. Our product offerings range from individual software tools to more comprehensive software products that solve problems encountered every day by IT professionals. Our products are designed to help enable efficient and effective management of their network, systems and application infrastructure. This includes software for managing the performance, health, and configurations of network devices, firewalls, applications, physical and virtual servers, storage devices, as well as software for log and security information management. It also includes software that provides IT professionals with mobile and remote access to their IT infrastructure and software to help them track and resolve IT issues along with their IT assets.

As a core part of our strategy, we utilize a differentiated business model for providing enterprise-class software to IT professionals within organizations of all sizes worldwide. Key differentiating elements of our business model include powerful and scalable, yet easy-to-use and affordable IT management software that is produced utilizing a highly efficient product development and engineering process, a scalable marketing model and a high-volume, transaction-oriented inside sales model that have allowed us to drive and support rapid growth in our business at high operating margins while offering our products at prices that are typically lower than competing vendors.

We manage our business with a culture and systems that are focused on metrics, helping us to achieve consistency in our execution. We design our products to be easy-to-install and easy-to-evaluate, allowing potential buyers of our software to see the value that the products provide after downloading a free version of the software from our website for evaluation. We design our marketing programs to drive visitors to our websites in order to generate large volumes of highly qualified leads. We are committed to an inside sales model which we call “selling from the inside.” This approach utilizes a disciplined, transaction-oriented process to convert these leads into paying customers at a higher level of productivity at a lower cost than is typically achieved with a traditional outside sales force that travels and incurs higher costs.

We incorporated in the State of Oklahoma in 1999 and reincorporated in the State of Delaware in 2008 under the name SolarWinds, Inc. Our principal executive offices are located at 3711 South MoPac Expressway, Building Two, Austin, Texas 78746, and our telephone number is (512) 682-9300.

Our Growth Strategy

Our differentiated business model of providing low-cost, easy-to-install and easy-to-use software marketed and sold directly to IT professionals through a highly productive and efficient inside sales force is the core of our strategy. We also sell our software through distributors and resellers to supplement our sales force, expand our global presence, reach various market segments and help us to initiate and fulfill sales orders from state, local and federal governments and those commercial customers that prefer to make purchases through a particular reseller or distributor. We evaluate all of our strategic opportunities to ensure that they are compatible with our model for providing cost-efficient, downloadable enterprise-class software that can be marketed and sold through a high volume, transaction-oriented model.

We plan to continue to focus on growth opportunities within our existing customer base and IT infrastructure management markets through increased brand awareness and product depth and breadth, through expansion into adjacent areas of IT infrastructure management and by expanding our business globally. Our objective is to extend our market presence by providing IT professionals with easy-to-use and affordable enterprise-class software that solves their specific needs. The following are key elements of our growth strategy:

 

   

Continue to Add New Customers in Under-penetrated Markets. We believe that the IT infrastructure management markets throughout North America and the rest of the world remain significantly

 

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under-penetrated and represent a significant opportunity to continue our growth. We intend to penetrate these markets further by leveraging our customer base and end-user community and by using our strategic marketing programs to identify and obtain new customers.

 

   

Expand Our Business in International Markets. We believe a substantial opportunity exists for sales of our software in the Europe, Middle East and Africa region (“EMEA”), the Asian-Pacific region and the Latin America region and we intend to increase our sales, marketing and support operations in these regions. We are in the initial phases of localizing our products, websites, and documentation for a number of key international markets. This includes local language versions of certain products with country-specific product documentation, websites and marketing material. We believe our market penetration is low in many geographic and end user markets in which we sell products. We anticipate continuing our international expansion to further market, sell and develop our products. In addition, we plan to continue to scale and develop our existing group of international distributors and resellers. In the new markets we enter, we plan to continue our strategy of delivering powerful, easy-to-use and affordable software while leveraging the web as the primary method to reach potential customers.

 

   

Cross-Sell and Up-Sell Existing Products into Our Growing Customer Base. Our customers are generally IT professionals in small- and mid-size businesses, enterprises, and local, state and federal government entities that have purchased one or more of our products. We have an active, loyal end-user community that is built from our customers and end-users who have downloaded our free tools. We seek to expand, and generate loyalty from, our customer base and our end-user community by providing a variety of free tools for IT professionals, by hosting our online community website, thwack, and through other marketing programs. We believe our customers are highly satisfied users of our products and that there is a significant opportunity for follow-on sales of both incremental capacity and additional products and modules to these customers.

 

   

Selectively Expand Our Product Portfolio by Pursuing Strategic Acquisitions and Product Development. We expect to continue to pursue product-oriented acquisitions that will enable us to utilize our go-to-market strategy and enter new markets or new segments of our existing markets by bringing new product offerings to market more quickly than we can develop them. In addition, we plan to continue to develop new software products and modules that enhance and expand our current offerings. We also intend to continue to expand our product offerings into new areas of software in which we can provide differentiated, easy-to-use enterprise-class software products that are marketed and sold directly to end-users.

Our Products

We offer a broad portfolio of powerful, yet easy-to-use and affordable products for IT infrastructure management. Our products are classified into three categories: core products, transactional products and free tools.

Core Products

Our core products consist of enterprise-class IT management products that are used by IT professionals and teams in companies of all sizes to configure, monitor, and report on the health and performance of their network, systems, and application infrastructure. These products provide advanced IT management functionality and are capable of scaling from simple to complex environments. Our core products are priced affordably so that individual IT professionals can typically purchase them with one or two levels of or, in some cases, no management approval. Our current core products provide enterprise-class functionality across network management and systems and application management and include:

Network Management. Our enterprise-class network management products share integrated components, databases, web servers and user administration. Our network management products are designed to operate together seamlessly, while still allowing network professionals to purchase and deploy only the products they

 

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need. Our network management product group also includes SolarWinds Log and Event Manager, which allows IT professionals to automate the collection and analysis of log data for the purposes of IT operations, security, and compliance management.

 

   

SolarWinds Network Performance Monitor. Our flagship product, Network Performance Monitor, is a server-based fault and performance management platform designed to minimize network downtime. Network Performance Monitor monitors and analyzes real-time, in-depth network performance metrics for routers, switches, servers and other Simple Network Management Protocol, or SNMP, enabled devices to provide both current and historical views into the availability and performance of a network and all devices attached to it. Network Performance Monitor is modular and has the ability to scale with the growth of a network. It can also be expanded through the use of add-on modules and polling engines. End-users can configure Network Performance Monitor to alert network professionals of network events, including thresholds, correlated events, sustained conditions and complex combinations of device states. Network Performance Monitor drives follow-on sales of our other products and, together with its related modules, currently generates a majority of our revenue.

 

   

Additional Network Management Products. We offer a number of additional network management products that solve a variety of network management issues and extend the capabilities of Network Performance Monitor. These products are purchased separately and are typically fully integrated with our Network Performance Monitor’s web console and database. These additional network management products include:

 

   

SolarWinds IP Address Manager. IP Address Manager tracks, manages and reports on the use of IP addresses through a web interface. In addition, IP Address Manager provides a single interface for management of third party DHCP and DNS IP infrastructure.

 

   

SolarWinds NetFlow Traffic Analyzer. NetFlow Traffic Analyzer utilizes Cisco Systems’ NetFlow protocol and other similar protocols to extract data from network devices to provide an in-depth view of which end-users, protocols and applications are consuming network bandwidth.

 

   

SolarWinds Network Configuration Manager. Network Configuration Manager is a server-based product that automates the processes of network device discovery, network inventory management and network change management.

 

   

SolarWinds VoIP & Network Quality Manager. VoIP & Network Quality Manager monitors VoIP and WAN performance from the perspective of multiple remote sites by tracking key edge-to-edge router performance statistics using Cisco IP SLA technology.

 

   

SolarWinds Firewall Security Manager. Firewall Security Manager provides multi-vendor support for firewall analytics and management enabling the automation of firewall security audits, firewall and router analysis, and simplified troubleshooting and change management.

 

   

SolarWinds User Device Tracker. User Device Tracker is a server-based switch port management tool for tracking and identifying the devices connected to the network, managing network port capacity and responding to network threats posed by rogue devices.

 

   

SolarWinds Enterprise Operations Console. Enterprise Operations Console is a server-based product that provides summarized web-based views of multiple instances of Network Performance Monitor, Network Performance Monitor modules, and Server & Application Monitor, enabling flexible deployment architectures for large or distributed environments.

 

   

SolarWinds Scalability Engines. Scalability engines increase the scale and provide fail-over for a number of our network management and systems and application management products increasing their monitoring capabilities to a larger number of devices by distributing the polling load across additional servers and ensuring up-time.

 

   

SolarWinds Log and Event Manager. Log and Event Manager is a server-based product that automates the collection and interpretation of logs from a wide variety of sources including network devices, physical and virtual servers, applications and storage infrastructure, providing IT professionals with

 

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real-time availability and performance monitoring of the IT infrastructure. Through log analysis and event correlation provided with approximately 700 built-in correlation rules along with customizable rules, Log and Event Manager supports compliance verification with internal policies and regulatory requirements and SOX and also provides IT professionals with real-time and forensic tools for responding to security threats and events.

Systems and Application Management. Our enterprise-class systems and application performance management products allow system administrators to monitor and manage the performance of physical and virtual servers, applications, and storage devices. This includes products for monitoring end-user application experience, performing patch management, IT help desk ticketing, and mobile device-based IT management capabilities. Many of our systems and application management products are designed to operate together seamlessly, as well as with our network management products.

 

   

SolarWinds Server & Application Monitor. Server & Application Monitor is a server-based availability and performance management system for applications and server infrastructure, both virtual and physical. Server & Application Monitor provides a view of critical IT services and allows system administrators to drill down and view application-specific server processes, performance counters, synthetic end-user transactions and custom data collected via scripts. With Server & Application Monitor, end-users can configure customized alerts and reports for tracking and managing application and server performance. These capabilities allow system administrators to monitor, manage and optimize the performance of an increasingly complex and growing number of mission-critical business applications. Server & Application Monitor supports over 200 major applications, with extensibility to support additional applications on both the Windows and Linux operating systems.

 

   

SolarWinds Storage Manager, powered by Profiler. Storage Manager is a server-based product that combines reporting, monitoring and notification on the performance of storage resources, including direct-attached storage, or DAS, network-attached storage, or NAS and storage area networks, or SAN, from a wide range of storage hardware vendors. In addition, Storage Manager provides mapping of storage resources to physical and virtual infrastructure to help optimize storage allocation.

 

   

SolarWinds Virtualization Manager. Virtualization Manager is a server-based product that provides virtualization administrators with a single solution to manage all the aspects of a virtual server infrastructure, including inventory, sprawl control, performance monitoring, capacity planning, and configuration tracking. Using a multi-dimensional, search-based approach Virtualization Manager combines multiple disparate data points into useable insights, which are presented in management dashboards and reports. Virtualization Manager integrates with other key enterprise applications such as configuration management databases, service desks and enterprise portals.

 

   

SolarWinds Patch Manager. Patch Manager is a server-based product that allows Systems Administrators to automate and improve the process of deploying, managing, and reporting on patches and configuration settings of Microsoft Windows servers and workstations.

 

   

SolarWinds Web Performance Monitor. Web Performance Monitor captures the user steps of any web application through an easy-to-use recorder and continuously monitors the end-user experience of those web applications.

 

   

SolarWinds Mobile Admin®. Mobile Admin provides secure access to over 40 IT management tools through Android, iOS, and Blackberry mobile devices.

 

   

SolarWinds Web Help Desk®. Web Help Desk provides IT help desk ticketing, change management, IT asset management, and self-resolution of issues using a searchable knowledge base.

 

   

SolarWinds Serv-U® Managed File Transfer Server. Serv-U Managed File Transfer Server allows IT professionals to secure, automate, and manage file transfers and workflows. In addition, Serv-U Managed File Transfer Server provides comprehensive enterprise security, tracking and reporting features to demonstrate compliance with SOX, HIPAA, and GLBA regulations, as well as internal corporate standards.

 

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Transactional Products

Our transactional products are desktop-based, laptop-based or server-based applications designed for individual IT professionals who need specific solutions for routine, but complicated tasks. Our transactional products include individual tools and toolsets, which combine many powerful tools together into a single package, as well as entry-level IT infrastructure monitoring functionality. Similar to our core products, we price our transactional products so that an individual IT professional can purchase them with one level of or, in some cases, no management approval. We believe that broad awareness and usage of our tools create positive relationships and loyalty with IT professionals, who in turn influence the purchase of our other products. Our transactional products sell at a much lower price point and higher volume than our core products and represent less than 15% of our new license sales.

Network Management. Our current network management transactional products include Standard Toolset, Engineer’s Toolset, Kiwi Syslog® Server, Kiwi CatTools®, and Kiwi Logviewer, or Kiwi products, ipMonitor® and LANsurveyor®.

Systems and Application Management. Our current systems and application management transactional products include DameWare® Remote Support and DameWare Mini Remote Control, or DameWare products, which allow system administrators to remotely manage computers on their networks.

Free Tools

Our free tools are desktop, laptop, server-based or internet-based applications designed for use by individual IT professionals, and typically focused on a single network or infrastructure management task or technology. We use free tools primarily to drive awareness of our brand and our paid products within the broader IT management community and to expand and build loyalty among our customers and our end-user community.

Maintenance and Support

Our perpetual license customers generally receive one year of software maintenance and support as part of their initial purchase of our products and have the option to renew their maintenance agreements. These maintenance agreements provide customers the right to receive software updates, maintenance releases and patches, when and if they become available, and access to our world-wide multi-lingual team of internal support representatives.

Our typical customers are network professionals, systems administrators, storage administrators or virtual administrators who are sophisticated users of software and related technologies. We devote significant resources to designing software products that are easy-to-install, configure and use, and to developing extensive, easy-to-understand instruction manuals and online tutorials for our products. We also utilize community websites, such as thwack, as forums for our end-users to share information, tips, tools and other valuable resources. Through these online communities, users of our software are able to find answers for many technical problems, discover new uses for our software, and provide suggestions or feedback to our product development teams. As a result of these efforts, our customers are able to resolve many technical issues without having to contact our support representatives, which significantly reduces our total support expenses.

Research and Development

Our research and development organization is responsible for the design, development and testing of our software. Our current research and development efforts are focused on new releases of existing products, as well as new products and modules.

We work closely with our customers in developing our products and have designed a product development process that is responsive to customer feedback throughout the process. Our customers and end-user community provide extensive input regarding a wide variety of use cases that we incorporate into our product definitions and requirements. A subset of customers participates in our product testing, helping us to identify issues prior to

 

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product release. Our research and development organization regularly assists customer support personnel with customer inquiries, which provides another mechanism for customer feedback during the development process.

We utilize small development teams. Each of these teams is dedicated to specific products and work according to a structured and repeatable, iterative process. These teams apply a standard architecture to their individual products, and are managed centrally to ensure standardization, efficiency and interoperability. We use a hybrid onshore and offshore development model, wherein product requirements definition and technical design are primarily performed by our technical staff in the United States along with staff in the Czech Republic, who work closely with development teams in our international facilities and with two contract development vendors in Eastern Europe that write code and do testing and quality assurance. Since establishing our research and development centers in the Czech Republic and India, and as a result of our acquisitions, we have significantly increased our research and development employee headcount. We expect to continue to invest in our research and development activities by hiring engineers in our international locations. We believe that we have developed a differentiated process that allows us to release new software rapidly and cost effectively, a process that we continue to improve upon each year. Using our development model, we had 53 product releases in 2010, 64 product releases in 2011 and 82 product releases in 2012.

Marketing and Sales

We have designed our marketing and sales model to be efficient for very high volumes of low-price transactions. Our marketing efforts focus on driving traffic to our websites and on generating high quality sales leads, primarily consisting of end-users who download a free evaluation of our software. Our sales efforts focus on converting these leads into paying customers through a high volume, short duration, sales process that we measure and manage frequently.

Marketing

We use a variety of online marketing programs for lead generation, as well as more traditional direct marketing and indirect channel partner marketing programs to drive traffic to our websites. These efforts leverage the ubiquity of Internet search engines through search engine marketing and optimization programs. In addition, we send a series of targeted emails to end-users who have downloaded free evaluations of one or more of our software products or received our corporate communications or public relations material. Once we drive traffic to our websites, we have a well-defined process that allows us to automatically track visitors’ activities, communicate with potential customers, encourage downloads of our software and provide highly qualified leads to our sales organization.

Our historical marketing approach, which continues to be important to us, was based on word-of-mouth and customer references. It allowed us to build a substantial customer base and community of network engineers and IT professionals who use our products and act as advocates for them. We continue to build our customer base and this community through marketing of relevant web-based content and online communications. Examples of our initiatives include thwack, a community website designed for IT professionals that provides our end-users and the broader IT management community with information, tools and valuable resources, several company sponsored blogs in which we provide perspectives and information relevant to the IT management marketplace, network engineering, systems management, virtualization, security and other technical topics, and quarterly newsletters designed to inform, and keep us connected to, our end-user base and other prospective customers. Other marketing activities include attending IT management related trade shows, social marketing programs, communicating with industry analysts and hosting webinars on IT management issues to create awareness of our brand and software products.

Sales

We license our software directly to our customers. The majority of our sales leads come from potential customers or existing customers who have downloaded one of our core products and use that product during a trial period. Therefore, our sales force typically contacts potential buyers and the potential buyers already understand how our products are used and the value of our products. As a result, our sales cycles are not as long as they are for companies making “cold” calls.

 

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We execute all of our direct sales through a sales organization that is physically located in one of our sales offices in the United States, Europe, Asia or Latin America. Our efficient and low-cost sales process is predicated on these sales professionals being physically located in one of our offices and having a deep knowledge of our sales model and process. We call this “selling from the inside” as it is different from other companies that simply use personnel that they call “inside sales” to create leads or to sell to only smaller organizations. Our sales teams respond to incoming demand and sell our products to companies of all sizes, from small businesses to Fortune 500 companies. We believe that our selling from the inside process has been one of the keys to our success.

We also sell our software through distributors and resellers to supplement our direct sales force, expand our global presence, reach various market segments and help us to initiate and fulfill sales orders from state, local and federal governments and those commercial customers that prefer to make purchases through a particular reseller. Sales to our channel partners often involve three tiers of distribution: a distributor, a reseller and an end-user customer. Our direct sales force works collaboratively with our channel partners to introduce them to customers and new sales opportunities. We provide licenses directly to the end user in sales of our software through our distributors and resellers. As we expand geographically, we expect to continue to add additional channel partners.

Our sales approach focuses on driving a high volume of relatively standardized transactions. We implement our approach through a disciplined sales process that provides clear guidelines for our sales force, and we actively measure and manage our sales results. We offer our products at low prices and typically using standard contract terms. We enable our customers to buy our products in a manner convenient to them, whether by purchase order, online with a credit card or through our channel partners.

We have experienced, and expect to continue to experience, some seasonality in our new license sales and, consequently, our cash collections. We typically achieve the highest levels of new license sales for the year in the third and fourth quarters. We believe that, in general, historical seasonality results primarily from the budgeting cycles of our customers being typically higher in the third and fourth quarters. New license sales for our U.S. federal business tend to peak in the third quarter of each calendar year as September 30 is the fiscal year end for the U.S. federal government. As a result, cash collections have historically been the highest in the fourth quarter of each calendar year. New license sales for our commercial business tend to peak in the fourth quarter of each calendar year as many companies typically have a December 31 fiscal year end.

We believe we have built a sales process and culture that is unique in the software industry, and that our sales force is able to achieve and maintain a higher level of productivity at a lower cost than most other enterprise software companies. Because our sales personnel do not need a professional software sales background, we have been able to keep our personnel costs low and can expand our direct sales force quickly.

Customers

In 2012, 2011 and 2010, we had one distributor that represented 10.2%, 11.9% and 12.4%, respectively, of our revenue from sales to various end-users. In 2010, we had one additional distributor that represented 10.0% of our revenue from sales to various end-users. We do not believe, however, that our business is substantially dependent on either distributor or that the loss of either relationship, or both relationships, would have a material adverse effect on our business, as we are generally directly involved with the end user in all of our sales regardless of whether we make the sale direct or through the reseller channel. For further information regarding concentrations of risks, see Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K.

Intellectual Property

We rely on a combination of copyright, trademark, trade dress and trade secret laws, as well as confidentiality procedures and contractual restrictions, to establish and protect our proprietary rights. These laws, procedures and restrictions provide only limited protection. We currently have eight patents. We have also filed patent applications, but we cannot guarantee that patents will be issued with respect to our current patent applications in a manner that gives us the protection that we seek or at all. Our patents and any future patents

 

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issued to us may be challenged, invalidated or circumvented and may not provide sufficiently broad protection or may not prove to be enforceable in actions against alleged infringers.

We endeavor to enter into agreements with our employees and contractors and with parties with which we do business in order to limit access to and disclosure of our proprietary information. We cannot be certain that the steps we have taken will prevent unauthorized use or reverse engineering of our technology. Moreover, others may independently develop technologies that are competitive with ours or that infringe our intellectual property. The enforcement of our intellectual property rights also depends on any legal actions against these infringers being successful, but these actions may not be successful, even when our rights have been infringed.

Furthermore, effective patent, trademark, trade dress, copyright and trade secret protection may not be available in every country in which our products are available over the Internet. In addition, the legal standards relating to the validity, enforceability and scope of protection of intellectual property rights are uncertain and still evolving.

Competition

We face competition from both traditional, larger software vendors offering enterprise-wide software frameworks and services and smaller companies offering point solutions for application, log and event, network, storage resource or virtualization management. We also compete with network equipment vendors and systems management product providers whose products and services also address network and IT management requirements. Our principal competitors vary depending on the product we offer and include Hewlett Packard, IBM, CA Technologies, Cisco Systems, Inc., VMware, Inc., EMC Corporation, NetApp, Inc., BMC Software, Inc., Quest Software, now a part of Dell Inc., Infoblox Inc., and several smaller vendors.

Competition in our market is based on the level of difficulty in using, maintaining and installing solutions; total cost of ownership, including product price and implementation and support costs; professional services implementation; product performance, functionality, flexibility, scalability and interoperability; brand and reputation; distribution channels; vertical markets or industries; and financial resources of the vendor. We generally compete favorably with respect to these factors; however, many of our actual and potential competitors enjoy substantial competitive advantages over us, such as greater name recognition, more comprehensive and varied products and services and substantially greater financial, technical and other resources. In addition, many of our competitors have established marketing relationships and access to larger customer bases, and have major distribution agreements with consultants, system integrators and resellers. We expect competition to continue to increase both from existing competitors and new market entrants.

Employees

As of December 31, 2012, we had 865 full-time employees, of which 473 were employed in the United States and 392 were employed outside of the United States. We consider our current relationship with our employees to be good. None of our employees is represented by a labor union or is a party to a collective bargaining agreement.

Additional Information

Our website address is www.solarwinds.com. Our website and the contents therein or connected thereto are not intended to be incorporated into this Annual Report on Form 10-K. Through a link on the Investor Relations section of our website, we make available the following filings as soon as reasonably practicable after they are electronically filed with or furnished to the SEC: our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act. All such filings are available free of charge. The public may read and copy any materials we file with SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC.

 

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ITEM 1A. RISK FACTORS

Risks Related to Our Business and Industry

Our quarterly revenue and operating results have fluctuated in the past and may fluctuate in the future due to a number of factors. As a result, we may fail to meet or exceed the expectations of securities analysts or investors, which could cause our stock price to decline.

We believe our quarterly revenue and operating results may vary significantly in the future. As a result, you should not rely on the results of any one quarter as an indication of future performance and period-to-period comparisons of our revenue and operating results may not be meaningful.

Our quarterly results of operations may fluctuate as a result of a variety of factors, including, but not limited to, those listed below, many of which are outside of our control:

 

   

our ability to maintain and increase sales to existing customers and to attract new customers;

 

   

general economic, industry and market conditions that impact expenditures for enterprise IT management software in the United States and other countries where we sell our software;

 

   

the timing and success of new product introductions by us or our competitors;

 

   

changes in our pricing policies or those of our competitors;

 

   

our ability to generate a significant volume of qualified sales leads;

 

   

higher marketing expenditures in an attempt to generate growing numbers of sales leads;

 

   

potential foreign exchange gains and losses related to expenses and sales denominated in currencies other than the functional currency of an associated entity;

 

   

the timing of revenue and expenses related to the development or acquisition of technologies, products or businesses;

 

   

potential goodwill and intangible asset impairment charges and amortization associated with acquired businesses;

 

   

decline in maintenance renewals;

 

   

the amount and timing of operating expenses and capital expenditures related to the expansion of our operations and infrastructure;

 

   

occasional large customer orders, including in particular those placed by the U.S. federal government;

 

   

unpredictability and timing of buying decisions by the U.S. federal government; and

 

   

changes in tax rates in jurisdictions in which we operate.

Fluctuations in our quarterly operating results might lead analysts to change their models for valuing our common stock. As a result, our stock price could decline rapidly and we could face costly securities class action suits or other unanticipated issues.

Our actual operating results may differ significantly from information we provide regarding our financial outlook.

From time to time, we may provide information regarding our financial outlook in our quarterly earnings releases, quarterly earnings conference calls, or otherwise, that represents our management’s estimates as of the date of release. This information regarding our financial outlook, which includes forward-looking statements, will be based on projections, including those related to certain of the factors listed above, prepared by our management. Neither our independent registered public accounting firm nor any other independent expert or outside party will compile or examine the projections nor, accordingly, will any such person express any opinion or any other form of assurance with respect thereto.

 

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These projections will be based upon a number of assumptions and estimates that, while presented with numerical specificity, will be inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which will be beyond our control, and will also be based upon specific assumptions with respect to future business decisions, some of which will change. For example, our management has excluded and currently intends to continue to exclude in their projections the potential revenue associated with certain transactions with U.S. federal government entities that are associated with projects involving larger end user technology implementations that typically involve multiple companies, resellers and/or service providers, or what we refer to as project-based transactions, which are difficult to predict. To the extent we recognize revenue from these project-based transactions during a specific quarter, our actual operating results may differ significantly from information we may have provided regarding our financial outlook. We intend to state possible outcomes as high and low ranges, which will be intended to provide a sensitivity analysis as variables are changed but will not be intended to represent that actual results could not fall outside of the suggested ranges. The principal reason that we release such information is to provide a basis for our management to discuss our business outlook with analysts and investors. We do not accept any responsibility for any projections or reports published by analysts.

Information regarding our financial outlook is necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying such information furnished by us will not materialize or will vary significantly from actual results. Accordingly, information that we provide regarding our financial outlook will only be an estimate of what management believes is realizable as of the date of release. Actual results will vary from our financial outlook, and the variations may be material and adverse. In light of the foregoing, investors are urged to consider these factors, not to rely exclusively upon information we provide regarding our financial outlook in making an investment decision regarding our common stock, and to take such information into consideration only in connection with other information included in our filings filed with or furnished to the SEC, including “Risk Factors” such as this one.

Any failure to implement our operating strategy successfully or the occurrence of any of the events or circumstances set forth under “Risk Factors” in this report could result in our actual operating results being different from information we provide regarding our financial outlook, and those differences might be adverse and material.

If we are unable to generate significant volumes of sales leads from Internet search engines, marketing campaigns and traffic to our websites, then our revenue may not grow as expected or may decline.

We generate many of our sales leads through visits to our websites by potential end-users interested in purchasing or downloading evaluations of our products. Many of these potential end-users find our websites by searching for enterprise IT management and monitoring products through Internet search engines, such as Google. A critical factor in attracting potential customers to our websites is how prominently our websites are displayed in response to search inquiries. If we are listed less prominently or fail to appear in search result listings for any reason, visits to our websites by customers and potential customers could decline significantly. We may not be able to replace this traffic and, if we attempt to replace this traffic, we may be required to increase our sales and marketing expenses, which may not be offset by additional revenue and could adversely affect our operating results.

We also generate leads through various marketing activities such as targeted email campaigns, attending networking-based trade shows and hosting webinars on enterprise IT management issues. Our marketing efforts may be unsuccessful in generating evaluation downloads, resulting in fewer sales leads. If we fail to generate a sufficient volume of leads from these activities and/or such sales leads do not result in actual sales, our revenue may not grow as expected or could decrease and our operating results could suffer.

If we are unable to sell products to new customers or to sell additional products or upgrades to our existing customers, our revenue growth will be adversely affected and our operating income could decrease.

To increase our revenue, we must regularly add new customers and/or sell additional products or upgrades to existing customers. Even if we generate a significant volume of leads from our marketing activities, we must

 

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be able to sell products to a sufficient number of these new sales leads in order to achieve our expected revenue growth. We expect to incur significant additional expenses in expanding our sales personnel and our international operations in order to convert leads into sales of our products. If we are unable to sell products to new customers and additional products or upgrades to our existing customers as a result of these expenditures, we may be unable to grow our revenue and/or our operating results may be adversely affected.

Challenging or uncertain economic conditions could adversely affect our operating results.

Economies in many countries are experiencing uncertain and challenging conditions as a result of a multitude of factors, including, but not limited to, declines in gross domestic product, increases in unemployment, sovereign debt levels, political uncertainty or unrest and volatility in commodity prices and worldwide stock markets. During these challenging and uncertain economic periods, customers may reduce or delay technology purchases, including purchases of our software products. Our typically short sales cycle may lengthen if purchasing decisions are delayed as a result of uncertain information technology budgets, contract negotiations become more protracted or customers institute additional internal approvals for software purchases. Uncertain and challenging economic conditions could result in reductions in sales of our products, longer sales cycles, difficulties in collecting accounts receivable or delayed payments, slower adoption of new technologies and increased price competition. Any of these events would likely harm our business, financial condition, operating results and cash flows.

The ability to recruit, retain and develop key employees is critical to our success and growth, and our inability to attract and retain qualified personnel could harm our business.

Our business requires certain expertise and intellectual capital, particularly within our management team. For us to compete successfully and grow, we must retain, recruit and develop key personnel who can provide the needed expertise for our industry and products. As we move into new geographic areas, we will need to attract, recruit and retain qualified personnel in those locations. In addition, acquisitions could cause us to lose key personnel of the acquired businesses. However, the market for qualified personnel is competitive and we may not succeed in recruiting additional key personnel or may fail to effectively replace current key personnel who depart with qualified or effective successors. We believe that replacing our key personnel with qualified successors is particularly challenging as we feel that our business model and approach to marketing and selling our products are unique. Any successors that we hire from outside of the Company would likely be unfamiliar with our business model and may therefore require significant time to understand and appreciate the important aspects of our business or fail to do so altogether. Our effort to retain and develop personnel may also result in significant additional expenses, including stock-based compensation expenses, which could adversely affect our profitability. New regulations and volatility or lack of performance in our stock price could also affect the value of our equity awards, which could affect our ability to attract and retain our key employees. We have made significant changes, and may make additional changes in the future, to our senior management team and other key personnel. We cannot provide assurances that key personnel, including our executive officers, will continue to be employed or that we will be able to attract and retain qualified personnel in the future. Failure to retain or attract key personnel could have a material adverse effect on our business.

Our business depends on customers renewing their maintenance contracts. Any decline in maintenance renewals could harm our future operating results.

We sell most of our products pursuant to a perpetual license, which ordinarily includes one year of maintenance as part of the initial price. Our customers have no obligation to renew their maintenance agreements after the expiration of this initial period. We may be unable to predict future customer renewal rates accurately. Our customers’ renewal rates may decline or fluctuate as a result of a number of factors, including their level of satisfaction with our products, the prices of our products, the prices of products and services offered by our competitors or reductions in our customers’ spending levels. If our customers do not renew their maintenance arrangements or if they renew them on less favorable terms, our revenue may decline and our business will

 

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suffer. A substantial portion of our quarterly maintenance revenue is attributable to maintenance agreements entered into during previous quarters. As a result, if there is a decline in renewed maintenance agreements in any one quarter, only a small portion of the decline will be reflected in our maintenance revenue recognized in that quarter and the rest will be reflected in our maintenance revenue recognized in the following four quarters or more.

If we are not able to integrate acquisitions successfully, our operating results and prospects could be harmed.

In order to expand our business, we made several acquisitions in 2012 and expect to continue making similar acquisitions and possibly larger acquisitions as part of our growth strategy. The success of our future acquisition strategy will depend on our ability to identify, negotiate, complete and integrate acquisitions and, if necessary, to obtain satisfactory debt or equity financing to fund those acquisitions. Mergers and acquisitions are inherently risky, and any mergers and acquisitions we complete may not be successful. Our past mergers and acquisitions and any mergers and acquisitions that we do in the future involve numerous risks, including, but not limited to, the following:

 

   

difficulties in integrating and managing the operations, systems, technologies and products of the companies we acquire;

 

   

diversion of our management’s attention from normal daily operations of our business;

 

   

our inability to maintain the key business relationships and the reputations of the businesses we acquire;

 

   

uncertainty of entry into markets in which we have limited or no prior experience and in which competitors have stronger market positions;

 

   

our dependence on unfamiliar affiliates, resellers, distributors and partners of the companies we acquire;

 

   

our inability to increase revenues from an acquisition for a number of reasons, including our failure to drive demand in our existing customer base for acquired products and our failure to obtain maintenance renewals or upgrades and new product sales from customers of the acquired businesses;

 

   

increased costs related to continuing support and development of acquired products;

 

   

our responsibility for the liabilities of the businesses we acquire;

 

   

potential goodwill and intangible asset impairment charges and amortization associated with acquired businesses;

 

   

adverse tax consequences associated with acquisitions;

 

   

changes in how we are required to account for our acquisitions under U.S. generally accepted accounting principles, including arrangements that we assume from an acquisition;

 

   

potential negative perceptions of our acquisitions by customers, financial markets or investors;

 

   

failure to obtain required approvals from governmental authorities under competition and antitrust laws on a timely basis, if at all, which could, among other things, delay or prevent us from completing a transaction, or otherwise restrict our ability to realize the expected financial or strategic goals of an acquisition;

 

   

our inability to apply and maintain our internal standards, controls, procedures and policies to acquired businesses; and

 

   

potential loss of key employees of the companies we acquire.

The occurrence of any of these risks could have a material adverse effect on our business, results of operations, financial condition or cash flows, particularly in the case of a larger acquisition or concurrent acquisitions.

 

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Additionally, acquisitions or asset purchases made entirely or partially for cash may reduce our cash reserves. We may seek to obtain additional cash to fund an acquisition by selling equity or debt securities. We may be unable to secure the equity or debt funding necessary to finance future acquisitions on terms that are acceptable to us. If we finance acquisitions by issuing equity or convertible debt securities, our existing stockholders will experience ownership dilution, and if we finance future acquisitions with debt funding, we will incur interest expense and may have to comply with financing covenants or secure the debt obligation with our assets.

Businesses that we acquire may have greater than expected liabilities for which we become responsible.

Businesses that we acquire may have liabilities or adverse operating issues, or both, that we fail to discover through due diligence or the extent of which we underestimate prior to the acquisition. For example, to the extent that any business that we acquire or any prior owners, employees or agents of any acquired businesses or properties: (i) failed to comply with or otherwise violated applicable laws, rules or regulations; (ii) failed to fulfill or disclose their obligations, contractual or otherwise, to applicable government authorities, their customers, suppliers or others; or (iii) incurred tax or other liabilities, we, as the successor owner, may be financially responsible for these violations and failures and may suffer harm to our reputation and otherwise be adversely affected. An acquired business may have problems with internal control over financial reporting, which could be difficult for us to discover during our due diligence process and could in turn lead us to have significant deficiencies or material weaknesses in our own internal control over financial reporting. These and any other costs, liabilities and disruptions associated with any of our past acquisitions and any future acquisitions could harm our operating results.

Charges to earnings resulting from acquisitions may adversely affect our operating results.

When we acquire businesses, we allocate the purchase price to tangible assets and liabilities and identifiable intangible assets acquired at their acquisition date fair values. Any residual purchase price is recorded as goodwill, which is also generally measured at fair value. We also estimate the fair value of any contingent consideration. Our estimates of fair value are based upon assumptions believed to be reasonable but which are uncertain and involve significant judgments by management. After we complete an acquisition, the following factors could result in material charges and adversely affect our operating results and may adversely affect our cash flows:

 

   

costs incurred to combine the operations of companies we acquire, such as transitional employee expenses and employee retention or relocation expenses;

 

   

impairment of goodwill or intangible assets;

 

   

a reduction in the useful lives of intangible assets acquired;

 

   

impairment of long-lived assets;

 

   

identification of, or changes to, assumed contingent liabilities;

 

   

charges to our operating results due to duplicative pre-merger activities;

 

   

charges to our operating results from expenses incurred to effect the acquisition; and

 

   

charges to our operating results due to the expensing of certain stock awards assumed in an acquisition.

Substantially all of these costs will be accounted for as expenses that will decrease our net income and earnings per share for the periods in which those costs are incurred. Charges to our operating results in any given period could differ substantially from other periods based on the timing and size of our acquisitions and the extent of integration activities. For further information regarding our accounting for acquisitions see “Critical Accounting Policies and Estimates—Acquisitions” under “Management’s Discussion & Analysis of Financial Condition and Results of Operations” and Note 2, Acquisitions, in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K.

 

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Our operating income could fluctuate and may decline as a percentage of revenue as we make further expenditures to expand our operations in order to support additional growth in our business.

We have continued to make significant investments in our operations to support additional growth, such as hiring substantial numbers of new personnel, investing in new facilities, acquiring other companies or their assets and establishing and broadening our international operations in order to expand our business. We intend to make additional investments in systems, facilities and personnel and to continue to expand our operations to support anticipated future growth in our business. We also expect to make acquisitions, many or all of which may increase our operating costs more than our revenue. As a result of these investments, our operating income could fluctuate and may decline as a percentage of revenue.

Failure to expand our sales operations effectively could harm our ability to increase our customer base and achieve broader market acceptance of our products.

Increasing our customer base and achieving broader market acceptance of our products will depend on our ability to expand our sales operations effectively. We are substantially dependent on our direct sales force, and to a significantly lesser extent certain resellers and distributors, to obtain new customers. We plan to continue to expand our sales force both domestically and internationally. Our ability to achieve significant growth in revenue in the future will depend on our success in recruiting, training and retaining sufficient numbers of sales personnel, and on the productivity of those personnel. Our recent and planned personnel additions may not become as productive as we would like, and we may be unable to hire or retain sufficient numbers of qualified individuals in the future in the markets where we do or plan to do business. Our operating results will be seriously harmed if these expansion efforts do not generate a corresponding significant increase in revenue.

If we are unable to enhance existing products, particularly our core products, or to develop or acquire new products that respond to rapidly changing customer requirements, technological developments or evolving industry standards, our long-term revenue growth will be harmed.

The market for our products is characterized by rapid technological advances, changes in customer requirements, changes in protocols and evolving industry standards. Our long-term growth depends on our ability to enhance and improve our existing products and to introduce or acquire new products that respond to these demands. The success of any enhancement or new product depends on a number of factors, including its timely completion, introduction and market acceptance. New products that we develop or acquire may not be introduced in a timely or cost-effective manner and may not achieve the broad market acceptance necessary to generate significant revenue. Additionally, our existing and prospective customers may develop their own competing technologies, purchase competitive products or services or engage third party providers. If we are unable to develop or acquire enhancements to, and new features for, our existing products or acceptable new products that keep pace with rapid technological developments, our products may become obsolete, less marketable and less competitive, and our business will be harmed.

We operate much of our research and development activities internationally and outsource a portion of the coding and testing of our products and product enhancements to contract development vendors. We believe that performing research and development in our international facilities and supplementing these activities with our contract development vendors enhances the efficiency and cost-effectiveness of our product development. If we experience problems with our workforce or facilities internationally, we may not be able to develop new products or enhance existing products in an alternate manner that may be equally or less efficient and cost-effective.

We depend significantly on our core products, which represent a majority of our revenue in 2012, 2011 and 2010. If we are unable to add products and develop enhancements to our core products that are satisfactory to our customers, or if our customers purchase or develop their own competing products and technologies causing a reduction in demand for our core products, our operating results will be harmed.

 

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We depend on the U.S. federal government for a meaningful portion of our sales, including maintenance renewals, and orders from the U.S. federal government are unpredictable. The delay or loss of these sales may harm our operating results.

A meaningful portion of our sales, including maintenance renewals, are to a number of different departments of the U.S. federal government. Any factors that cause a decline in government expenditures generally or government IT expenditures in particular could cause our revenue to grow less rapidly or even to decline. Furthermore, sales orders from the U.S. federal government tend to be dependent on many factors and therefore unpredictable in timing. Any sales we expect to make in a fiscal quarter may not be made in that quarter or at all, and our operating results for that quarter may therefore be adversely affected.

Because our long-term success depends on our ability to operate our business internationally and increase sales of our products to customers located outside of the United States, our business will be susceptible to risks associated with international operations.

We have international operations in the Republic of Ireland, the Czech Republic, Australia, India, Singapore and Brazil, all of which we established or acquired within the past five years. We also expect to continue to expand our international operations for the foreseeable future. The continued international expansion of our operations requires significant management attention and financial resources and results in increased administrative and compliance costs. Our limited experience in operating our business outside the United States increases the risk that our current and future international expansion efforts may not be successful. In particular, our business model may not be successful in particular countries or regions outside the United States for reasons that we currently are unable to anticipate. In addition, conducting international operations subjects us to risks that we have not generally faced in the United States. These include, but are not limited to:

 

   

fluctuations in currency exchange rates (which we only hedge to a limited extent at this time);

 

   

the complexity of, or changes in, foreign regulatory requirements;

 

   

difficulties in managing the staffing of international operations, including compliance with local labor and employment laws and regulations;

 

   

potentially adverse tax consequences, including the complexities of foreign value added tax systems, overlapping tax regimes, restrictions on the repatriation of earnings and changes in tax rates;

 

   

dependence on resellers and distributors to increase customer acquisition or drive localization efforts;

 

   

the burdens of complying with a wide variety of foreign laws and different legal standards;

 

   

increased financial accounting and reporting burdens and complexities;

 

   

longer payment cycles and difficulties in collecting accounts receivable;

 

   

longer sales cycles;

 

   

political, social and economic instability abroad;

 

   

terrorist attacks and security concerns in general; and

 

   

reduced or varied protection for intellectual property rights in some countries.

The occurrence of any one of these risks could negatively affect our international business and, consequently, our operating results. We cannot be certain that the investment and additional resources required to establish, acquire or integrate operations in other countries will produce desired levels of revenue or profitability. If we are unable to effectively manage our expansion into additional geographic markets, our financial condition and results of operations could be harmed.

 

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If we fail to develop and maintain our brands cost-effectively, our financial condition and operating results might suffer.

We believe that developing and maintaining awareness and integrity of our brands in a cost-effective manner are important to achieving widespread acceptance of our existing and future products and are important elements in attracting new customers. We believe that the importance of brand recognition will increase as we enter new markets and as competition in our existing markets further intensifies. Successful promotion of our brands will depend on the effectiveness of our marketing efforts and on our ability to provide reliable and useful products at competitive prices. We intend to increase our expenditures on brand promotion. Brand promotion activities may not yield increased revenue, and even if they do, the increased revenue may not offset the expenses we incur in building our brands. We rely on resellers and distributors to some extent in the distribution of our products. We have limited control over these third parties and actions by these third parties could negatively impact our brand. We also rely on our customer base and community of end-users in a variety of ways, including to give us feedback on our products and to provide user-based support to our other customers through thwack, our online community website. If poor advice or misinformation regarding our products is spread among users of thwack, it could adversely affect our reputation, our financial results and our ability to promote and maintain our brands. If we fail to promote and maintain our brands successfully, maintain loyalty among our customers and our end-user community, or incur substantial expenses in an unsuccessful attempt to promote and maintain our brands, we may fail to attract new customers or retain our existing customers and our financial condition and results of operations could be harmed.

We operate in a highly competitive market, which could make it difficult for us to acquire and retain customers.

The market for enterprise IT management solutions is intensely competitive. Competition in our market is based primarily on the level of difficulty in using, maintaining and installing solutions; total cost of ownership, including product price and implementation and support costs; professional services implementation; product performance, functionality, flexibility, scalability and interoperability; brand and reputation; distribution channels; vertical markets or industries; and financial resources of the vendor. We often compete to sell our products against existing products or systems that our potential customers have already made significant expenditures to install. Many of our actual and potential competitors enjoy substantial competitive advantages over us, such as greater name recognition, more comprehensive and varied products and services, and substantially greater financial, technical and other resources. In addition, many of our competitors have established marketing relationships and access to larger customer bases, and have major distribution agreements with consultants, system integrators and resellers. Given their larger size, greater resources and existing customer relationships, our competitors may be able to compete and respond more effectively than we can to new or changing opportunities, technologies, standards or customer requirements.

We face competition from both traditional, larger software vendors offering enterprise-wide software frameworks and services and smaller companies offering point solutions for IT infrastructure management. We also compete with network equipment vendors and systems management product providers whose products and services also address network and IT management requirements. Our principal competitors vary depending on the product we offer and include Hewlett Packard, IBM, CA Technologies, Cisco Systems, Inc., VMware, Inc., EMC Corporation, NetApp, Inc., BMC Software, Inc., Quest Software, now a part of Dell Inc., Infoblox Inc., and several smaller vendors.

Some of our competitors have made acquisitions or entered into strategic relationships with one another to offer more comprehensive or bundled or integrated product offerings. We expect this trend to continue as companies attempt to strengthen or maintain their market positions in an evolving industry and as companies

 

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enter into partnerships or are acquired. Companies and alliances resulting from these possible consolidations and partnerships may create more compelling product offerings and be able to offer more attractive pricing, making it more difficult for us to compete effectively.

We have experienced rapid growth in recent periods. If we fail to manage our growth effectively, our financial performance may suffer.

We have substantially expanded our overall business, customer base, headcount and operations since 2006 both domestically and internationally. We have made substantial investments in our information systems, significantly expanded our operations outside the United States, made several acquisitions and significantly increased the number of our customers, including resellers and distributors. Our expansion has placed, and our expected future growth will continue to place, a significant strain on our managerial, administrative, operational, financial and other resources. As we continue to grow, we must effectively integrate, develop and motivate a large number of new employees, while maintaining the effectiveness of our business model and approach to marketing and selling our products. If we are unable to manage our growth successfully, our operating results will suffer.

Interruptions or performance problems associated with our technology and infrastructure, and our reliance on technologies from third parties, may adversely affect our ability to manage our business and meet reporting obligations.

Currently, we use NetSuite to manage our order management and financial processes, salesforce.com to track our sales and marketing efforts and other third party vendors to manage online marketing and web services. We believe the availability of these services is particularly essential to the management of our high-volume, transaction-oriented business model. We also use third party vendors to manage our equity compensation plans and certain aspects of our financial reporting processes. As we expand our operations, we expect to utilize additional systems and service providers that may also be essential to managing our business. Although the systems and services that we require are typically available from a number of providers, it is time consuming and costly to qualify and implement these relationships. Therefore, if one or more of our providers suffer an interruption in their business, or experience delays, disruptions or quality control problems in their operations, or we have to change or add additional systems and services, our ability to manage our business and produce timely and accurate financial statements would suffer.

In addition, our continued growth depends in part on the ability of our existing and potential customers to access our website and download our software or encrypted access keys for our software within an acceptable amount of time. We have experienced, and may in the future experience, website disruptions, outages and other performance problems due to a variety of factors, including infrastructure changes, human or software errors, capacity constraints due to an overwhelming number of users accessing our website simultaneously and denial of service or fraud or security attacks. In some instances, we may not be able to identify the cause or causes of these website performance problems within an acceptable period of time. It may become increasingly difficult to maintain and improve our website performance, especially during peak usage times and as our user traffic increases. If our websites are unavailable or if our customers users are unable to download our software or encrypted access keys within a reasonable amount of time or at all, our business would be negatively affected.

Material defects or errors in our products could harm our reputation, result in significant costs to us and impair our ability to sell our products.

Software products are inherently complex and often contain defects and errors when first introduced or when new versions are released. Any defects or errors in our products could result in:

 

   

lost or delayed market acceptance and sales of our products;

 

   

a reduction in maintenance renewals;

 

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diversion of development resources;

 

   

legal claims; and

 

   

injury to our reputation and our brand.

The costs incurred in correcting or remediating the impact of defects or errors in our products may be substantial and could adversely affect our operating results.

Litigation exposure related to our pending and any future litigation could adversely affect our results of operations, profitability and cash flows.

We have been and may be involved, from time-to-time, in disputes incidental to our business. We are currently the subject of allegations of patent infringement further described under the caption “Legal Proceedings” in Part I, Item 3 of this Annual Report on Form 10-K. We cannot predict when these lawsuits will be completed and are unable to accurately assess the financial outcome that could result from these matters at this time. Pending or future lawsuits may result in a diversion of management’s attention and resources, significant costs, including monetary damages and legal fees, injunctive relief, and may contribute to current and future stock price volatility. No assurance can be made that pending or future litigation will not result in material financial exposure or reputational harm, which could have a material adverse effect upon our results of operations, profitability and cash flows.

In particular, the software and technology industries are characterized by the existence of a large number of patents, copyrights, trademarks and trade secrets and by frequent litigation based on allegations of infringement or other violations of intellectual property rights. We have received, and from time to time may receive, letters claiming that our products infringe or may infringe the patents or other intellectual property rights of others. As we face increasing competition, the possibility of additional intellectual property rights claims against us grows. Our technologies may not be able to withstand any third-party claims or rights against their use. Additionally, we have licensed from other parties proprietary technology covered by patents, and these patents may be challenged, invalidated or circumvented. These types of claims could harm our relationships with our customers, might deter future customers from acquiring our products or could expose us to litigation with respect to these claims. Even if we are not a party to any litigation between a customer and a third party, an adverse outcome in that litigation could make it more difficult for us to defend our intellectual property in any subsequent litigation in which we are a named as a party. Additionally, we use open source software in our products and expect to continue to use open source software in the future. We may face claims from others claiming ownership of, or seeking to enforce the terms of, an open source license, including by demanding release of the open source software, derivative works or our proprietary source code that was developed using such software. Any of these results would have a negative effect on our business and operating results.

Any additional intellectual property rights claim against us or our customers, with or without merit, could be time-consuming, expensive to litigate or settle, and divert management resources and attention. As a result of any successful intellectual property rights claim against us or our customers, we might have to pay damages or stop using technology found to be in violation of a third party’s rights, which could prevent us from offering our products to our customers. We could also have to seek a license for the technology, which might not be available on reasonable terms, might significantly increase our cost of revenue or might require us to restrict our business activities in one or more respects. The technology also might not be available for license to us at all. As a result, we could also be required to develop alternative non-infringing technology or cease to offer a particular product, which could require significant effort and expense or hurt our revenue and financial results of operations.

Our exposure to risks associated with the use of intellectual property may be increased as a result of our past and any future acquisitions as we have a lower level of visibility into the development process with respect to acquired technology or the care taken to safeguard against infringement risks. Third parties may make infringement and similar or related claims after we have acquired technology that had not been asserted prior to our acquisition.

 

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The success of our business depends on our ability to protect and enforce our intellectual property rights.

We rely primarily on a combination of patent, copyright, trademark, trade dress, unfair competition and trade secret laws, as well as confidentiality procedures and contractual restrictions, to establish and protect our proprietary rights. These laws, procedures and restrictions provide only limited protection. We currently have eight patents and have also filed patent applications, but patents may not be issued with respect to these applications. Our patents and any future patents issued to us may be challenged, invalidated or circumvented, and may not provide sufficiently broad protection or may not prove to be enforceable in actions against alleged infringers.

We endeavor to enter into agreements with our employees and contractors and with parties with which we do business in order to limit access to and disclosure of our proprietary information. We cannot be certain that the steps we have taken will prevent unauthorized use or reverse engineering of our technology. Moreover, others may independently develop technologies that are competitive to ours or infringe our intellectual property. The enforcement of our intellectual property rights also depends on our legal actions against these infringers being successful, but these actions may not be successful, even when our rights have been infringed. Further, any litigation, whether or not resolved in our favor, could be costly and time-consuming.

Our exposure to risks related to the protection of intellectual property may be increased in the context of acquired technologies as we have a lower level of visibility into the development process and the actions taken to establish and protect proprietary rights in the acquired technology. In connection with past acquisitions, we have found that some associated intellectual property rights, such as domain names and trademarks in certain jurisdictions, are owned by resellers, distributors or other third parties. In the past, we have experienced difficulties in obtaining assignments of these associated intellectual property rights from third parties.

Furthermore, effective patent, trademark, trade dress, copyright and trade secret protection may not be available in every country in which our products are available over the Internet. In addition, the legal standards relating to the validity, enforceability and scope of protection of intellectual property rights are uncertain and still evolving.

Failure to maintain proper and effective internal controls could have a material adverse effect on our business, operating results and stock price.

Section 404 of the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”) and related requirements require an annual management assessment of the effectiveness of our internal control over financial reporting and an audit by our independent auditors of our internal control over financial reporting. Ensuring that we have adequate internal financial and accounting controls and procedures in place so that we can produce reliable financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles. If we fail to maintain proper and effective internal controls, our ability to produce accurate and timely financial statements could be impaired or our operating results could be harmed, either result which could have a material adverse effect on our business and stock price.

We have documented, tested and improved, to the extent necessary, our internal controls over financial reporting for the year ended December 31, 2012. If in the future we are not able to comply with the requirements of Section 404 of the Sarbanes-Oxley Act in a timely manner, or if as part of our process of documenting and testing our internal controls over financial reporting, we or our independent registered public accounting firm identify deficiencies or areas for further attention and improvement, implementing appropriate changes to our internal controls may distract our officers and employees, entail substantial costs to modify our existing processes and take significant time to complete. These changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain that adequacy, or consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and harm our business. In

 

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addition, investors’ perceptions that our internal controls are inadequate or that we are unable to produce accurate financial statements on a timely basis may harm our stock price and make it more difficult for us to effectively market and sell our services to new and existing customers.

Changes in financial accounting standards or practices may cause adverse, unexpected financial reporting fluctuations and affect our reported results of operations.

A change in accounting standards or practices can have a significant effect on our reported results and may even affect our reporting of transactions completed before the change is effective. New accounting pronouncements and varying interpretations of accounting pronouncements have occurred and may occur in the future. Changes to existing rules or the questioning of current practices may adversely affect our reported financial results or the way in which we conduct our business.

We may be subject to regulation of our marketing and customer solicitation, which could harm our business.

As part of our product download process and during our sales process, most of our customers agree to receive emails and other communications from us. We also use tracking technologies, including cookies and related technologies, to help us track the activities of the visitors to our websites and to communicate with existing and potential customers. However, we may be subject to restrictions on our ability to collect and use customer data and communicate with customers through email and phone calls. Several jurisdictions have proposed or adopted privacy-related laws that restrict or prohibit unsolicited email or “spam” or regulate the use of cookies. We expect increased regulation related to data privacy to continue. New laws and regulations may impose significant monetary penalties for violations and complex and often burdensome requirements in connection with sending commercial email or other data-driven marketing practices. As a result of such regulation, we may be required to modify or discontinue our existing marketing practices, which could increase our marketing costs.

We offer products to customers in multiple states and foreign jurisdictions and, accordingly, may become subject to laws and regulations of different jurisdictions imposing different standards and requirements related to data privacy. Our business efficiencies and economies of scale depend on generally uniform product offerings and uniform treatment of customers across all jurisdictions in which we operate. Compliance requirements that vary significantly from jurisdiction to jurisdiction would impose added costs on our business and increase liability for compliance deficiencies.

If we fail to protect confidential information against security breaches, or if our customers or potential customers are reluctant to use our websites because of privacy concerns, we might face additional costs and activity in our websites could decline.

Some of our customers pay for our products with credit cards. During the purchasing process and in connection with evaluations of our software, either we or third party providers collect and use personally identifiable information, such as credit card numbers, email addresses and phone numbers. This information could be compromised or accessed as a result of misappropriation or security breaches, and we could be subject to liability as a result. Our policies concerning the collection, use and disclosure of personally identifiable information are described on our websites. We could be subject to legal claims, government action or harm to our reputation if we or our third party service providers fail to comply or are seen as failing to comply with our policies concerning personally identifiable information or if our policies are inadequate. Concern among prospective customers regarding our use of personal information collected on our websites could keep prospective customers from purchasing our products.

Our servers and those of our third party service providers are vulnerable to computer viruses or physical or electronic break-ins. Industry-wide incidents or incidents with respect to our specific websites, including misappropriation of third party information, security breaches, or changes in industry standards, regulations or

 

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laws, could deter people from using the Internet or our websites to conduct transactions that involve the transmission of confidential information, which could harm our business.

The laws of some states and countries require businesses that maintain personal information about their residents in electronic databases to implement reasonable measures to keep that information secure. In addition, under the laws of some states and countries, if there is a breach of our computer systems and we know or suspect that unencrypted personal customer information has been stolen, we are required to inform any customers whose information was stolen, which could harm our reputation and business. Other states and countries have enacted different and often contradictory requirements for protecting personal information collected and maintained electronically. Compliance with numerous and contradictory requirements of the different states and countries is particularly difficult for an online business such as ours that collects personal information from customers in multiple jurisdictions. Failure to comply with these laws could result in legal liability. In addition, we could suffer adverse publicity and loss of consumer confidence were it known that we did not take adequate measures to assure the confidentiality of the personally identifiable information that our customers had given to us. This could result in a loss of customers and revenue that could jeopardize our success. We may not be successful in avoiding potential liability or disruption of business resulting from the failure to comply with these laws. If we were required to pay any significant amount of money in satisfaction of claims under these new laws, or any similar laws enacted by other jurisdictions, or if we were forced to cease our business operations for any length of time as a result of our inability to comply fully with any of these laws, our business, operating results and financial condition could be adversely affected. Further, complying with the applicable notice requirements in the event of a security breach could result in significant costs.

Our business and financial performance could be negatively impacted by changes in tax laws or regulations.

New income, sales, use or other tax laws, statutes, rules, regulations or ordinances could be enacted at any time. Further, existing tax laws, statutes, rules, regulations or ordinances could be interpreted, changed, modified or applied adversely to us. Any changes to these existing tax laws could adversely affect our domestic and international business operations, and our business and financial performance. Additionally, these events could require us or our customers to pay additional tax amounts on a prospective or retroactive basis, as well as require us or our customers to pay fines and/or penalties and interest for past amounts deemed to be due. If we raise our product and maintenance prices to offset the costs of these changes, existing customers may elect not to renew their maintenance arrangements and potential customers may elect not to purchase our products. Additionally, new, changed, modified or newly interpreted or applied tax laws could increase our customers’ and our compliance, operating and other costs, as well as the costs of our products. Further, these events could decrease the capital we have available to operate our business. Any or all of these events could adversely impact our business and financial performance.

Our results of operations benefit from the tax credit incentives under the U.S. research and experimentation tax credit, or R&E tax credit, for the years ended December 31, 2010 and 2011. Our results of operations for the year ended December 31, 2012 do not reflect an income tax benefit related to the R&E tax credits as the R&E tax credit expired on December 31, 2011. However, the R&E tax credit was extended by the signing of the American Taxpayer Relief Act of 2012, or the Act, on January 2, 2013. The Act retroactively extended the R&E tax credit from January 1, 2012 through December 31, 2013. Since the Act was enacted during 2013, the income tax benefit related to the 2012 R&E tax credit will be reflected in our results of operations for the quarter ended March 31, 2013, which we expect will reduce our effective tax rate for the quarter and to a lesser extent the effective annual tax rate.

The R&E tax credit is currently set to expire on December 31, 2013, and may not be renewed, or if renewed, it may be renewed on terms significantly less favorable than current tax incentives or on terms resulting in our disqualification from the benefits of the R&E tax credit. The elimination or significant reduction in the tax credit would increase our effective tax rate and would adversely affect our results of operations.

 

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Additional liabilities related to taxes or potential tax adjustments could adversely impact our business and financial performance.

We are subject to tax and related obligations in various federal, state, local and foreign jurisdictions in which we operate or do business. The taxing rules of the various jurisdictions in which we operate or do business are often complex and subject to differing interpretations. Tax authorities could challenge our tax positions we historically have taken, or intend to take in the future, or may audit the tax filings we have made and assess additional taxes. Tax authorities may also assess taxes in jurisdictions where we have not made tax filings. Any assessments incurred could be material, and may also involve the imposition of substantial penalties and interest. Significant judgment is required in evaluating our tax positions and in establishing appropriate reserves, and the resolutions of our tax positions are unpredictable. The payment of additional taxes, penalties or interest resulting from any assessments could adversely impact our business and financial performance.

We intend either to invest our non-U.S. earnings permanently in foreign operations or to remit these earnings to our U.S. entities in a tax-free manner. If for some reason our need for U.S. cash changes, and we are unable to remit these foreign earnings to our U.S. entities in a tax-free manner, we could incur material U.S. federal tax liabilities which could adversely impact our business and financial performance.

Government regulation of the Internet and e-commerce is evolving, and unfavorable changes or our failure to comply with regulations could harm our operating results.

As Internet commerce continues to evolve, increasing regulation by federal, state or foreign agencies becomes more likely. For example, we believe increased regulation is likely in the area of data privacy. Laws and regulations applying to the solicitation, collection, processing or use of personal or consumer information could affect our customers’ ability to use and share data, potentially reducing demand for our products. In addition, taxation of products and services provided over the Internet or other charges imposed by government agencies or by private organizations for accessing the Internet may also be imposed. Any regulation imposing greater fees for Internet use or restricting information exchange over the Internet could result in a decline in the use of the Internet and the viability of Internet-based services and product offerings, which could harm our business and operating results.

Risks Related to Ownership of Our Common Stock

Our stock price may be volatile.

The market price of our common stock has been and could be subject to wide fluctuations in response to, among other things, the factors described in this “Risk Factors” section or otherwise, and other factors beyond our control, such as fluctuations in the valuations of companies perceived by investors to be comparable to us.

Furthermore, the stock markets have experienced price and volume fluctuations that have affected and continue to affect the market prices of equity securities of many companies. These fluctuations often have been unrelated or disproportionate to the operating performance of those companies. These broad market fluctuations, as well as general economic, political and market conditions, such as sovereign debt issues, interest rate changes and international currency fluctuations, may negatively affect the market price of our common stock.

We and other companies that have experienced volatility in the market price of their stock have become subject to securities class action litigation. We may be the target of additional litigation of this type in the future. Additional securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns, which could seriously harm our business.

Your ownership percentage could be diluted and our stock price could decline due to the issuance of additional shares of stock in connection with acquisitions, our equity incentive plans or otherwise.

We have a number of shares of common stock authorized but unissued and not reserved for issuance under our equity incentive plans or otherwise. As of December 31, 2012, we had 74.6 million shares outstanding,

 

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4.2 million shares subject to issuance upon the exercise of stock options and settlement of restricted stock units, and 10.3 million shares available for issuance under our 2008 equity incentive plan, or 2008 Plan. In addition, our 2008 Plan contains an evergreen provision, which provides for an automatic annual increase in the number of shares of available for issuance under the 2008 Plan on the first day of each fiscal year in an amount equal to the lesser of 6.0 million shares, 4.75% of the number of shares outstanding on the last day of the immediately preceding fiscal year or such lesser number of shares as may be determined by our board of directors. For 2013, the amount of the annual increase pursuant to the evergreen provision was 3.5 million shares of common stock, which was 4.75% of our common stock outstanding on December 31, 2012. We may issue all of these shares without any action or approval by our stockholders. We intend to continue to pursue strategic acquisitions and may pay for such acquisitions, in part or in full, through the issuance of additional equity. Any issuance of shares in connection with our acquisitions, the exercise of stock options, the settlement of restricted stock units or otherwise would dilute the percentage ownership held by our then existing stockholders and could cause our stock price to decline.

We can issue shares of preferred stock without stockholder approval, which could adversely affect the rights of common stockholders.

Our amended and restated certificate of incorporation permits us to establish the rights, privileges, preferences, and restrictions, including voting rights, of future series of our preferred stock and to issue such stock without approval from our stockholders. The rights of holders of our common stock may suffer as a result of the rights granted to holders of preferred stock that we may issue in the future. In addition, we could issue preferred stock to prevent a change in control of us, depriving common stockholders of an opportunity to sell their stock at a price in excess of the prevailing market price.

Our charter documents and Delaware law could prevent a takeover that stockholders consider favorable and could also reduce the market price of our stock.

Our amended and restated certificate of incorporation and our amended and restated bylaws contain provisions that could delay or prevent a change in control of our Company. These provisions could also make it more difficult for stockholders to elect directors and take other corporate actions. These provisions include:

 

   

a classified board of directors with three-year staggered terms;

 

   

not providing for cumulative voting in the election of directors;

 

   

authorizing the board to issue, without stockholder approval, preferred stock with rights senior to those of our common stock;

 

   

prohibiting stockholder action by written consent; and

 

   

requiring advance notification of stockholder nominations and proposals.

These and other provisions in our amended and restated certificate of incorporation and our amended and restated bylaws and under Delaware law could discourage potential takeover attempts, reduce the price that investors might be willing to pay in the future for shares of our common stock and result in the market price of our common stock being lower than it would be without these provisions.

If securities analysts do not continue to publish research or reports about our business or if they publish negative evaluations of our stock, the price of our stock could decline.

We believe that the trading price for our common stock will be affected by research or reports that industry or financial analysts publish about us or our business. If one or more of the analysts who may elect to cover us downgrade their evaluations of our stock, the price of our stock could decline. If one or more of these analysts cease coverage of our company, we could lose visibility in the market for our stock, which in turn could cause our stock price to decline.

We do not intend to pay dividends on our common stock.

We have neither declared nor paid any cash dividends on our common stock. We currently anticipate that all of our future earnings will be used for the operation and growth of our business and do not expect to pay any dividends in the foreseeable future.

 

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ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

 

ITEM 2. PROPERTIES

We lease our offices and do not own any real estate. Our largest leased facilities consist of approximately (i) 109,645 square feet for our corporate headquarters in Austin, Texas under a lease agreement that expires on May 31, 2016; (ii) 19,372 square feet for our international headquarters in Cork, Ireland under a lease agreement that expires on September 1, 2027 subject to our right to terminate earlier each five year period; (iii) 18,837 square feet for our research and development facility in Brno, Czech Republic that expires on June 30, 2022 and (iv) 13,722 square feet for our facility in Chennai, India that expires on June 30, 2014. We also lease space domestically and internationally for our operations, including local sales, support and development personnel. We believe our current facilities and planned expansion facilities may not be adequate for the foreseeable future and additional space may be required. The timing, extent and location of the additional required space has not been determined.

 

ITEM 3. LEGAL PROCEEDINGS

From time to time, we have been and may be involved in various legal proceedings and claims, including the pending litigation discussed below, as well as other legal proceedings and claims that have not been fully resolved and that have arisen in our ordinary course of business. In the opinion of management, there was not at least a reasonable possibility we may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to any legal proceedings. However, the outcome of legal proceedings and claims brought against us are subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against us in the same reporting period for amounts in excess of management’s expectations, our consolidated financial statements of a particular period could be materially adversely affected. See the risk factor “Litigation exposure related to our pending and any future litigation could adversely affect our results of operations, profitability and cash flows” in Part I, Item 1A under the heading “Risk Factors.”

Uniloc USA, Inc. and parent and/or affiliates have brought two lawsuits against the Company and have brought a series of lawsuits against numerous software companies around the world.

On September 13, 2010, Uniloc USA, Inc. and Uniloc (Singapore) Private Limited (“Uniloc”) brought a lawsuit against the Company and several other defendants in the United States District Court for the Eastern District of Texas (“Eastern District of Texas”). The complaint filed by Uniloc alleges that the Company and each of the other fifteen named defendants’ software infringe U.S. patent 5,490,216 (“216 Patent”) allegedly owned by Uniloc. Uniloc alleges that the Company’s software, specifically its license key system, infringes upon its patent that utilizes a system for activating software products through a registration process. In September 2011, another company, Sureloc, Inc. (“Sureloc”) claimed that it owns the 216 Patent. As a result, on November 3, 2011, Uniloc and its affiliates filed a lawsuit in the Superior Court of the State of California against Sureloc, Patrick Rooney, and Does 1-100 (the “Sureloc case”), seeking, among other things, a declaratory judgment that Uniloc and not Sureloc, is the exclusive owner of the 216 Patent. Once the Eastern District of Texas was informed of the Sureloc case, all Uniloc cases that were pending before the Eastern District of Texas were stayed on December 1, 2011. Subsequently, Uniloc and Sureloc settled their dispute regarding ownership of the 216 Patent, and the Sureloc case was dismissed with prejudice on September 25, 2012. On January 25, 2013, the Eastern District of Texas lifted the stay of all Uniloc cases and set the cases for a status conference on February 25, 2013. Because this lawsuit continues to only be in the initial stages, it is not possible to reliably predict the outcome of the litigation. Therefore, we cannot currently estimate the loss, if any, associated with the litigation. We intend to contest the claims associated with this lawsuit vigorously.

On March 30, 2012, Uniloc Luxembourg, S.A. and Uniloc USA, Inc. brought a lawsuit against the Company and several other defendants in the United States District Court for the Eastern District of Texas (“Eastern District of Texas”). The complaint filed by Uniloc alleges that the Company and each of the other fifteen named defendants’

 

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software infringe U.S. patent 7,024,696 (“696 Patent”) allegedly owned by Uniloc. Uniloc alleges that the Company’s software, specifically its license key system, infringes upon its patent that utilizes a system for activating software products through a registration process. Because this lawsuit is in its early stages, it is not possible to reliably predict the outcome of the litigation. Therefore, we cannot currently estimate the loss, if any, associated with the litigation. We intend to contest the claims associated with this lawsuit vigorously.

On June 22, 2011, Achates Reference Publishing, Inc. (“Achates”) brought a lawsuit against SolarWinds, Inc. and several other defendants in the United States District Court for the Eastern District of Texas. The complaint filed by Achates alleges that SolarWinds, Inc. and each of the other twelve named defendants’ software infringe U.S. Patent No. 5,982,889 (“889 Patent”) and U.S. Patent No. 6,173,403 (“403 Patent”), which are allegedly owned by Achates. Achates alleges that SolarWinds, Inc.’s Engineer Suite family of software infringes upon the 889 and 403 Patents “by employing activation technology.” Achates has brought a series of lawsuits against numerous software companies around the world. Currently, it is not possible to reliably predict the outcome of the litigation. Therefore, we cannot currently estimate the loss, if any, associated with the litigation. We intend to contest the claims associated with this lawsuit vigorously.

 

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

 

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PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

Our common stock is listed on the New York Stock Exchange (“NYSE”) under the symbol “SWI.” The following table sets forth for the periods indicated the high and low sales prices per share of our common stock as reported on the NYSE:

 

     Sales Price Per Share
in 2012
 

Quarter

       Low              High      

Fourth Quarter

   $ 44.83       $ 58.57   

Third Quarter

   $ 39.10       $ 60.95   

Second Quarter

   $ 35.34       $ 48.64   

First Quarter

   $ 27.25       $ 42.22   

 

     Sales Price Per Share
in 2011
 

Quarter

       Low              High      

Fourth Quarter

   $ 21.05       $ 33.28   

Third Quarter

   $ 20.05       $ 26.30   

Second Quarter

   $ 22.79       $ 26.16   

First Quarter

   $ 18.64       $ 24.07   

On February 14, 2013, the last reported sales price of our common stock on the NYSE was $53.41 per share and, as of December 31, 2012, there were 24 holders of record of our common stock. Because many of our shares of common stock are held by brokers and other institutions on behalf of stockholders, this number is not representative of the total number of stockholders represented by these stockholders of record.

Dividend Policy

We have neither declared nor paid any cash dividends on our common stock and we do not expect to pay dividends on our common stock for the foreseeable future. We anticipate that all of our earnings will be used for the operation and growth of our business. Any future determination to pay dividends on our common stock would be subject to the discretion of our board of directors and would depend upon various factors, including our results of operations, financial condition and liquidity requirements, restrictions that may be imposed by applicable law and our contracts, and other factors deemed relevant by our board of directors.

Performance Graph

The graph set forth below compares the cumulative total stockholder return on our common stock between May 20, 2009 (the date of our initial public offering (“IPO”)) and December 31, 2012, with the cumulative total return of the (i) the Russell 2000 Index, (ii) the Russell Midcap Index and (iii) the Nasdaq Computer Index (the “Industry Index”). This graph assumes the investment of $100 on May 20, 2009 in our common stock at our IPO offering price of $12.50 per share, the Russell 2000 Index, the Russell Midcap Index and the Industry Index, and assumes the reinvestment of dividends, if any. Our common stock was added to the Russell Midcap Index in 2012 and, for this reason, we have selected the Russell Midcap Index to replace the Russell 2000 Index as the broad equity market index for purposes of comparison in the graph below. In accordance with Item 201(e) of Regulation S-K, we are showing the performance of both the Russell Midcap Index and the Russell 2000 Index in this year’s performance graph. The Industry Index consists of NASDAQ-listed computer hardware and software companies that provide products or services. Note that historic stock price performance is not necessarily indicative of future stock price performance.

 

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The information contained in the Stock Performance Graph shall not be deemed to be soliciting material or to be filed with the SEC nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or the Exchange Act, except to the extent we specifically incorporate it by reference into such filing.

 

LOGO

 

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ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

We have derived the following consolidated statement of income data for 2012, 2011 and 2010 and consolidated balance sheet data as of December 31, 2012 and 2011 from our audited consolidated financial statements contained in this Annual Report on Form 10-K. We have derived the following consolidated statement of income data for 2009 and 2008 and consolidated balance sheet data as of December 31, 2010, 2009 and 2008 from our audited consolidated financial statements included in our other SEC filings and not included in this Annual Report. You should read the consolidated financial data set forth below in conjunction with our consolidated financial statements and related notes and the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Our historical results are not necessarily indicative of our results to be expected in any future period.

 

Consolidated Statements of Income Data:

(in thousands, except per share data)

   Year Ended December 31,  
   2012     2011     2010     2009     2008  

Revenue:

          

License

   $ 123,984      $ 92,254      $ 75,603      $ 62,378      $ 55,461   

Maintenance and other

     144,980        106,104        76,790        54,068        37,674   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenue

     268,964        198,358        152,393        116,446        93,135   

Cost of revenue

     18,400        11,989        7,930        4,860        3,588   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     250,564        186,369        144,463        111,586        89,547   

Operating expenses:

          

Sales and marketing

     73,046        53,850        43,252        30,548        22,664   

Research and development

     28,769        21,332        15,731        11,199        8,452   

General and administrative

     35,649        28,076        23,476        26,038        16,464   

Accrued earnout gain

     (570     (664     —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     136,894        102,594        82,459        67,785        47,580   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating income

     113,670        83,775        62,004        43,801        41,967   

Other income (expense):

          

Interest income

     430        308        177        267        528   

Interest expense

     —          —          (1,146     (4,253     (8,539

Other income (expense), net

     419        720        115        90        (934
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other income (expense)

     849        1,028        (854     (3,896     (8,945
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     114,519        84,803        61,150        39,905        33,022   

Income tax expense

     33,176        22,360        16,404        10,396        10,717   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     81,343        62,443        44,746        29,509        22,305   

Amount allocated to participating preferred stockholders

     —          —          —          —          (10,922
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income available to common stockholders

   $ 81,343      $ 62,443      $ 44,746      $ 29,509      $ 11,383   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Basic earnings per share available to common stockholders

   $ 1.10      $ 0.86      $ 0.65      $ 0.58      $ 0.40   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted earnings per share available to common stockholders

   $ 1.07      $ 0.84      $ 0.61      $ 0.52      $ 0.35   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Shares used in computation of basic earnings per share available to common stockholders

     74,166        72,812        68,664        51,042        28,137   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Shares used in computation of diluted earnings per share available to common stockholders

     76,035        74,413        72,862        56,824        32,652   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Consolidated Balance Sheet Data:

(in thousands)

   December 31,  
   2012      2011      2010      2009      2008  

Cash and cash equivalents

   $ 179,702       $ 122,707       $ 142,003       $ 129,788       $ 40,566   

Short-term and long-term investments

     62,099         29,688         —           —           —     

Working capital

     146,554         93,187         108,203         89,699         16,393   

Deferred revenue

     102,756         77,147         55,758         38,647         27,162   

Total assets

     517,395         362,408         247,477         181,470         86,907   

Long-term obligations and convertible preferred stock

     9,391         4,367         3,992         29,377         95,379   

Total stockholders’ equity (deficit)

     382,814         264,947         175,609         89,066         (48,555

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the “Selected Consolidated Financial Data” and our consolidated financial statements and related notes included elsewhere in this report. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially and adversely from those anticipated in the forward-looking statements. See the sections entitled “Safe Harbor Cautionary Statement” and “Risk Factors” above for a discussion of the uncertainties, risks and assumptions associated with these statements.

Overview

We design, develop, market, sell and support powerful yet easy-to-use enterprise-class IT infrastructure management software to IT professionals in organizations of all sizes. Our product offerings range from individual software tools to more comprehensive software products that solve problems encountered every day by IT professionals and help to enable efficient and effective management of their network, systems and application infrastructure. Our products are ready-to-use, featuring intuitive and easily customized user interfaces and built-in workflows. Our products can be downloaded directly from our websites and installed and configured by our end-users in a matter of hours. Our customers include small- and mid-size businesses, large enterprises, and local, state and federal government entities that have purchased our products.

Acquisitions

We have made a number of strategic product acquisitions and product releases in 2011 and 2012 that we believe are important to our long-term growth. We entered into several new markets including the system and application management market, virtualization management market and the log and security information management market. These new markets include software for managing network devices, firewalls, applications, physical and virtual servers, storage devices, log and security management and mobile and remote access to IT infrastructures. We will continue to look for acquisitions similar to those we have completed in the past and will be more aggressive in looking at new markets in the future to supplement our internal product development efforts.

During 2012, we acquired Athena Security, Inc., or Athena and Rhino Software, Inc., or RhinoSoft and certain assets of EminentWare, Inc., or EminentWare, Rove Mobile, Inc., or Rove and MacsDesign, LLC, or MacsDesign for a combined purchase price of $68.3 million. We account for our acquisitions using the acquisition method of accounting. Accordingly, the financial results for these entities are included in our consolidated financial results since the applicable acquisition dates. For further information regarding these acquisitions, see Note 2, Acquisitions, in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K.

Key Financial Highlights

Key financial highlights for 2012 include the following:

 

   

Total revenue was $269.0 million for 2012 compared to $198.4 million for 2011, or an increase of 35.6%;

 

   

Net income was $81.3 million for 2012 compared to $62.4 million for 2011, or an increase of 30.3%;

 

   

Net income was $1.07 per share on a fully diluted basis for 2012 compared to $0.84 per share on a fully diluted basis for 2011, or an increase of 27.4%, and

 

   

Cash flow from operating activities was $143.4 million for 2012 compared to $110.5 million for 2011, or an increase of 29.8%.

 

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In 2012, we have transitioned from a network management software company into an IT infratructure management software company with a portfolio of products for IT professionals in organizations of all sizes. We made a number of strategic investments in our business in 2012 that we believe are an important foundation for our long term growth such as:

 

   

We acquired new technology that significantly expands the number of IT management problems that we solve for IT professionals;

 

   

We introduced certain localized products with country-specific product documentation, websites and marketing material for the Japanese and German markets as part of the ongoing effort to more effectively reach, market and support users around the world. In addition, our sales and support organizations added language capabilities to their teams to ensure we are maintaining the same high quality customer experience for our international customers;

 

   

We continued to expand our international research and development locations allowing us to respond to user demand and support new product releases and enhancements for our acquired and internally developed technologies;

 

   

We released enhancements to SolarWinds.com and thwack.com to reach potential buyers and integrate our user community. We also invested in marketing programs to build brand awareness and enhance our search optimization; and

 

   

We added targeted sales teams for products and regions that utilize our low touch, high-volume sales model.

Despite these specific investments and a number of other important investments, we continued to grow our operating income and increase our cash flows from operating activities.

We are committed to our business model and have continued to focus on ways to leverage and refine our model. We are pursuing a number of strategies that we believe will enable us to continue to grow. We have made progress towards our goals in recent periods but there are still many areas where we believe that we can continue to grow and improve. We expect to grow our business by focusing on the following initiatives:

 

   

Acquisitions of products that will expand our network management and systems and application management offerings or potentially acquisitions of products in new markets;

 

   

Increasing our presence in several key geographic markets including Asia-Pacific, Latin America, Europe, Middle East and Africa by expanding our product portfolio, websites and marketing material, which includes additional localization of our products, websites, and documentation, and establishing new relationships with distributors and resellers;

 

   

Expanding our web presence, brand awareness and improving our communication with prospects and our current customers domestically and internationally; and

 

   

International expansion company-wide at lower cost locations to drive our competitive advantage.

We expect to continue to generate solid growth while delivering strong operating income and increase our cash flows from operating activities in 2013 with our disciplined approach to investing in our business combined with the large market opportunity.

 

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Key Business Metrics

We review a number of key business metrics to help us monitor the performance of our business model and to identify trends affecting our business. The measures that we believe are the primary indicators of our quarterly and annual performance are as follows:

Revenue Growth

Revenue growth includes the total revenue growth in our license and maintenance revenue, which are both critical to our long-term success. We have employed a differentiated business model for marketing and selling high volumes of enterprise-class software, which is focused on revenue growth at high operating margins. We regularly review our total revenue growth to measure the success of our investments and strategic business decisions. We have built a financial and operational model that focuses on the long term value of our customer relationships. After the initial new license purchase, our goal is to create opportunities for sales of additional products, license upgrades and renewal purchases from the customer. This is an important component of our financial model and future revenue growth. This model is based on the premise that we will be able to deliver ongoing value to our customers and maintain a long-term financial relationship with the users of our IT management products. Our annual revenue growth percentages were 35.6%, 30.2% and 30.9% for the years ended December 31, 2012, 2011 and 2010, respectively.

Core Product Transaction Growth for New License Sales.

We focus our sales, marketing and research and development efforts on IT professionals in organizations of all sizes, with the goal of driving purchases of our software by these IT professionals in short sales cycles. In addition, many of our customers make small initial purchases of our software and then over time may purchase an upgrade to increase the size of their license or buy additional software products from us. We review the core product transaction growth to ensure the effectiveness of our marketing and sales model and expect core product transaction volume growth to be the primary driver of our new license growth.

We define our core product transactions as the number of new license sales transactions that include at least one of our core products. We define a transaction as each invoice issued for the sale of one or more of our products. If one of our core products is included in a particular transaction, then that transaction is a core product transaction. New license sales of core products represented more than 85% of our license revenue for 2012. Accordingly, we believe that management can better evaluate changes in our product portfolio, expansion into new markets and the addition of new customers by evaluating the transactional growth of our core products. Our core product transaction growth for new license sales was 36.3%, 30.9% and 24.7% for the years ended December 31, 2012, 2011 and 2010, respectively.

Non-GAAP Operating Income

Our management uses non-GAAP operating income as one key measure of our performance. Because non-GAAP operating income excludes certain items such as amortization of intangible assets, stock-based compensation and related employer-paid payroll taxes and certain acquisition related adjustments that may not be indicative of our core business, we believe that this measure provides us with additional useful information to measure and understand our performance, particularly with respect to changes in performance from period to period. We use non-GAAP operating income in the preparation of our budgets and to measure and monitor our performance. Non-GAAP operating income is not determined in accordance with GAAP and is not a substitute for, or superior to, financial measures determined in accordance with GAAP.

Free Cash Flow

We believe free cash flow is an important liquidity measure that reflects the cash generated by the business after the purchase of property and equipment that can then be used for, among other things, strategic acquisitions

 

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and investments in the business, stock repurchases and funding ongoing operations. We regularly review our free cash flow generation to measure our effectiveness at running our operations efficiently and in a manner that maximizes the value of our business. We define free cash flow as cash flows from operating activities plus the excess tax benefit from stock-based compensation and less the purchase of property and equipment. Free cash flow does not represent the total increase or decrease in the cash balance for the period, is not determined in accordance with GAAP and is not a substitute for, or superior to, financial measures determined in accordance with GAAP.

For further discussion regarding non-GAAP financial measures including non-GAAP operating income and free cash flow, see “Non-GAAP Financial Measures” below.

Opportunities, Trends and Uncertainties

Businesses, governments and other organizations are increasingly relying on networks, systems, and applications to execute their operations, facilitate their internal and external communications and transact business with their customers and partners. The size of these networks, the number of applications and servers, and the complexity of physical and virtual server environments are increasing as organizations place more reliance on them. In addition, the adoption of cloud computing technologies, which is shifting a growing number of critical workloads off premises, along with business initiatives to capture, store, and analyze an increasing amount of organizational data are creating new IT management challenges. In order to address these challenges, we offer a cohesive portfolio of powerful, yet easy-to-use and affordably priced IT management products spanning networks, systems, and application management. This includes software that we have either developed or acquired that allows IT professionals to manage the performance, health, and configurations of network devices, firewalls, applications, physical and virtual servers, storage devices, as well as software for log and security information management. It also includes software that provides IT professionals with mobile and remote access to their IT infrastructure and software to help them track and resolve IT issues along with their IT assets. We believe that IT-related trends and the limitations of existing offerings present a significant market opportunity for our products. We expect our revenue to continue to grow as we capitalize on these and other market opportunities and target license revenue growth of 20% over the next three to five years. Any revenue growth and operating synergies of our acquired products and businesses depends on our ability to successfully integrate those products and businesses and may be lower than expected if we are unable to do so in the future.

In 2012, we recognized 24.5% of our revenue from sales by our international subsidiaries. We believe there is a substantial opportunity for additional sales of our software in the Europe, Middle East and Africa, or EMEA, region, the Asian-Pacific region, and the Latin American region and we intend to increase our sales, marketing and support operations in these regions. However, we believe there is significant uncertainty regarding the economic conditions in certain of these geographic regions, particularly in parts of Europe. While we believe that any difficult economic conditions may adversely affect the sales of our products, this could also offer us an opportunity to market and sell our products to mid-size businesses and enterprise customers at compelling prices compared to the prices of some competing products.

We expect the U.S. federal government to continue to be a significant market opportunity, as we believe the ease of deployment, power and scalability of our products gives us a competitive advantage to sell to various agencies and departments of the U.S. federal government. The U.S. federal government new license sales were 10.7% of our total new license sales in 2012. We have experienced and continue to expect inconsistency in the buying pattern of the U.S. federal government for larger transactions with our products. Our sales, both new licenses and maintenance renewals, to the U.S. federal government are largely dependent on systems integrators, distributors and resellers whose purchases from us have been difficult to predict. In addition, we believe that many of our larger transactions with the U.S. federal government are dependent on specific projects that may or may not be continued at the same scale in the future due to budgetary cuts or other reasons, and the reduction or cancellation of specific projects such as these may change the buying patterns of the U.S. federal government and could result in our sales to the U.S. government being less than expected.

 

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Key Components of Our Results of Operations

Sources of Revenue

Our revenue is primarily comprised of license and maintenance revenue. We license our software under perpetual licenses, which ordinarily include one year of maintenance as part of the initial purchase price of the product. License revenue reflects the revenue recognized from sales of new licenses and upgrades of license size to our software. We have experienced annual growth in license revenue. Customers can renew, and generally have renewed, their maintenance agreements at our standard list maintenance renewal pricing for their software products. Current customers with maintenance agreements are entitled to receive unspecified upgrades or enhancements when and if they become available. Maintenance revenue is an important source of our future revenue. We have experienced strong and consistent annual and quarterly growth in maintenance and other revenue. Because our maintenance base grew during 2010, 2011 and 2012 due to new license sales, high customer retention and acquisitions, we expect maintenance revenue to continue to increase in absolute dollars in future periods.

Cost of Revenue

Cost of revenue primarily consists of personnel costs related to providing technical support services and amortization of acquired developed product technologies and third party software licenses. Personnel costs include salaries, bonuses and stock-based compensation and related employer-paid payroll taxes for technical support personnel, as well as an allocation of our facilities, information technology, employee benefit and other overhead costs. We allocate stock-based compensation expense and related employer-paid payroll taxes to personnel costs based on the expense category in which the option or restricted stock unit holder works. We allocate overhead, such as rent, computer and other technology costs, and employee benefit costs to personnel costs in each expense category based on worldwide headcount in that category.

The amortization of developed product technologies can vary significantly each period based on the size and timing of our acquisitions. We expect our cost of revenue to increase in absolute dollars and to fluctuate as a percentage of revenue as we acquire additional companies and as we increase our headcount to support new customers and product offerings.

Operating Expenses

We classify our operating expenses into four categories: sales and marketing, research and development, general and administrative and accrued earnout gain.

Our operating expenses primarily consist of personnel costs, contract research and development costs, marketing program costs and legal, accounting, consulting and other professional service fees. Personnel costs for each category of operating expenses primarily include employee compensation costs and facility overhead costs.

Our operating expenses increased in absolute dollars and decreased as a percentage of revenue in 2012 compared to 2011 and 2010, as we have continued to build infrastructure and add employees through acquisitions and organic growth across all departments in order to accelerate and support our growth. The number of full-time employees as of December 31, 2012, was 865, as compared to 628, as of December 31, 2011 and 458 as of December 31, 2010. We expect our operating expenses to continue to increase in absolute dollars as we make long-term investments in our business both domestically and internationally. As we acquire additional companies and integrate the businesses, we will continue to target our corporate margin structure although our operating expenses in future periods may increase in absolute dollars and fluctuate as a percentage of revenue as a result of such acquisitions. In addition, we intend to continue to grant equity awards to our current executives and employees and those who join us in the future through acquisitions or otherwise, which will result in additional stock-based compensation expense.

 

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Sales and Marketing. Sales and marketing expenses primarily consist of personnel costs for our sales, marketing and business development employees and executives, commissions earned by our sales personnel, the cost of marketing programs such as paid search, search engine optimization and management, website maintenance and design and the cost of business development programs. We expect to continue to hire sales personnel in the United States and in our international sales offices at a rate consistent with our expected new license sales growth. In 2013, as part of our international expansion initiatives, we are opening a sales office in Brazil to help us leverage the sales opportunity in Latin America. We also expect to continue to invest in our websites, online user community site and marketing programs to drive customer downloads and support our new product launches.

Research and Development. Research and development expenses primarily consist of personnel costs for our product development employees and executives and, to a lesser extent, contractor fees. We have devoted our development efforts primarily to expanding our product line and increasing the functionality and enhancing the ease-of-use of our software products. We have significantly increased our research and development employee headcount with the continued expansion of our research and development centers in the Czech Republic and India, which has resulted in and will continue to result in an increase in facilities and personnel costs. We expect to continue to invest in our research and development activities by hiring engineers in our international locations, which will allow us to continue our research and development growth strategy internationally.

General and Administrative. General and administrative expenses primarily consist of personnel costs for our executive, finance, legal, human resources and administrative personnel and amortization of acquired intangible assets. Legal, accounting and other professional service fees along with general corporate expenses are also recorded in general and administrative expenses. We expect to incur higher administrative costs in future periods as our business continues to grow both organically and through acquisitions.

Accrued Earnout Gain. Accrued earnout gain represents the change in the fair value of the contingent consideration liability recorded on the acquisition due to subsequent adjustments in the probability assumptions. We review the probability of achieving the earnout objectives each quarter to determine if the probability assumptions need to be adjusted and the contingent consideration revalued.

Other Income (Expense)

Other income (expense) primarily consists of interest income, grant income, transactional foreign exchange gains (losses), foreign exchange contracts gains (losses) and acquisition related contingent consideration fair value adjustments due to the passage of time. We periodically receive government grant income related to grants in our Czech Republic and Ireland entities for the creation of job positions and related training costs. The amount and timing of the grant payments is determined by the Czech and Irish governments. Interest income represents interest received on our cash, cash equivalents and short-term and long-term investments, including any amortization or accretion of the premium and discount. Foreign exchange gains (losses) primarily relate to expenses and billing transactions denominated in currencies other than the functional currency of the associated subsidiary. Foreign exchange contracts gains (losses) relate to the settlement of foreign currency forward contracts utilized to hedge foreign currency exposures that are not formally designated as hedges. Interest expense in 2010 was associated with our outstanding long-term debt which was paid in full in May 2010.

Income Tax Expense

Income tax expense primarily consists of corporate income taxes related to profits resulting from the sale of our software offerings by our only two entities that sell our software, one in the United States and one in Ireland. The rate of taxation on income earned by our U.S. entity is higher than the rate of taxation on income earned by our Irish entity. If our international income, as a percentage of total income, increases as we expect, then our effective income tax rate should correspondingly decline. However, our effective tax rate may be affected by many other factors, such as changes in tax laws, regulations or rates, new interpretations of existing laws or

 

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regulations, the impact of accounting for stock-based compensation, the impact of accounting for business combinations, the impact of accounting for uncertain tax positions, changes in our international structure, shifts in the amount of taxable income earned in the United States, as compared with other regions in the world, and changes in overall levels of income before tax.

Our results of operations reflect an income tax benefit from the tax credit incentives under the U.S. research and experimentation tax credit, or R&E tax credit, for the years ended December 31, 2010 and 2011. Our results of operations for the year ended December 31, 2012 do not reflect an income tax benefit related to the R&E tax credits as the R&E tax credit expired on December 31, 2011. However, the R&E tax credit was extended by the signing of the American Taxpayer Relief Act of 2012, or the Act, on January 2, 2013. The Act retroactively extended the R&E tax credit from January 1, 2012 through December 31, 2013. Since the Act was enacted during 2013, the income tax benefit related to the 2012 R&E tax credit will be reflected in our results of operations for the quarter ended March 31, 2013, which we expect will reduce our effective tax rate for the quarter and to a lesser extent the effective annual tax rate.

The tax credit is currently set to expire on December 31, 2013, and may not be renewed, or if renewed, it may be renewed on terms significantly less favorable than current tax incentives or on terms resulting in our disqualification from the benefits of the R&E tax credit. The elimination or significant reduction in the R&E tax credit would increase our effective tax rate and could adversely affect our results of operations.

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in conformity with United States of America generally accepted accounting principles, or GAAP, and require our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could reasonably use different accounting estimates, and in some instances, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected, perhaps materially.

In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application, while in other cases, management’s judgment is required in selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. We believe that these accounting policies requiring significant management judgment and estimates are critical to understanding our historical and future performance, as these policies relate to the more significant areas of our financial results. These critical accounting policies are:

 

   

Valuation of goodwill, intangibles, long-lived assets and contingent consideration, including accrued earnouts;

 

   

Revenue recognition;

 

   

Stock-based compensation;

 

   

Income taxes; and

 

   

Loss contingencies.

Acquisitions, Goodwill and Identifiable Intangible Assets. When we acquire businesses, we allocate the purchase price to tangible assets and liabilities and identifiable intangible assets acquired. Any residual purchase price is recorded as goodwill. We must also estimate the fair value of any contingent consideration. The operating results of acquisitions are included in our consolidated financial statements from the effective date of the acquisition.

 

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The fair value of identifiable intangible assets is based on significant judgments made by management. We typically engage third party valuation appraisal firms to assist us in determining the fair values and useful lives of the assets acquired. Such valuations and useful life determinations require us to make significant estimates and assumptions. These estimates and assumptions are based on historical experience and information obtained from management, and also include, but are not limited to, future expected cash flows earned from the intangible asset and discount rates applied in determining the present value of those cash flows. Unanticipated events and circumstances may occur that could affect the accuracy or validity of such assumptions, estimates or actual results.

The acquired developed product technologies recorded for each acquisition were feasible at the date of acquisition as they were being actively marketed and sold by the acquired company at the acquisition date. In addition to the acquired developed product technologies, we also record intangible assets for the acquired company’s customer relationships, trademarks, in process research and development and non-competition covenants.

An impairment of goodwill or indefinite-lived intangible assets is recognized when the carrying amount of the assets exceeds their fair value. The process of evaluating the potential impairment is highly subjective and requires the application of significant judgment. For purposes of the annual impairment test, we assess qualitative factors to determine if it is more likely than not that goodwill and indefinite-lived assets might be impaired and whether it is necessary to perform the quantitative impairment test which considers our market capitalization compared with the carrying amount of our net assets on the date of the test, since we have only one reporting unit. If an event occurs that would cause us to revise our estimates and assumptions used in analyzing the value of our goodwill and other intangible assets with indefinite lives, the revision could result in a non-cash impairment charge that could have a material impact on our financial results. As of December 31, 2012 and 2011, we performed our annual review of goodwill and indefinite-lived intangible assets and concluded that no impairment existed for our reporting unit during any of the periods presented. No impairment charges have been required to date.

We evaluate long-lived assets, including identifiable intangible assets and other assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Events or changes in circumstances that could result in an impairment review include, but are not limited to, significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for our overall business, and significant negative industry or economic trends. If an event occurs that would cause us to revise our estimates and assumptions used in analyzing the value of our property and equipment or our finite-lived intangibles and other assets, that revision could result in a non-cash impairment charge that could have a material impact on our financial results. As of December 31, 2012 and 2011, there were no indicators that our long-lived assets were impaired.

Contingent Consideration. Our acquisitions may include contingent consideration payments based on future sales or product milestones of an acquired entity. We estimate the fair value of contingent consideration liabilities based on certain milestones of the acquired companies and estimated probabilities of achievement and discount the liabilities to present value using our pre-tax cost of debt. We believe our estimates and assumptions are reasonable, however, there is significant judgment involved. Changes in the fair value of contingent consideration liabilities may result from changes in discount periods, changes in the timing and amount of sales and/or other specific milestone estimates and changes in probability assumptions with respect to the likelihood of achieving the various earnout criteria. At each reporting date, the contingent consideration liability is revalued to estimated fair value and changes in fair value subsequent to the acquisitions are reflected in net income in the consolidated statements of income and could cause a material impact to, and volatility in, our operating results.

 

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Revenue Recognition

We derive substantially all of our revenue from the licensing of our software products and from the sale of maintenance agreements. We typically include one year of maintenance as part of the initial purchase price of each software offering and then sell renewals of this maintenance agreement. In accordance with current guidance, we recognize revenue for software, maintenance and other services when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is probable. Our return policy generally does not allow our customers to return software products.

License Revenue. We consider delivery of our software to have occurred and recognize revenue from the sale of perpetual licenses to our software when risk of loss transfers to the customer, reseller or distributor, which is generally upon electronic transfer of the license key which provides immediate availability of the product to the purchaser.

We sell licenses to our software products through our direct sales force and through our distributors and other resellers. Our distributors and resellers do not carry inventory of our software and we generally require them to specify the end-user of the software at the time of the order. If the distributor or reseller does not provide end-user information, then we will generally not fulfill the order. Our distributors and resellers have no rights of return or exchange for software that they purchase from us and payment for these purchases is due to us without regard to whether the distributors or resellers collect payment from their customers.

Because our software is generally sold with maintenance, we calculate the amount of revenue allocated to the software license by determining the fair value of the maintenance and subtracting it from the total invoice or contract amount. We establish vendor-specific objective evidence, or VSOE, of the fair value of maintenance services by the standard published list pricing for our maintenance renewals since we generally charge list prices for our maintenance renewals. If in the future we were unable to establish VSOE of fair value of the maintenance or other services we would defer all revenue over the term of the agreement and until all elements of the agreement had been delivered which could significantly impact the timing of our revenue recognition.

Maintenance and Other Revenue. We derive maintenance revenue from fees for software maintenance services which includes the maintenance portion allocated from the initial license transaction and any subsequent maintenance renewal transactions. We generally bill maintenance renewal agreements annually in advance for services to be performed over a 12-month period. Customers have the option to purchase maintenance renewals for periods other than 12 months. We initially record the amounts to be paid under maintenance agreements as deferred revenue and recognize these amounts ratably on a daily basis over the term of the contract period. Customers with maintenance agreements are entitled to receive unspecified upgrades or enhancements to new versions of their software products on a when-and-if-available basis.

Other revenue consists primarily of subscription revenue which is recognized ratably on a daily basis over the term of the contract period. Other revenue is not currently significant.

Stock-Based Compensation

We have granted and expect to continue to grant our employees and directors stock-based incentive awards. These awards are in the form of stock options, restricted stock and restricted stock units. We measure stock-based compensation expense for all share-based awards granted based on the estimated fair value of those awards on the date of grant. The fair values of stock option awards are estimated using a Black-Scholes valuation model. The fair value of restricted stock and restricted stock unit awards is determined using the fair market value of our common stock based on the quoted market price on the date of grant, or intrinsic value.

We use various assumptions in estimating the fair value of options at the date of grant using the Black-Scholes option model including expected dividend yield, volatility, risk-free rate of return and expected life. We have not paid and do not anticipate paying cash dividends on our common stock; therefore, we assume the

 

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expected dividend yield to be zero. Since we were a private entity prior to our IPO in May 2009 and have limited historical data regarding the volatility of our own common stock price, we based the expected volatility on the historical and implied volatility of comparable companies from a representative industry peer group. We determined expected volatility of options granted using an average of the historical volatility measures of this peer group of companies. We based the risk-free rate of return on the average U.S. treasury yield curve for five- and seven-year terms. As allowed under current guidance, we have elected to apply the “simplified method” in developing our estimate of expected life for “plain vanilla” stock options by using the midpoint between the vesting date and contractual termination date since we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term due to the limited period of time our common stock has been publicly traded. For all dates, we granted employees options at exercise prices equal to the fair value of the underlying common stock on the date of grant, which is the closing price of our common stock as reported by the NYSE.

We plan to grant restricted stock units as the primary form of equity awards to our employees in 2013. We will continue to grant restricted stock units and stock options to our executives and board of directors in 2013.

Income Taxes

We use the liability method of accounting for income taxes as set forth in the authoritative guidance for accounting for income taxes. Under this method, we recognize deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the respective carrying amounts and tax basis of our assets and liabilities.

The guidance on accounting for uncertainty in income taxes prescribes a recognition threshold and measurement attribute for financial statement disclosure of tax positions taken or expected to be taken on a tax return. At December 31, 2012 and 2011, we had $8.8 million and $4.0 million of gross unrecognized tax benefits, respectively, all of which, if recognized, would affect our effective tax rate.

We accrue interest and penalties related to unrecognized tax benefits as a component of income tax expense. As of December 31, 2012 and 2011, there was an insignificant amount accrued for interest and penalties related to unrecognized tax benefits.

In calculating our effective tax rate, we make judgments regarding certain tax positions, including the timing and amount of deductions and allocations of income among various tax jurisdictions.

The guidance requires us to identify, evaluate and measure all uncertain tax positions taken or to be taken on tax returns and to record liabilities for the amount of these positions that may not be sustained, or may only partially be sustained, upon examination by the relevant taxing authorities. Although we believe that our estimates and judgments are reasonable, actual results may differ from these estimates. Some or all of these judgments are subject to review by the taxing authorities.

We establish valuation allowances when necessary to reduce deferred tax assets to the amounts expected to be realized. On a quarterly basis, we evaluate the need for, and the adequacy of, valuation allowances based on the expected realization of our deferred tax assets. The factors used to assess the likelihood of realization include our latest forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets.

We intend either to invest our non-U.S. earnings permanently in foreign operations or to remit these earnings to our U.S. entities in a tax-free manner. For this reason, we do not record federal income taxes on the undistributed earnings of our foreign subsidiaries.

 

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Comparison of the Years Ended December 31, 2012 and 2011

 

     Year Ended December 31,  
     2012     % of
Revenue
    2011     % of
Revenue
    Change  
     (in thousands)           (in thousands)           (in thousands)  

Revenue:

          

License

   $ 123,984        46.1   $ 92,254        46.5   $ 31,730   

Maintenance and other

     144,980        53.9        106,104        53.5        38,876   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenue

     268,964        100.0        198,358        100.0        70,606   

Cost of revenue

     18,400        6.8        11,989        6.0        6,411   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     250,564        93.2        186,369        94.0        64,195   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating expenses:

          

Sales and marketing

     73,046        27.2        53,850        27.1        19,196   

Research and development

     28,769        10.7        21,332        10.8        7,437   

General and administrative

     35,649        13.3        28,076        14.2        7,573   

Accrued earnout gain

     (570     (0.2     (664     (0.3     94   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     136,894        50.9        102,594        51.7        34,300   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating income

     113,670        42.3        83,775        42.2        29,895   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other income (expense):

          

Interest income

     430        0.2        308        0.2        122   

Other income, net

     419        0.2        720        0.4        (301
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other income

     849        0.3        1,028        0.5        (179
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     114,519        42.6        84,803        42.8        29,716   

Income tax expense

     33,176        12.3        22,360        11.3        10,816   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 81,343        30.2   $ 62,443        31.5   $ 18,900   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Revenue

Revenue increased $70.6 million, or 35.6%, in the year ended December 31, 2012 compared to the year ended December 31, 2011. Maintenance and other revenue increased $38.9 million due to a growing maintenance renewal customer base and an increase in new license sales, which drives new maintenance revenue. We have maintained high customer retention and in addition, our renewal base has continued to increase each quarter as we have begun to renew and recognize the maintenance revenue associated with our acquired products. License revenue increased $31.7 million due to continued growth in new license sales of our newly acquired system management products and our network management products. We define newly acquired products as those acquired within the last year.

Our core product transaction growth was 36.3% in 2012 as compared to 2011 as a result of our growth in new license sales of our newly acquired systems management products and our network management products. As the number of core product transactions fluctuates with changes in the business or product mixes, this also affects our trailing 12-month average transaction size for new license sales. As of December 31, 2012, the trailing 12-month average transaction size for new license sales, excluding our high-volume and low-priced Kiwi and DameWare products, was approximately $8,500 as compared to approximately $8,600 for the trailing 12-month period as of December 31, 2011, a decrease of 0.8%.

New license sales in our global commercial business increased 36.9% and new license sales in our U.S. federal government business increased 11.9% in 2012 as compared to 2011. This growth in our commercial business was primarily driven by year-over-year core product transaction growth of 37.9%. The increase in our

 

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U.S. federal government new license sales was primarily driven by year-over-year core product transaction growth of 9.1% in 2012 as compared to 2011. We had three transactions in 2011 that resulted in license revenue greater than $0.5 million, whereas we had two transactions that resulted in license revenue greater than $0.5 million in 2012. Our revenue from our foreign subsidiaries was 24.5% and 23.7% of total revenue in 2012 and 2011, respectively.

Cost of Revenue

Cost of revenue increased $6.4 million, or 53.5%, in 2012 compared to 2011. Cost of license revenue increased by $4.1 million in 2012 compared to 2011, primarily due to the amortization of acquired product technologies associated with our acquisitions that were completed in the second half of 2011 and during 2012. Cost of maintenance revenue also increased $2.3 million, primarily due to increased headcount to support new customers, additional product offerings from acquisitions and internal product development.

Operating Expenses

Sales and Marketing. Sales and marketing expenses increased $19.2 million, or 35.6%, in 2012 compared to 2011. We continue to invest in the sales and marketing efforts that drive our revenue growth. In addition, we have increased employee headcount in our sales, marketing and maintenance renewal teams. As a result of these expansion efforts, our sales and marketing personnel costs, which include stock-based compensation expense, increased by $13.6 million, marketing program costs increased $4.7 million and other costs such as web-related contract services and fees increased $0.8 million. Our sales expense as a percentage of revenue remained consistent in 2012 as compared to 2011.

Research and Development. Research and development expenses increased $7.4 million, or 34.9%, in 2012 compared to 2011. In order to support the ongoing development of acquired and new products, we continued to increase the size of our Czech Republic and India research and development centers during 2011 and 2012. Due to this growth, our personnel costs, which include stock-based compensation expense, increased by $6.8 million and contract services increased $0.5 million in 2012 as compared to 2011.

General and Administrative. General and administrative expenses increased $7.6 million, or 27.0%, in 2012 compared to 2011. This increase was primarily due to an increase of $4.1 million in amortization expense related to certain acquired intangible assets, a $3.9 million increase in personnel costs, which include stock-based compensation expense and a $0.6 million increase in other miscellaneous costs including professional fees. These increases were slightly offset by a decrease of $1.0 million in acquisition related costs for the year.

Accrued Earnout Gain. We recorded a $0.6 million accrued earnout gain in 2012 as compared to a $0.7 million accrued earnout gain in 2011 due to the changes in probability of achieving certain sales milestones related to our acquisition related contingent considerations during the periods.

Other Income (Expense)

Other income (expense) decreased by $0.2 million primarily due to a decrease in the amount of grant income received in 2012 as compared to 2011 partially offset by decreases in acquisition related contingent consideration fair value adjustments due to the passage of time and net losses on foreign currency transactions. In 2012, we began utilizing purchased foreign currency forward contracts, therefore, the gains or losses on our foreign currency transactions are partially offset by the settlement of our foreign currency forward contracts.

Income Tax Expense

Our income tax expense increased by $10.8 million in 2012 as compared to 2011. This increase resulted from an increase in our income before income taxes of $29.7 million when comparing the same periods. Our

 

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effective tax rate increased from 26.4% in 2011 to 29.0% in 2012, which was primarily attributable to the expiration of the R&E tax credit and a reduction to the permanent income tax benefit related to the U.S. domestic production activities deduction, which was partially offset by an increase in international earnings, which are generally taxed at lower tax rates. Although our results of operations for the year ended December 31, 2012 do not reflect an income tax benefit related to the R&E tax credits as the R&E tax credit expired on December 31, 2011, the R&E tax credit was extended by the signing of the American Taxpayer Relief Act of 2012, or the Act, on January 2, 2013. The Act retroactively extended the R&E tax credit from January 1, 2012 through December 31, 2013. Since the Act was enacted during 2013, the income tax benefit related to the 2012 R&E tax credit will be reflected in our results of operations for the quarter ended March 31, 2013, which we expect will reduce our effective tax rate for the quarter and to a lesser extent the effective annual tax rate.

Comparison of the Years Ended December 31, 2011 and 2010

 

     Year Ended December 31,  
     2011     % of
Revenue
    2010     % of
Revenue
    Change  
     (in thousands)           (in thousands)           (in thousands)  

Revenue:

          

License

   $ 92,254        46.5   $ 75,603        49.6   $ 16,651   

Maintenance and other

     106,104        53.5        76,790        50.4        29,314   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenue

     198,358        100.0        152,393        100.0        45,965   

Cost of revenue

     11,989        6.0        7,930        5.2        4,059   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     186,369        94.0        144,463        94.8        41,906   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating expenses:

          

Sales and marketing

     53,850        27.1        43,252        28.4        10,598   

Research and development

     21,332        10.8        15,731        10.3        5,601   

General and administrative

     28,076        14.2        23,476        15.4        4,600   

Accrued earnout gain

     (664     (0.3     —          —          (664
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     102,594        51.7        82,459        54.1        20,135   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating income

     83,775        42.2        62,004        40.7        21,771   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other income (expense):

          

Interest income

     308        0.2        177        0.1        131   

Interest expense

     —          —          (1,146     (0.8     1,146   

Other income

     720        0.4        115        0.1        605   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other income (expense)

     1,028        0.5        (854     (0.6     1,882   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     84,803        42.8        61,150        40.1        23,653   

Income tax expense

     22,360        11.3        16,404        10.8        5,956   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 62,443        31.5   $ 44,746        29.4   $ 17,697   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Revenue

Revenue increased $46.0 million, or 30.2%, in the year ended December 31, 2011 compared to the year ended December 31, 2010. Maintenance and other revenue increased $29.3 million due to a growing maintenance renewal customer base and an increase in new license sales which drives new maintenance revenue. We have maintained high customer retention and our renewal base has continued to grow with acquisitions. License revenue increased $16.7 million due to continued growth in new license sales of our network management products and sales of our newly developed and newly acquired products such as those in the virtualization and log and security information management markets.

 

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Our core product transaction growth increased 30.9% in 2011 compared to 2010 as a result of our growth in new license sales of our network management products and the release of new stand-alone products and acquired products. As the number of core product transactions fluctuates with changes in the business or product mixes, this also affects our trailing 12-month average transaction size for new license sales. As of December 31, 2011, the trailing 12-month average transaction size for new license sales was approximately $8,600 as compared to approximately $8,300 for the trailing 12-month period as of December 31, 2010, an increase of 3.6%.

New license sales in our global commercial business increased 23.4% and new license sales in our U.S. federal government business increased 21.2% in 2011 as compared to 2010. This growth in both businesses was driven by year-over-year growth in core product transaction volume. We had three transactions in 2011 and two transactions in 2010 with the U.S. federal government that each resulted in license revenue greater than $0.5 million. Our revenue from our foreign subsidiaries was 23.7% and 22.1% of total revenue in 2011 and 2010, respectively.

Cost of Revenue

Cost of revenue increased $4.1 million, or 51.2%, in 2011 compared to 2010. Cost of license revenue increased by $2.2 million in 2011 compared to 2010, primarily due to the amortization of acquired product technologies associated with the Hyper9 and TriGeo acquisitions. The increase in cost of revenue was also due to a $1.9 million increase in cost of maintenance revenue related to increased headcount from the acquisition of TriGeo combined with an increase in the headcount in our international organization to support new customers added in 2011, additional product offerings from acquisitions and internal product development.

Operating Expenses

Sales and Marketing. Sales and marketing expenses increased $10.6 million, or 24.5%, in 2011 compared to 2010. We increased the size of our sales management team and marketing personnel to give us the ability to scale our sales effort as we continue to grow and enter new markets. As a result of these expansions efforts, our sales and marketing personnel costs, which include stock-based compensation expense, increased by $9.9 million and consulting and contractor fees increased $0.7 million offset by a decrease of $0.3 million in marketing program costs.

Research and Development. Research and development expenses increased $5.6 million, or 35.6%, in 2011 compared to 2010. In order to support our product development strategy and the development of new stand-alone, acquired and other products, we continued to increase the size of our Czech Republic research center during 2010 and 2011. We also added research and development personnel in the United States with the acquisition of Hyper9 in January 2011 and TriGeo in July 2011. Due to this growth, our personnel costs, which include stock-based compensation expense, increased by $4.8 million in 2011 compared to 2010. Other costs such as contract services and travel expenses increased by $0.6 million.

General and Administrative. General and administrative expenses increased $4.6 million, or 19.6%, in 2011 compared to 2010. This increase was primarily due to an increase of $2.1 million in amortization expense related to certain acquired intangible assets, $1.5 million in acquisition related costs and a $0.7 million in professional fees.

Accrued Earnout Gain. We recorded a $0.7 million accrued earnout gain in 2011 due to the change in probability of achieving sales milestones during 2011 related to the Hyper9 accrued earnout. In February 2012, we paid approximately $3.5 million of cash upon the achievement of these sales milestones.

Other Income (Expense)

Other income increased by $0.6 million in 2011 as compared to 2010 primarily due to the receipt of payment for the government grant related to job creation and related training costs in our Czech entity. Interest

 

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expense in 2011 was $0, decreasing by $1.1 million from 2010, because we paid all of the outstanding principal balance of our credit facilities in 2010.

Income Tax Expense

Our income tax expense increased by $6.0 million for the year ended December 31, 2011 as compared to 2010. This increase resulted from an increase in our income before income taxes of $23.7 million when comparing the same periods. Our effective tax rate decreased from 26.8% for the year ended December 31, 2010 compared to 26.4% for the year ended December 31, 2011, which was primarily attributable to an increase in permanent U.S. income tax benefit related to the U.S. domestic production activities deduction and an increase in international earnings, which are generally taxed at lower tax rates.

Non-GAAP Financial Measures

In addition to disclosing financial measures prepared in accordance with GAAP, this Form 10-K includes the following financial measures which are non-GAAP financial measures under SEC rules: (i) non-GAAP operating income; (ii) non-GAAP net income; (iii) non-GAAP diluted earnings per share; and (iv) free cash flow. Each of these financial measures excludes the impact of certain items and therefore has not been calculated in accordance with GAAP. In this report, these non-GAAP financial measures exclude stock-based compensation expense and related employer-paid payroll taxes; amortization of intangible assets; and acquisition related adjustments, including contingent consideration fair value adjustments due to the changes in probability assumptions of achieving the earnout criteria and due to the passage of time. Each of these non-GAAP adjustments is described in more detail below. In addition to these adjustments, management may include or exclude additional items from these or similar non-GAAP financial measures in future periods to the extent that management believes such items may not be indicative of our core business. A reconciliation of each of these non-GAAP financial measures to its most comparable GAAP financial measure is also included below.

We believe that these non-GAAP financial measures provide meaningful supplemental information regarding our operating results because they exclude certain amounts that our management and Board of Directors do not consider part of core operating results when assessing our operational performance, allocating resources, preparing annual budgets and determining employee incentive compensation. Accordingly, these non-GAAP financial measures may provide insight to investors into the motivation and decision-making of management in operating the business. In addition, by comparing our non-GAAP financial measures in different historical periods, our investors can evaluate our operating results without the additional variations of certain items that may not be indicative of our core operations, including stock-based compensation expense, which is a non-cash expense that is not a key measure of our operations.

While we believe that these non-GAAP financial measures provide useful supplemental information, there are limitations associated with the use of these non-GAAP financial measures. These non-GAAP financial measures are not prepared in accordance with GAAP, do not reflect a comprehensive system of accounting and may not be comparable to similarly titled measures of other companies due to potential differences in their financing and accounting methods, the book value of their assets, their capital structures, the method by which their assets were acquired and the manner in which they define non-GAAP measures. Items such as the amortization of intangible assets, stock-based compensation expense and related employer-paid payroll taxes and acquisition related adjustments, as well as the related tax impacts of these items can have a material impact on operating and net income. In addition, free cash flow does not represent the total increase or decrease in the cash balances for the period. As a result, these non-GAAP financial measures have limitations and should not be considered in isolation from, or as a substitute for, their most comparable GAAP measures. We compensate for these limitations by using these non-GAAP financial measures as supplements to GAAP financial measures and by reconciling the non-GAAP financial measures to their most comparable GAAP financial measure. Investors are encouraged to review the reconciliations of these non-GAAP financial measures to their most comparable GAAP financial measures below.

 

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For a detailed explanation of the adjustments made to comparable GAAP financial measures, the reasons why management uses these measures and the usefulness of these measures, see footnotes (1)—(7) below.

Non-GAAP Operating Income

 

     Year Ended December 31,  
(in thousands)    2012      2011      2010  

GAAP operating income

   $ 113,670       $ 83,775       $ 62,004   

Amortization of intangible assets (1)

     14,894         7,170         3,170   

Stock-based compensation expense and related employer-paid payroll taxes (2)

     15,819         10,974         12,047   

Public offering costs (3)

     —           —           170   

Lawsuit settlement costs and related legal fees (reimbursements) (3)

     —           —           (217

Severance costs related to retirement of former Executive Chairman (3)

     —           —           208   

Acquisition related adjustments (4)

     445         1,339         501   
  

 

 

    

 

 

    

 

 

 

Non-GAAP operating income

   $ 144,828       $ 103,258       $ 77,883   
  

 

 

    

 

 

    

 

 

 

The increase in non-GAAP operating income for the year ended December 31, 2012 as compared to the same periods in 2011 and 2010 was primarily due to increases in the corresponding GAAP operating income, which were driven by higher revenue volumes in the corresponding periods. Amortization of intangible assets, which is excluded from our non-GAAP operating income, also increased in 2012 as compared to 2011 and 2010 primarily due to increases in intangible assets resulting from the various acquisitions that were completed during 2011 and 2012. See Note 2, Acquisitions of our Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for additional acquisition details including the intangibles acquired. Stock-based compensation expense and related employer-paid payroll taxes increased in 2012 as compared to 2011 and 2010 primarily due to share-based incentive awards issued to employees for retention and, to a lesser extent, the addition of employees through acquisitions and organic growth. The 2010 stock-based compensation expense and related employer-paid payroll taxes amount includes a one-time stock-based compensation expense of $1.4 million from the acceleration of the vesting of certain options related to the retirement of our former Executive Chairman on June 30, 2010. Our acquisition related adjustments fluctuate due to variations in the legal, accounting and advisory fees and restructuring costs associated with each of our acquisitions.

Non-GAAP Net Income and Non-GAAP Diluted Earnings Per Share

 

     Year Ended December 31,  
(in thousands)    2012     2011     2010  

GAAP net income

   $ 81,343      $ 62,443      $ 44,746   

Amortization of intangible assets (1)

     14,894        7,170        3,170   

Stock-based compensation expense and related employer-paid payroll taxes (2)

     15,819        10,974        12,047   

Debt issuance costs write-off (3)

     —          —          334   

Public offering costs (3)

     —          —          170   

Lawsuit settlement costs and related legal fees (reimbursements) (3)

     —          —          (217

Severance costs related to retirement of former Executive Chairman (3)

     —          —          208   

Acquisition related adjustments (4)

     519        1,578        758   

Tax benefits associated with above adjustments (5)

     (8,886     (4,970     (4,494
  

 

 

   

 

 

   

 

 

 

Non-GAAP net income

   $ 103,689      $ 77,195      $ 56,722   
  

 

 

   

 

 

   

 

 

 

Weighted-average number of shares used in computing diluted earnings per share

     76,035        74,413        72,862   
  

 

 

   

 

 

   

 

 

 

Non-GAAP diluted earnings per share (6)

   $ 1.36      $ 1.04      $ 0.78   
  

 

 

   

 

 

   

 

 

 

 

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The increase in non-GAAP net income for year ended December 31, 2012 as compared to the same periods in 2011 and 2010 was primarily due to increases in the corresponding GAAP net income and the adjustments discussed above in the calculation of non-GAAP operating income. Other adjustments to non-GAAP net income include fair value adjustments due to the passage of time related to contingent consideration included in acquisition related costs and the tax benefits associated with the excluded items. Non-GAAP diluted earnings per share increased for the year ended December 31, 2012 as compared to the same periods in 2011 and 2010 primarily due to the increase in non-GAAP net income as discussed above as the number of shares used in the computation did not change significantly.

Free Cash Flow

 

     Year Ended December 31,  
(in thousands)    2012     2011     2010  

GAAP cash flows from operating activities

   $ 143,447      $ 110,530      $ 66,043   

Excess tax benefit from stock-based compensation

     10,486        6,359        26,748   

Purchases of property and equipment

     (3,885     (2,945     (2,740
  

 

 

   

 

 

   

 

 

 

Free cash flow (7)

   $ 150,048      $ 113,944      $ 90,051   
  

 

 

   

 

 

   

 

 

 

The increase in free cash flow for the year ended December 31, 2012 as compared to the same periods in 2011 and 2010 was primarily due to the increase in operating income that converted to cash flow. The excess tax benefit from stock-based compensation fluctuates with the exercise of stock option awards.

 

Non-GAAP Footnotes:

 

(1) Amortization of Intangible Assets. We provide non-GAAP information that excludes expenses for the amortization of intangible assets that primarily relate to purchased intangible assets associated with our acquisitions. We believe that eliminating this expense from our non-GAAP measures is useful to investors, because the amortization of intangible assets can be inconsistent in amount and frequency and is significantly impacted by the timing and magnitude of our acquisition transactions, which also vary in frequency from period to period. Accordingly, we analyze the performance of our operations in each period without regard to such expenses.

 

(2) Stock-Based Compensation Expense and Related Employer-Paid Payroll Taxes. We provide non-GAAP information that excludes expenses for stock-based compensation and related employer-paid payroll taxes. We believe the exclusion of these items allows for financial results that are more indicative of our continuing operations. We believe that the exclusion of stock-based compensation expense provides for a better comparison of our operating results to prior periods and to our peer companies as the calculations of stock-based compensation vary from period to period and company to company due to different valuation methodologies, subjective assumptions and the variety of award types. Employer-paid payroll taxes on stock-based compensation is dependent on our stock price and the timing of the taxable events related to the equity awards, over which our management has little control, and does not correlate to the core operation of our business. Because of these unique characteristics of stock-based compensation and the related employer-paid payroll taxes, management excludes these expenses when analyzing the organization’s business performance.

 

(3)

Other Items. We exclude certain other unplanned items which we believe are not indicative of our continuing operations and which amounts and timing are difficult to estimate in advance, including the following, when applicable: (i) write-off of debt issuance costs; (ii) public offering costs; (iii) lawsuit settlement costs and related legal fees, net of related reimbursements from insurance proceeds; and (iv) severance costs related to retirement of certain executive officers. Although these events are reflected in our GAAP financials, these transactions which are not indicative of our continuing operations may limit the comparability of our ongoing operations with prior and future periods. Because of these factors, we assess

 

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  our operating performance both with these amounts included and excluded, and by providing this information, we believe the users of our financial statements are better able to understand the financial results of what we consider our continuing operations.

 

(4) Acquisition Related Adjustments. We exclude certain expense items resulting from acquisitions including the following, when applicable: (i) amortization of purchased intangible assets associated with our acquisitions (see Note 1 for further discussion); (ii) legal, accounting and advisory fees to the extent associated with acquisitions; (iii) changes in fair value of contingent consideration; (iv) costs related to integrating the acquired businesses; and (v) restructuring costs, including adjustments related to changes in estimates, related to acquisitions. We consider these adjustments, to some extent, to be unpredictable and dependent on a significant number of factors that are outside of our control. Furthermore, acquisitions result in non-continuing operating expenses, which would not otherwise have been incurred by us in the normal course of our organic business operations, with respect to each acquisition. We believe that providing non-GAAP information for acquisition related expense items in addition to the corresponding GAAP information allows the users of our financial statements to better review and understand the historical and current results of our continuing operations, and also facilitates comparisons to our historical results and results of less acquisitive peer companies, both with and without such adjustments.

 

(5) Income Tax Effect of Non-GAAP Exclusions. We believe providing financial information with and without the income tax effect of excluding items related to our non-GAAP financial measures provide our management and users of the financial statements with better clarity regarding the ongoing performance and future liquidity of our business.

 

(6) Non-GAAP Diluted Earnings Per Share Item. We provide non-GAAP diluted earnings per share. The non-GAAP diluted earnings per share amount was calculated based on our non-GAAP net income and the shares used in the computation of GAAP diluted earnings per share.

 

(7) Free Cash Flow. We define free cash flow as cash flows from operating activities plus the excess tax benefit from stock-based compensation and less the purchases of property and equipment. We believe free cash flow is an important liquidity measure that reflects the cash generated by the business after the purchase of property and equipment that can then be used for, among other things, strategic acquisitions and investments in the business, stock repurchases and funding ongoing operations. Free cash flow does not represent the total increase or decrease in the cash balance for the period. The changes in free cash flow result from fluctuations in cash flows from operating activities offset by excess tax benefits associated with the exercises of options. For further discussion regarding cash flows from operating activities, see the discussion under the caption “Liquidity and Capital Resources” included in this Item 7.

Liquidity and Capital Resources

Cash and cash equivalents and short-term and long-term investments were $241.8 million as of December 31, 2012. Our international subsidiaries held approximately $47.8 million of cash and cash equivalents of which 93.3% was held in Euros as of December 31, 2012. We expect our international cash and cash equivalents to continue to increase as a percentage of our consolidated cash and cash equivalents. We currently intend that the earnings generated by our international operations will be invested indefinitely in those operations and we do not expect to repatriate those earnings to our domestic operations. If we were to try and repatriate these earnings, we would incur a U.S. federal income tax liability that is not currently accrued in our consolidated financial statements.

Our available cash and cash equivalents are held in bank demand deposits and money market funds at December 31, 2012. Our short-term and long-term investments, classified as available-for-sale securities, consist of corporate bonds, municipal bonds and commercial paper held in investment accounts in the United States.

Our emphasis is primarily on safety of principal while secondarily maximizing yield on those funds. The balances held in our demand deposit accounts in the United States may exceed the Federal Deposit Insurance

 

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Corporation, or FDIC, insurance limits. While we monitor the balances in our accounts and adjust the balances as appropriate, these balances could be impacted by adverse conditions in the financial markets or by failure of the underlying depository institutions or guarantors. We strive to maintain our cash deposits, money market funds and investments with multiple financial institutions of reputable credit and therefore, bear minimal credit risk. We actively monitor the third party depository institutions that hold our cash, cash equivalents and investments. To date, we have experienced no loss or lack of access to our invested cash, cash equivalents, and investments; however, we can provide no assurances that access to our funds will not be impacted by future adverse conditions.

Summarized annual cash flow information is as follows (in thousands):

 

     Year Ended December 31,  
(in thousands)    2012     2011     2010  

Net cash provided by operating activities

   $ 143,447      $ 110,530      $ 66,043   

Net cash used in investing activities

     (103,118     (142,414     (31,574

Net cash provided by (used in) financing activities

     15,482        14,193        (21,313

Effect of exchange rate changes

     1,184        (1,605     (941

Net increase (decrease) in cash and cash equivalents

     56,995        (19,296     12,215   

Operating Activities

Cash provided by operating activities is comprised of net income, adjustments primarily related to non-cash operating activities and changes in operating assets and liabilities. Adjustments for non-cash (benefits) expenses were $23.3 million, $16.5 million and $(11.9) million for the years ended December 31, 2012, 2011 and 2010, respectively. These adjustments primarily consist of depreciation and amortization, stock-based compensation expense and excess tax benefits related to employee stock-based awards. Stock-based compensation expense reduced income before income taxes by $15.3 million, $10.7 million and $10.9 million in the years ended December 31, 2012, 2011 and 2010, respectively. We also recognized a gain on the change in fair value of our acquisition related earnouts of $0.6 million and $0.7 million for years ended December 31, 2012 and 2011, respectively, due to adjustments in our probability assumption of achieving the specified earnout criteria.

The change in cash flows relating to operating activities resulted from changes in operating assets and liabilities and is primarily driven by the sales of our software and maintenance renewals. The significant changes in operating assets and liabilities include the following:

 

   

Deferred revenue increased to $102.8 million at December 31, 2012 as compared to $77.1 million at December 31, 2011, resulting in an increase in operating liabilities and reflecting a cash inflow of $22.5 million for the year ended December 31, 2012. For the years ended December 31, 2011 and 2010, net cash provided by operating activities increased $19.1 million and $15.3 million, respectively, due to an increase in deferred revenue during those years as compared to the respective prior year. The increase in deferred revenue was due primarily to the increase in the sales of our software and maintenance renewals.

 

   

Changes in our income tax receivable and payable balances are also significant components of our cash flows from operating activities. The increase in our income tax payable was primarily due to the growth in our taxable income. Net cash provided by operating activities was reduced by income tax payments of $15.3 million in 2012, $1.0 million in 2011, was increased by a U.S. federal income tax refund of $3.3 million in 2010.

 

   

Accounts receivables increased to $32.5 million at December 31, 2012 as compared to $27.0 million at December 31, 2011 resulting in an increase in operating assets and reflecting a cash outflow of $5.7 million for the year ended December 31, 2012. The increase in accounts receivable for the years ended December 31, 2011 and 2010 as compared to the respective prior year resulted in cash outflows of $7.0 million and $5.1 million, respectively. Our accounts receivable balance fluctuates from period

 

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to period depending on the timing of our sales, cash collections and changes to our allowance for doubtful accounts, which affects our cash flow from operating activities. Our accounts receivable balance represents trade receivables from customers, including resellers and distributors, when we have provided software licenses and/or software maintenance agreements and we have not yet received payment. We have historically had insignificant write-offs related to bad debts. The allowance for doubtful accounts was $0.3 million, $0.2 million and $0.2 million at December 31, 2012, 2011 and 2010, respectively. We use days sales outstanding, or DSO, calculated on a quarterly basis, as a measurement of the quality and status of our receivables. We define DSO as (a) accounts receivable divided by (b) total revenue for the most recent quarter, multiplied by (c) the number of days in the quarter. Our DSO was 40.7 days and 44.6 days at December 31, 2012 and 2011, respectively.

 

   

Other changes in operating assets and liabilities include cash paid for interest payments of $1.3 million in 2010.

Investing Activities

Net cash used in investing activities for the year ended December 31, 2012 was primarily related to $65.9 million of cash used to purchase available-for-sale securities classified as short-term and long-term investments, $66.0 million of cash used for acquisitions (refer to Note 2, Acquisitions, of our Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for additional details) and $33.9 million of proceeds from maturities of investments.

Net cash used in investing activities for the year ended December 31, 2011 was primarily related to $109.5 million of cash used for acquisitions (refer to Note 2, Acquisitions, of our Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for additional details) and $33.2 million of cash used to purchase available-for-sale securities classified as short-term and long-term investments. Also during 2011, we had $4.0 million of proceeds from maturities of investments.

Net cash used in investing activities for the year ended December 31, 2010 was primarily due to the $28.0 million of cash used in our purchase of certain assets of Tek-Tools.

We expect our capital expenditures in fiscal year 2013 to be approximately $6.0 to $8.0 million. Our estimated capital expenditures for 2013 primarily include equipment, software, leasehold improvements and furniture related to the expected growth of our corporate headquarters in Austin, Texas and our international research and development centers in the Czech Republic and India.

Financing Activities

Net cash provided by financing activities for the year ended December 31, 2012 was primarily due to $10.6 million of proceeds from the exercise of employee stock options and $10.5 million of excess tax benefit related to stock-based awards, which is a reduction in cash payments related to income taxes. In addition, for the year ended December 31, 2012, we withheld and retired shares of common stock to satisfy $1.5 million of minimum statutory withholding tax requirements that we pay in cash to the appropriate taxing authorities on behalf of our employees related to restricted stock units issued during the period. These shares are treated as common stock repurchases in our consolidated financial statements as of December 31, 2012. Also during the year ended December 31, 2012, we paid approximately $4.5 million of cash upon the achievement of certain earnout objectives related to acquisition accrued earnouts. The earnout payments of $4.2 million are reflected in cash flows from financing activities and the changes in fair value due to the passage of time of $0.3 million are reflected in cash flows from operating activities in the consolidated statement of cash flows for the year ended December 31, 2012. We reclassified our earnout payments from cash flows from investing activities to cash flows from financing activities in our consolidated statement of cash flows for the year ended December 31, 2012. See Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for further information.

 

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Net cash provided by financing activities for the year ended December 31, 2011 was primarily due to $11.9 million of proceeds from the exercise of employee stock options and the excess tax benefit related to stock-based awards of $6.4 million, which is a reduction in cash payments related to income taxes. Also during 2011, we paid $4.0 million of cash to Tek-Tools upon the achievement of certain performance criteria related to the asset acquisition in January 2010. The earnout payment of $3.7 million is reflected in cash flows from financing activities and the change in fair value due to the passage of time of $0.3 million is reflected in cash flows from operating activities in the consolidated statement of cash flows for the year ended December 31, 2011.

Net cash used in financing activities for the year ended December 31, 2010 was due to a $44.1 million repayment of long-term debt partially offset by $21.0 million of proceeds from the exercise of stock options and a $26.7 million excess tax benefit related to stock-based compensation, which is a reduction in cash payments related to income taxes. The debt payments in 2010 paid off our entire outstanding principal under our First Lien Note and Second Lien Note.

On August 2, 2010, our board of directors approved a share repurchase program, authorizing us to purchase up to $25.0 million of our outstanding common stock. The share repurchase program was completed in August 2010, and we repurchased and retired 1.7 million shares of our common stock for an aggregate purchase price of $25.0 million. The repurchase was authorized to reflect the confidence of management and the board of directors in our business. We believed the share repurchase program would generate a positive return to our shareholders by reducing the number of shares outstanding. Given the low rates of return on cash and short-term investments and as there was no outstanding debt at the time of the share repurchase, we believed the share repurchase program was a proper use of our available cash.

Anticipated Cash Flows

We believe that our existing cash and cash equivalents and our cash flows from operating activities will be sufficient to fund our operations and our capital expenditures for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the timing and extent of spending to support product development efforts and expansion into new territories, the timing of any acquisitions to expand our business, the timing of expansions to our office facilities, the timing of introductions of new software products and enhancements to existing software products, and the continuing market acceptance of our software offerings. We expect to continue to pursue acquisitions that will enable us to enter new markets or new segments of our existing markets by bringing new product offerings to market more quickly than we can develop them.

Although we are not currently a party to any material definitive agreement regarding potential investments in, or acquisitions of, complementary businesses, applications or technologies, we may enter into these types of arrangements, which could reduce our cash and cash equivalents, require us to seek additional equity or debt financing or repatriate cash generated by our international operations that would cause us to incur a U.S. federal income tax liability. Additional funds from financing arrangements may not be available on terms favorable to us or at all.

 

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Contractual Obligations and Commitments

We generally do not enter into long-term minimum purchase commitments. Our principal commitments as of December 31, 2012 consisted of operating lease obligations for our office facilities. The following table summarizes our outstanding contractual obligations as of December 31, 2012, that require us to make future cash payments:

 

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

Operating leases

   $ 20,221       $ 4,488       $ 7,672       $ 2,765       $ 5,296   

Purchase obligations (1)

     8,177         8,014        163         —           —     

Accrued earnout (2)

     121         121         —          —          —    
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Sub-total

   $ 28,519       $ 12,623       $ 7,835       $ 2,765       $ 5,296   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Uncertain tax positions (3)

     8,776               
  

 

 

             

Total

   $ 37,295               
  

 

 

             

 

(1) Purchase obligations represent purchases of software license and support fees, marketing activities, accounting, legal and contractor fees, corporate health insurance costs and computer hardware and software.
(2) Acquisition related contingent consideration of $2.5 million to be paid if new license sales during the one-year earnout measurement period equal or exceed the milestone specified in the purchase agreement. The contingent consideration is recorded at fair value in our consolidated balance sheet at December 31, 2012 as an accrued earnout of $0.1 million. See Note 5, Fair Value Measurements, in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K for additional details.
(3) We have included our long-term tax liabilities related to uncertain tax positions at December 31, 2012, however, we have not included the payments due by period as the timing and amounts that will be settled in cash, if any, are not known.

Off-Balance Sheet Arrangements

During 2012, 2011 and 2010, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Recent Accounting Pronouncements

See Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K, for a full description of recent accounting pronouncements which is incorporated herein by reference.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to certain financial market risks, including the following:

Interest Rate Risk

We had cash and cash equivalents of $179.7 million and $122.7 million at December 31, 2012 and 2011, respectively. We also had short-term and long-term investments classified as available-for-sale securities of $62.1 million and $29.7 million at December 31, 2012 and 2011, respectively. Our cash and cash equivalents consist primarily of bank demand deposits and money market funds, and our available-for-sale securities consist primarily of corporate bonds, municipal bonds and commercial paper held in investment accounts in the United

 

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States. We hold cash, cash equivalents and available-for-sale securities for working capital purposes. Our investments are made for capital preservation purposes, and we do not enter into investments for trading or speculative purposes.

We do not have material exposure to market risk with respect to our cash and cash equivalents, as these consist of highly liquid investments purchased with original maturities of three months or less at December 31, 2012. Our portfolio of available-for-sale securities classified as investments is subject to market risk due to changes in interest rates. Changes in interest rates could impact our future investment income, or we may suffer losses in principal if we are forced to sell securities that decline in market value due to changes in interest rates. However, because we classify our investment securities as “available for sale,” no gains or losses are recognized due to changes in interest rates unless such securities are sold prior to maturity or declines in fair value are determined to be other-than-temporary.

Foreign Currency Risk

As a global company, we face exposure to adverse movements in foreign currency exchange rates. Our revenue from our foreign subsidiaries was approximately 24.5% of our total revenue for the year ended December 31, 2012. The foreign currencies that we invoice and on which we collect are the Euro, British Pound Sterling, Australian Dollar and Japanese Yen. Expenses incurred by our international subsidiaries are, generally, denominated in the local currency of the subsidiary. Our consolidated statements of income are translated into U.S. dollars at the average exchange rates in each applicable period. To the extent the U.S. dollar strengthens against foreign currencies, the translation of these foreign currency denominated transactions results in reduced revenues, operating expenses and net income for our international operations. Similarly, our revenues, operating expenses and net income will increase for our international operations if the U.S. dollar weakens against foreign currencies.

During the first quarter of 2012, we began utilizing purchased foreign currency forward contracts to minimize our foreign exchange exposure on certain foreign balance sheet positions denominated in currencies other than the Euro. We do not enter into any derivative financial instruments for trading or speculative purposes. Our objective in managing our exposure to foreign currency exchange rate fluctuations is to reduce the impact of adverse fluctuations in such exchange rates on our earnings and cash flow. The notional amounts and currencies underlying our foreign currency forward contracts will fluctuate period to period as they are principally dependent on the balances of the balance sheet positions that are denominated in currencies other than the Euro held by our global entities. There can be no assurance that our foreign currency hedging activities will substantially offset the impact of fluctuation in currency exchange rates on our results of operational and functional positions. As of December 31, 2012, we did not have any forward contracts outstanding and while we do not have a formal policy to settle all derivatives prior to the end of each quarter, our current practice is to do so. See Note 6, Derivative Instruments, in the Notes to Consolidated Financial Statements in Item 8 of Part II of this Annual Report on Form 10-K, for a summary of the effect of derivative instruments on our consolidated statements of income.

We are exposed to credit-related losses in the event of non-performance by counterparties to derivative financial instruments, but we do not expect any counterparties to fail to meet their obligations given their high credit ratings. In addition, we diversify this risk across several counterparties and actively monitor their ratings.

We are also exposed to foreign exchange rate fluctuations as we translate the financial statements of our foreign subsidiaries into U.S. dollars in consolidation. If there is a change in foreign currency exchange rates, the conversion of the foreign subsidiaries’ financial statements into U.S dollars will lead to a translation gain or loss that is recorded as a component of accumulated other comprehensive income (loss).

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The information required by this item is incorporated by reference to the Consolidated Financial Statements set forth on pages F-1 through F-38 hereof.

 

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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

There were no changes in or disagreements with our accountants on accounting and financial disclosure matters.

 

ITEM 9A. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2012. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2012, our Chief Executive Officer and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

Management’s Annual Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company, (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that our degree of compliance with the policies or procedures may deteriorate.

Our management conducted an evaluation of the effectiveness of our internal control over financial reporting as of the end of the period covered by this report based on the framework in Internal Control— Integrated Framework issued by the Committee of Sponsoring Organization of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of the end of the period covered by this report.

Our independent registered public accounting firm, which has audited our consolidated financial statements, has also audited the effectiveness of the Company’s internal control over financial reporting as of December 31, 2012, as stated in their report, which is included in Part II, Item 8 of this report.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2012, that have materiality affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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ITEM 9B. OTHER INFORMATION

None.

 

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PART III

Certain information required by Part III is omitted from this report. We intend to file such information within our definitive proxy statement pursuant to Regulation 14A with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this report relating to our 2013 annual meeting of stockholders (the “Proxy Statement”).

 

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required by this Item will be included in our Proxy Statement and is incorporated herein by reference.

 

ITEM 11. EXECUTIVE COMPENSATION

The information required by this Item will be included in our Proxy Statement and is incorporated herein by reference.

 

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this Item will be included in our Proxy Statement and is incorporated herein by reference.

Equity Compensation Plan Information

The following table provides information as of December 31, 2012, with respect to shares of our common stock that may be issued, subject to certain vesting requirements, under our existing equity compensation plans, including our Amended and Restated Stock Incentive Plan (“2005 Plan”) and our 2008 Equity Incentive Plan (“2008 Plan”):

 

     A     B      C  

Plan Category

   Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights
    Weighted-average
exercise price of
outstanding options,

warrants and rights
     Number of securities
remaining available for

future issuance under
equity compensation
plans (excluding

securities reflected in
column (A))
 

Equity compensation plans approved by security holders

     4,220,868 (1)    $ 14.48         10,298,837 (2) 

Equity compensation plans not approved by security holders

     —          —           —     
  

 

 

   

 

 

    

 

 

 

Total

     4,220,868      $ 14.48         10,298,837   
  

 

 

   

 

 

    

 

 

 

 

(1) Consists of 1,292,171 shares and 2,928,697 shares of common stock underlying outstanding options and restricted stock units granted under our 2005 Plan and 2008 Plan, respectively.
(2) Represents shares of common stock available for issuance under our 2008 Plan as of December 31, 2012 and does not include the automatic increase on January 1, 2013 of 3,545,087 additional shares of our common stock reserved for issuance under our 2008 Plan.

 

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information required by this Item will be included in our Proxy Statement and is incorporated herein by reference.

 

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this Item will be included in our Proxy Statement and is incorporated herein by reference.

 

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Table of Contents

PART IV

 

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

(a) Documents Filed with Report

 

  (1) Financial Statements.

 

Management’s Report on Internal Control Over Financial Reporting

     F-2   

Report of Independent Registered Public Accounting Firm

     F-3   

Consolidated Balance Sheets

     F-4   

Consolidated Statements of Income

     F-5   

Consolidated Statements of Comprehensive Income

     F-6   

Consolidated Statements of Changes in Stockholders’ Equity

     F-7   

Consolidated Statements of Cash Flows

     F-8   

Notes to Consolidated Financial Statements

     F-9   

 

  (2) Financial Statement Schedules.

The following financial statement schedule should be read in conjunction with the consolidated financial statements of SolarWinds, Inc. filed as part of this Report:

 

   

Schedule II—Valuation and Qualifying Accounts

Schedules other than that listed above have been omitted since they are either not required or not applicable or because the information required is included in the consolidated financial statements included elsewhere herein or the notes thereto.

 

  (3) Exhibits.

The information required by this Item is set forth on the exhibit index that follows the signature page of this Annual Report on Form 10-K.

 

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Table of Contents

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

  SOLARWINDS, INC.
Dated: February 19, 2013   By:  

/s/    Michael J. Berry        

    Michael J. Berry
   

Executive Vice President and

Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

Signature

  

Title

 

Date

/s/    Kevin B. Thompson      

Kevin B. Thompson

  

President, Chief Executive Officer and Director
(principal executive officer)

  February 19, 2013

/s/    Michael J. Berry      

Michael J. Berry

  

Executive Vice President and Chief Financial Officer
(principal financial officer)

  February 19, 2013

/s/    J. Barton Kalsu      

J. Barton Kalsu

  

Chief Accountant and Senior Vice President, Finance
(principal accounting officer)

  February 19, 2013

/s/    Steven M. Cakebread      

Steven M. Cakebread

  

Lead Independent Director

  February 19, 2013

/s/    Mark Bonham      

Mark Bonham

  

Director

  February 19, 2013

/s/    J. Benjamin Nye      

J. Benjamin Nye

  

Director

  February 19, 2013

/s/    Ellen F. Siminoff      

Ellen F. Siminoff

  

Director

  February 19, 2013

/s/    Roger J. Sippl      

Roger J. Sippl

  

Director

  February 19, 2013

/s/    Lloyd G. Waterhouse      

Lloyd G. Waterhouse

  

Director

  February 19, 2013

 

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Table of Contents

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page  

SOLARWINDS, INC.

  

Management’s Report on Internal Control Over Financial Reporting

     F-2   

Report of Independent Registered Public Accounting Firm

     F-3   

Consolidated Balance Sheets

     F-4   

Consolidated Statements of Income

     F-5   

Consolidated Statements of Comprehensive Income

     F-6   

Consolidated Statements of Changes in Stockholders’ Equity

     F-7   

Consolidated Statements of Cash Flows

     F-8   

Notes to Consolidated Financial Statements

     F-9   

 

F-1


Table of Contents

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Our management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company, (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that our degree of compliance with the policies or procedures may deteriorate.

Our management conducted an evaluation of the effectiveness of our internal control over financial reporting as of the end of the period covered by this report based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organization of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of the end of the period covered by this report.

Our independent registered public accounting firm, which has audited our consolidated financial statements in Part II, Item 8 of this report, has also audited the effectiveness of the Company’s internal control over financial reporting as of December 31, 2012, as stated in their report, which is included below.

 

F-2


Table of Contents

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of SolarWinds, Inc.:

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of comprehensive income, of changes in stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of SolarWinds, Inc. and its subsidiaries at December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ PricewaterhouseCoopers LLP

Austin, Texas

February 19, 2013

 

F-3


Table of Contents

SolarWinds, Inc.

Consolidated Balance Sheets

(In thousands, except share and per share information)

 

     December 31,  
     2012     2011  

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 179,702      $ 122,707   

Short-term investments

     49,276        29,688   

Accounts receivable, net of allowances of $271 and $192 as of December 31, 2012 and 2011, respectively

     32,506        26,965   

Income tax receivable

     142        110   

Deferred taxes

     1,712        668   

Prepaid and other current assets

     3,322        2,770   
  

 

 

   

 

 

 

Total current assets

     266,660        182,908   

Property and equipment, net

     8,342        7,341   

Long-term investments

     12,823        —     

Deferred taxes

     338        3,334   

Goodwill

     158,601        110,746   

Intangible assets and other, net

     70,631        58,079   
  

 

 

   

 

 

 

Total assets

   $ 517,395      $ 362,408   
  

 

 

   

 

 

 

Liabilities and stockholders’ equity

    

Current liabilities:

    

Accounts payable

   $ 4,050      $ 2,213   

Accrued liabilities

     14,226        9,442   

Accrued earnout

     121        3,513   

Income taxes payable

     4,037        779   

Current portion of deferred revenue

     97,672        73,774   
  

 

 

   

 

 

 

Total current liabilities

     120,106        89,721   

Long-term liabilities:

    

Deferred revenue, net of current portion

     5,084        3,373   

Non-current deferred taxes

     483        289   

Other long-term liabilities

     8,908        4,078   
  

 

 

   

 

 

 

Total liabilities

     134,581        97,461   

Commitments and contingencies (Note 14)

    

Stockholders’ equity:

    

Common stock, $0.001 par value: 123,000,000 shares authorized and 74,633,412 and 73,367,367 shares issued and outstanding as of December 31, 2012 and 2011, respectively

     75        73   

Additional paid-in capital

     229,277        194,379   

Accumulated other comprehensive loss

     (1,145     (2,769

Accumulated earnings

     154,607        73,264   
  

 

 

   

 

 

 

Total stockholders’ equity

     382,814        264,947   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 517,395      $ 362,408   
  

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

F-4


Table of Contents

SolarWinds, Inc.

Consolidated Statements of Income

(In thousands, except for per share information)

 

     Year Ended December 31,  
     2012     2011     2010  

Revenue:

      

License

   $ 123,984      $ 92,254      $ 75,603   

Maintenance and other

     144,980        106,104        76,790   
  

 

 

   

 

 

   

 

 

 

Total revenue

     268,964        198,358        152,393   

Cost of license revenue

     8,203        4,097        1,943   

Cost of maintenance and other revenue

     10,197        7,892        5,987   
  

 

 

   

 

 

   

 

 

 

Gross profit

     250,564        186,369        144,463   

Operating expenses:

      

Sales and marketing

     73,046        53,850        43,252   

Research and development

     28,769        21,332        15,731   

General and administrative

     35,649        28,076        23,476   

Accrued earnout gain

     (570     (664     —     
  

 

 

   

 

 

   

 

 

 

Total operating expenses

     136,894        102,594        82,459   
  

 

 

   

 

 

   

 

 

 

Operating income

     113,670        83,775        62,004   

Other income (expense):

      

Interest income

     430        308        177   

Interest expense

     —          —          (1,146

Other income, net

     419        720        115   
  

 

 

   

 

 

   

 

 

 

Total other income (expense)

     849        1,028        (854
  

 

 

   

 

 

   

 

 

 

Income before income taxes

     114,519        84,803        61,150   

Income tax expense

     33,176        22,360        16,404   
  

 

 

   

 

 

   

 

 

 

Net income

   $ 81,343      $ 62,443      $ 44,746   
  

 

 

   

 

 

   

 

 

 

Net income per share:

      

Basic earnings per share

   $ 1.10      $ 0.86      $ 0.65   
  

 

 

   

 

 

   

 

 

 

Diluted earnings per share

   $ 1.07      $ 0.84      $ 0.61   
  

 

 

   

 

 

   

 

 

 

Weighted-average shares used to compute net income per share:

      

Shares used in computation of basic earnings per share

     74,166        72,812        68,664   
  

 

 

   

 

 

   

 

 

 

Shares used in computation of diluted earnings per share

     76,035        74,413        72,862   
  

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

F-5


Table of Contents

SolarWinds, Inc.

Consolidated Statements of Comprehensive Income

(In thousands)

 

     Year Ended December 31,  
     2012      2011     2010  

Net income

   $ 81,343       $ 62,443      $ 44,746   

Other comprehensive income (loss):

       

Foreign currency translation adjustment

     1,597         (1,502     (1,097

Unrealized gains (losses) on investments, net of income tax expense (benefit) of $14, $(6) and $0 for the years ended December 31, 2012, 2011 and 2010 respectively

     27         (11     —     
  

 

 

    

 

 

   

 

 

 

Other comprehensive income (loss)

     1,624         (1,513     (1,097
  

 

 

    

 

 

   

 

 

 

Comprehensive income

   $ 82,967       $ 60,930      $ 43,649   
  

 

 

    

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

F-6


Table of Contents

SolarWinds, Inc.

Consolidated Statements of Changes in Stockholders’ Equity

(In thousands)

 

     Common Stock     Additional
Paid-in
Capital
    Accumulated
Other
Comprehensive
Loss
    Retained
Earnings
(Deficit)
    Total
Stockholders’
Equity
 
   Shares     Amount          

Balances at December 31, 2009

     66,502      $ 67      $ 123,083      $ (159   $ (33,925   $ 89,066   

Comprehensive income:

            

Foreign currency translation adjustment

     —          —          —          (1,097     —          (1,097

Net income

     —          —          —          —          44,746        44,746   
            

 

 

 

Comprehensive income

               43,649   
            

 

 

 

Shares issued in connection with business acquisition

     453        —          9,221        —          —          9,221   

Exercise of stock options

     6,406        7        21,025        —          —          21,032   

Repurchase of common stock

     (1,702     (2     (24,985     —          —          (24,987

Stock-based compensation

     —          —          10,880        —          —          10,880   

Excess tax benefit from stock-based compensation

     —          —          26,748        —          —          26,748   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balances at December 31, 2010

     71,659        72        165,972        (1,256     10,821        175,609   

Comprehensive income:

            

Foreign currency translation adjustment

     —          —          —          (1,502     —          (1,502

Unrealized gains (losses) on investments, net of taxes

     —          —          —          (11     —          (11

Net income

     —          —          —          —          62,443        62,443   
            

 

 

 

Comprehensive income

               60,930   
            

 

 

 

Exercise of stock options

     1,664        1        11,918        —          —          11,919   

Restricted stock units issued, net of shares withheld for taxes

     44        —          (342     —          —          (342

Stock-based compensation

     —          —          10,690        —          —          10,690   

Excess tax benefit from stock-based compensation

     —          —          6,141        —          —          6,141   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balances at December 31, 2011

     73,367        73        194,379        (2,769     73,264        264,947   

Comprehensive income:

            

Foreign currency translation adjustment

     —          —          —          1,597        —          1,597   

Unrealized gains (losses) on investments, net of taxes

     —          —          —          27        —          27   

Net income

     —          —          —          —          81,343        81,343   
            

 

 

 

Comprehensive income

               82,967   
            

 

 

 

Exercise of stock options

     1,142        2        10,620        —          —          10,622   

Restricted stock units issued, net of shares withheld for taxes

     124        —          (1,472     —          —          (1,472

Stock-based compensation

     —          —          15,264        —          —          15,264   

Excess tax benefit from stock-based compensation

     —          —          10,486        —          —          10,486   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balances at December 31, 2012

     74,633      $ 75      $ 229,277      $ (1,145   $ 154,607      $ 382,814   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

F-7


Table of Contents

SolarWinds, Inc.

Consolidated Statements of Cash Flows

(In thousands)

 

     Year Ended December 31,  
     2012     2011     2010  

Cash flows from operating activities

      

Net income

   $ 81,343      $ 62,443      $ 44,746   

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

      

Depreciation and amortization

     18,359        9,957        5,498   

Provision for doubtful accounts

     258        97        194   

Stock-based compensation expense

     15,264        10,690        10,880   

Accrued earnout gain

     (570     (664     —     

Deferred taxes

     (989     2,123        (2,220

Excess tax benefit from stock-based compensation

     (10,486     (6,359     (26,748

Premium on investments

     (1,605     (888     —     

Other non-cash expenses

     1,432        622        470   

Changes in operating assets and liabilities, net of assets acquired and liabilities assumed in business combinations:

      

Accounts receivable

     (5,695     (7,038     (5,078

Income taxes receivable

     (28     (33     31   

Prepaid income taxes

     —          —          4,675   

Prepaid and other current assets

     (1,220     (189     (1,199

Accounts payable

     1,807        56        (1,127

Accrued liabilities

     4,473        747        3,958   

Accrued interest payable

     —          —          (539

Income taxes payable

     18,565        19,886        17,160   

Deferred revenue

     22,539        19,080        15,342   
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

     143,447        110,530        66,043   

Cash flows from investing activities

      

Purchases of investments

     (65,929     (33,241     —     

Maturities of investments

     33,930        4,000        —     

Purchases of property and equipment

     (3,885     (2,945     (2,740

Purchases of intangible assets and other

     (1,203     (745     (795

Acquisition of businesses, net of cash acquired

     (66,031     (109,483     (28,039
  

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

     (103,118     (142,414     (31,574

Cash flows from financing activities

      

Repurchase of common stock

     (1,472     (342     (24,987

Exercise of stock options

     10,622        11,919        21,032   

Excess tax benefit from stock-based compensation

     10,486        6,359        26,748   

Earnout payments for acquisitions

     (4,154     (3,743     —     

Repayment of long-term debt

     —          —          (44,097

Repayment of capital lease obligations

     —          —          (9
  

 

 

   

 

 

   

 

 

 

Net cash provided by (used in) financing activities

     15,482        14,193        (21,313

Effect of exchange rate changes on cash and cash equivalents

     1,184        (1,605     (941
  

 

 

   

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     56,995        (19,296     12,215   

Cash and cash equivalents

      

Beginning of period

     122,707        142,003        129,788   
  

 

 

   

 

 

   

 

 

 

End of period

   $ 179,702      $ 122,707      $ 142,003   
  

 

 

   

 

 

   

 

 

 

Supplemental disclosure of cash flow information

      

Cash paid for interest

   $ —        $ —        $ 1,280   
  

 

 

   

 

 

   

 

 

 

Cash paid (received) for income taxes

   $ 15,285      $ 1,013      $ (3,282
  

 

 

   

 

 

   

 

 

 

Noncash investing and financing transactions

      

Accrued earnout (Note 5)

   $ 1,547      $ 3,938      $ 3,743   
  

 

 

   

 

 

   

 

 

 

Stock issued for acquisition (Note 2)

   $ —        $ —        $ 9,221   
  

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

SolarWinds, Inc.

Notes to Consolidated Financial Statements

1. Summary of Significant Accounting Policies

Organization and Nature of Operations

SolarWinds, Inc., a Delaware corporation, and its subsidiaries (“we” or “us”) design, develop, market, sell and support enterprise-class information technology, or IT, infrastructure management software to IT professionals in organizations of all sizes. Our product offerings range from individual software tools to more comprehensive software products that solve problems encountered every day by IT professionals. Our products are designed to help enable efficient and effective management of their networks, systems and application infrastructure.

Basis of Consolidation

The accompanying consolidated financial statements include our accounts and the accounts of our wholly owned subsidiaries. We have eliminated all intercompany balances and transactions.

Reclassifications

Certain reclassifications have been made to prior periods’ consolidated financial statements to conform to the current period presentation. These reclassifications did not result in any change in previously reported net income, total assets or shareholders’ equity.

Use of Estimates

The preparation of financial statements in conformity with United States of America generally accepted accounting principles, or GAAP, requires our management to make estimates and assumptions that affect the reported amounts and the disclosure of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. The actual results that we experience may differ materially from our estimates. The accounting estimates that require our most significant, difficult and subjective judgments include:

 

   

the valuation of goodwill, intangibles, long-lived assets and contingent consideration, including accrued earnouts;

 

   

revenue recognition;

 

   

stock-based compensation;

 

   

income taxes; and

 

   

loss contingencies.

Foreign Currency Translation

The functional currency of our foreign subsidiaries is determined in accordance with authoritative guidance issued by the Financial Accounting Standards Board, or FASB. We translate assets and liabilities for these subsidiaries at exchange rates in effect at the balance sheet date. We translate income and expense accounts for these subsidiaries at the average monthly exchange rates for the periods. We record resulting translation adjustments as a component of accumulated other comprehensive income (loss) within stockholders’ equity (deficit). We record gains and losses from currency transactions denominated in currencies other than the functional currency as other income (expense) in our consolidated statements of income. There were no equity transactions denominated in foreign currencies for the years ended December 31, 2012 and 2011.

 

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Table of Contents

SolarWinds, Inc.

Notes to Consolidated Financial Statements—(Continued)

 

Local currency transactions of international subsidiaries that have the U.S. dollar as the functional currency are remeasured into U.S. dollars using current rates of exchange for monetary assets and liabilities and historical rates of exchange for non-monetary assets and liabilities. Gains and losses from remeasurement of monetary assets and liabilities, as reflected within our consolidated statements of income, were not material for the years ended December 31, 2012, 2011 and 2010.

Recent Accounting Pronouncements

In July 2012, FASB issued a standard to provide updated guidance on the periodic testing of indefinite-lived intangible assets for impairment. This guidance will allow companies to assess qualitative factors to determine if it is more likely than not that the indefinite-lived intangible asset might be impaired and whether it is necessary to perform the quantitative impairment test required under current accounting standards. The updated accounting guidance is effective for annual periods beginning after September 15, 2012. Early application is permitted. We adopted the updated guidance in the fourth quarter of fiscal year 2012. Adoption of this standard did not have an impact on our consolidated financial statements.

Acquisitions

We account for acquired businesses using the acquisition method of accounting, which requires that the assets acquired, liabilities assumed, contractual contingencies and contingent consideration be recorded at the date of acquisition at their respective fair values. Goodwill represents the excess of the purchase price, including any contingent consideration, over the fair value of the net assets acquired. It further requires acquisition related costs to be recognized separately from the acquisition and expensed as incurred, most restructuring costs to be expensed in periods subsequent to the acquisition date and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period to impact the provision for income taxes. The acquired developed product technologies recorded for each acquisition were feasible at the date of acquisition as they were being actively marketed and sold by the acquired company at the acquisition date. In addition to the acquired developed product technologies, we also recorded intangible assets for the acquired companies’ customer relationships, trademarks, in process research and development and certain non-competition covenants. We include the operating results of acquisitions in our consolidated financial statements from the effective date of the acquisitions. Acquisition related costs are included in general and administrative expenses in our consolidated statements of income.

The fair value of identifiable intangible assets is based on significant judgments made by management. We typically engage third party valuation appraisal firms to assist us in determining the fair values and useful lives of the assets acquired. Such valuations and useful life determinations require us to make significant estimates and assumptions. These estimates and assumptions are based on historical experience and information obtained from management, and also include, but are not limited to, future expected cash flows earned from the product technology and discount rates applied in determining the present value of those cash flows. Unanticipated events and circumstances may occur that could affect the accuracy or validity of such assumptions, estimates or actual results. Acquired identifiable intangible assets are amortized on the net cash flow method over their estimated economic lives, which are generally three to seven years for trademarks, customer relationships, non-competition covenants and acquired developed product technologies and ten years for intellectual property. We include amortization of acquired developed product technologies in cost of license revenue and amortization of other acquired intangible assets in general and administrative expenses in our consolidated statements of income. We record acquired in process research and development as indefinite-lived intangible assets. On completion of the related development projects, the in process research and development assets are reclassified to developed technology and amortized over their estimated economic lives.

 

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Table of Contents

SolarWinds, Inc.

Notes to Consolidated Financial Statements—(Continued)

 

Goodwill, Intangible Assets and Long-lived Assets

As we operate our business in one operating segment and one reporting unit, our goodwill is assessed at the consolidated level for impairment in the fourth quarter of each year or more frequently if events or changes in circumstances indicate that impairment may exist. If we perform a qualitative assessment, we first determine whether it is more likely than not that the fair value of our reporting unit is less than its carrying amount and whether the two-step quantitative analysis is necessary. If determined necessary, for the first step of our quantitative analysis, we consider our market capitalization compared with the carrying amount of our net assets on the date of the test, since we have only one reporting unit. An impairment of goodwill is recognized when the carrying amount exceeds the fair value.

We also evaluate indefinite-lived intangible assets for impairment annually during our fourth fiscal quarter and whenever events or changes in circumstances indicate impairment may exist. We first perform a qualitative assessment to determine whether it is more likely than not that the fair value of our indefinite-lived intangible assets is less than its carrying amount and whether the quantitative analysis is necessary. The quantitative analysis compares the fair value of our indefinite-lived intangible assets to their carrying amount and an impairment loss is recognized when the carrying amount exceeds the fair value.

The process of evaluating the potential impairment related to our goodwill and indefinite-lived intangible assets is highly subjective and requires the application of significant judgment. If an event occurs that would cause us to revise our estimates and assumptions used in analyzing the value of our goodwill and other intangible assets with indefinite lives, the revision could result in a non-cash impairment charge that could have a material impact on our financial results. As of December 31, 2012 and 2011, we performed our annual review of goodwill and indefinite-lived intangible assets and concluded that no impairment existed for our reporting unit during any of the periods presented. No impairment charges have been required to date.

We evaluate long-lived assets, including identifiable intangible assets and other assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Events or changes in circumstances that could result in an impairment review include, but are not limited to, significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for our overall business, and significant negative industry or economic trends. Impairment is recognized when the asset is not recoverable and the carrying amount of an asset exceeds its fair value as calculated on a discounted cash flow basis. If an event occurs that would cause us to revise our estimates and assumptions used in analyzing the value of our property and equipment or our finite-lived intangibles and other assets, that revision could result in a non-cash impairment charge that could have a material impact on our financial results. As of December 31, 2012 and 2011, there were no indicators that our long-lived assets were impaired.

Investments

Short-term and long-term investments at December 31, 2012 and 2011 were as follows:

 

     December 31,  
(in thousands)    2012      2011  

Short-term investments

   $ 49,276       $ 29,688   

Long-term investments

     12,823         —     
  

 

 

    

 

 

 

Total investments

   $ 62,099       $ 29,688   
  

 

 

    

 

 

 

 

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Table of Contents

SolarWinds, Inc.

Notes to Consolidated Financial Statements—(Continued)

 

Our short-term and long-term investments, classified as available-for-sale securities, consist primarily of marketable securities such as corporate bonds, municipal bonds and commercial paper. We determine the appropriate classification of our investments at the time of purchase and reevaluate such determination at each balance sheet date. All securities classified as short-term investments have contractual maturities of less than twelve months. All securities classified as long-term investments have contractual maturities greater than twelve months.

Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax, reported as a separate component of stockholders’ equity (deficit). Any premiums or discounts are amortized or accreted, respectively, to maturity as a component of other income (expense) in our consolidated statements of income. Cash flows from the principal amount of purchases, sales and maturities of available-for-sale securities are classified as cash flows from investing activities. Any amount of premium on purchased securities and discount on matured and sold securities and the related amortization and accretion are classified as cash flows from operating activities in our consolidated statements of cash flows. During 2012, we reclassified the purchased premium and matured discount on investments from cash flows from investing activities to cash flows from operating activities in our consolidated statements of cash flows for the prior periods presented to conform to the current period presentation which impacted cash flows from operations and investing but had no impact on total cash flows.

The cost of securities sold is based on the specific-identification method. In determining if and when a decline in fair value is judged to be other-than-temporary, we evaluate, among other factors: the duration and extent to which the fair value has been less than the carrying value and the intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair market value. Declines in fair value deemed other-than-temporary are included as a component of other income (expense). We have not recorded any other-than-temporary impairments related to marketable securities. See Note 4 for a summary of our investments.

Fair Value Measurements

We apply the authoritative guidance on fair value measurements for financial assets and liabilities that are measured at fair value on a recurring basis and non-financial assets and liabilities, such as goodwill, indefinite-lived intangible assets and property, plant and equipment that are measured at fair value on a non-recurring basis.

The guidance establishes a three-tiered fair value hierarchy that prioritizes inputs to valuation techniques used in fair value calculations. The three levels of inputs are defined as follows:

Level 1: Unadjusted quoted prices for identical assets or liabilities in active markets accessible by us.

Level 2: Inputs that are observable in the marketplace other than those inputs classified as Level 1.

Level 3: Inputs that are unobservable in the marketplace and significant to the valuation.

We determine the fair value of our available-for-sale securities based on inputs obtained from multiple pricing vendors, who may use quoted prices in active markets for identical assets (Level 1 inputs) or inputs other than quoted prices that are observable either directly or indirectly (Level 2 inputs) in determining fair value. However, we classify all of our available-for-sale securities as being valued using Level 2 inputs. The valuation techniques used to determine the fair value of our financial instruments having Level 2 inputs are derived from unadjusted, non-binding market consensus prices that are corroborated by observable market data, quoted market prices for similar instruments, or pricing models. Our procedures include controls to ensure that appropriate fair values are recorded by a review of the valuation methods and assumptions.

 

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Table of Contents

SolarWinds, Inc.

Notes to Consolidated Financial Statements—(Continued)

 

We began classifying our available-for-sale securities as being valued using Level 2 inputs in the fourth quarter of 2012 and have reclassified our balances at December 31, 2011 as being valued using Level 2 inputs rather than Level 1 inputes to conform to the current period presentation. The change in fair value classification from Level 1 inputs to Level 2 inputs had no impact on the recorded fair values of our available-for-sale securities in our previously reported consolidated financial statements. See Note 5 for a summary of our financial instruments and acquisition related contingent considerations accounted for at fair value on a recurring basis. The carrying amounts reported in our consolidated balance sheets for cash, accounts receivable, accounts payable and other accrued expenses approximate fair value due to relatively short periods to maturity.

Contingent Consideration

Contingent consideration, which includes earnout payments in connection with our acquisitions, is recognized at fair value on the acquisition date and remeasured each reporting period with subsequent adjustments recognized in our consolidated statements of income. We estimate the fair value of contingent consideration liabilities based on certain milestones of the acquired companies and estimated probabilities of achievement and discount the liabilities to present value using our pre-tax cost of debt. Contingent consideration is valued using significant inputs that are not observable in the market which are defined as Level 3 inputs pursuant to fair value measurement accounting. We believe our estimates and assumptions are reasonable, however, there is significant judgment involved. At each reporting date, the contingent consideration liability is revalued to estimated fair value.

Changes in the fair value of contingent consideration liabilities may result from changes in discount periods, changes in the timing and amount of sales and/or other specific milestone estimates and changes in probability assumptions with respect to the likelihood of achieving the various earnout criteria. We reflect changes in fair value due to probability changes as accrued earnout (gains) losses in total operating expenses and changes in fair value due to the passage of time as an expense in total other income (expense) in our consolidated statements of income. These changes could cause a material impact to, and volatility in our operating results. Earnout payments are reflected in cash flows from financing activities and the changes in fair value are reflected in cash flows from operating activities in our consolidated statements of cash flows.

Previously, we classified acquisition related earnout payments as cash flows from investing activities in our consolidated statement of cash flows as they related to acquisitions; however, we now believe it is more appropriate to classify earnout payments within cash flows from financing activities as the delayed payments for acquisitions are more analogous to financing activities. As such, we have reclassified the earnout payments made during the prior periods from cash flows from investing activities to cash flows from financing activities in our consolidated statement of cash flows to conform to current period presentation.

Derivative Instruments

We utilize purchased foreign currency forward contracts to minimize our foreign exchange exposure on certain foreign balance sheet positions denominated in currencies other than the Euro. We do not use forward contracts for trading or speculative purposes. Our use of foreign currency forward exchange contracts is intended to principally offset gains and losses associated with these exposures. Therefore, the notional amounts and currencies underlying our foreign currency forward contracts will fluctuate period to period as they are principally dependent on the balances of the balance sheet positions maintained by our international entities that are denominated in currencies other than the Euro.

These foreign currency forward contracts are not designated as hedging instruments, and the gain or loss on the derivatives is recognized in our consolidated statements of income as other income (expense). The fair value

 

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Table of Contents

SolarWinds, Inc.

Notes to Consolidated Financial Statements—(Continued)

 

of our outstanding foreign currency forward contracts in a gain position is recorded within prepaid and other current assets and the fair value of contracts in a loss position is recorded within accrued liabilities in our consolidated balance sheets. The maturities of the forward contracts are generally less than three months. See Note 6 for further discussion of our derivative instruments.

Accounts Receivable

Accounts receivable represent trade receivables from customers when we have provided software licenses and/or software maintenance agreements and we have not yet received payment. We present accounts receivable net of an allowance for doubtful accounts. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. In doing so, we consider the current financial condition of the customer, the specific details of the customer account, the age of the outstanding balance and the current economic environment. Any change in the assumptions used in analyzing a specific account receivable might result in an additional allowance for doubtful accounts being recognized in the period in which the change occurs. We have historically had insignificant write-offs related to bad debts.

Property and Equipment

We record property and equipment at cost and depreciate them using the straight-line method over their estimated useful lives as follows:

 

     Useful Life
     (in years)

Equipment and other

   5

Furniture and fixtures

   5 - 7

Software

   3 - 5

Leasehold improvements

   Lesser of

lease term or

useful life

Upon retirement or sale of property and equipment, we remove the cost of assets disposed of and any related accumulated depreciation from our accounts and credit or charge any resulting gain or loss to operating expense. We expense repairs and maintenance as they are incurred.

Costs related to software developed or obtained for internal use are included in property and equipment and are depreciated on a straight line basis over the useful life of the software. Costs incurred during the preliminary planning and evaluation stage of the project and during the post implementation operational stage are expensed as incurred. Costs incurred during the application development stage of the project are capitalized.

Capitalized Software

Costs incurred in the research and development of our products are expensed as incurred, except for certain software development costs. We expense costs associated with the development of computer software to be marketed prior to the establishment of technological feasibility and capitalize them from the point technological

 

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Table of Contents

SolarWinds, Inc.

Notes to Consolidated Financial Statements—(Continued)

 

feasibility is reached until the product is ready for general availability. At December 31, 2012 and 2011, we had unamortized capitalized software development costs of $0.4 million and $0.2 million, respectively, related to localizing our products.

Capitalized software development costs are periodically assessed for recoverability in the event of changes to the anticipated future revenue for the software products or changes in product technologies. Unamortized capitalized software development costs that are determined to be in excess of the net realizable value of the software products would be expensed in the period in which such a determination is made. Capitalized localization product costs are included in intangible assets and other, net in our consolidated balance sheets and are amortized over their estimated useful life, generally three to five years. Amortization of capitalized software development costs is included in cost of license revenue in our consolidated statements of income and was insignificant for the years ended December 31, 2012, 2011 and 2010.

Website Development Costs

We capitalize certain direct costs to develop functionality as well as certain upgrades and enhancements that are probable to result in additional functionality to our website. The costs incurred in the preliminary stages of development are expensed as incurred. Once an application has reached the development stage, costs are capitalized until the software is substantially complete and ready for its intended use. Capitalized website development costs are recorded in intangible assets and other, net in our consolidated balance sheets and amortized over their estimated useful life, generally three years, as general and administrative expenses in our consolidated statements of income. Capitalized website development costs at December 31, 2012 and 2011 were insignificant.

Long-Term Debt

On December 13, 2005, we entered into credit agreements with an investment management firm pursuant to which we borrowed $85.0 million on a first lien note, or First Lien Note, and $25.0 million on a second lien note, or Second Lien Note, and collectively the Notes. We amortize debt issuance costs over the term of the associated debt. In March 2010, we repaid the $19.1 million outstanding principal balance on our First Lien Note and wrote-off $0.2 million of debt issuance costs associated with the note. In May 2010, we fully repaid the $25.0 million outstanding principal balance on our Second Lien Note and wrote-off the remaining $0.1 million of debt issuance costs. The amortization and write-off of debt issuance costs of $0.4 million were included in interest expense for the year ended December 31, 2010.

Contingencies

We account for claims and contingencies in accordance with authoritative guidance that requires we record an estimated loss from a claim or loss contingency when information available prior to issuance of our consolidated financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of our consolidated financial statements and the amount of the loss can be reasonably estimated. If we determine that it is reasonably possible but not probable that an asset has been impaired or a liability has been incurred or if the amount of a probable loss cannot be reasonably estimated, then in accordance with the authoritative guidance, we disclose the amount or range of estimated loss if the amount or range of estimated loss is material. Accounting for claims and contingencies requires us to use our judgment. We consult with legal counsel on those issues related to litigation and seek input from other experts and advisors with respect to matters in the ordinary course of business. See Note 14 for a discussion of contingencies.

 

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Table of Contents

SolarWinds, Inc.

Notes to Consolidated Financial Statements—(Continued)

 

Revenue Recognition

We derive substantially all of our revenue from the licensing of our software products and from the sale of annual maintenance agreements for these products. We typically include one year of maintenance as part of the initial purchase price of each software offering and then sell renewals of this maintenance agreement. In accordance with current guidance, we recognize revenue for software, maintenance and other services when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is probable. Our return policy generally does not allow our customers to return software products.

License Revenue. We consider delivery of our software to have occurred and recognize revenue from the sale of perpetual licenses to our software when risk of loss transfers to the customer, reseller or distributor, which is generally upon electronic transfer of the license key that provides immediate availability of the product to the purchaser.

We sell licenses to our software products through our direct sales force and through our distributors and other resellers. Our distributors and resellers do not carry inventory of our software and we generally require them to specify the end-user of the software at the time of the order. If the distributor or reseller does not provide end-user information, then we will generally not fulfill the order. Our distributors and resellers have no rights of return or exchange for software that they purchase from us and payment for these purchases is due to us without regard to whether the distributors or resellers collect payment from their customers. We account for sales incentives to customers, resellers or distributors as a reduction of revenue at the time we recognize the revenue from the related product sale. We report revenue net of any sales tax collected.

We generally use a purchase order, an authorized credit card, an electronic or manually signed license agreement, or the receipt of a cash payment as evidence of an arrangement. Sales through resellers and distributors are typically evidenced by a reseller or distributor agreement, together with purchase orders or authorized credit cards on a transaction-by-transaction basis.

Because our software is generally sold with maintenance, we calculate the amount of revenue allocated to the software license by determining the fair value of the maintenance and subtracting it from the total invoice or contract amount. We establish vendor-specific objective evidence, or VSOE, of the fair value of maintenance services by the standard published list pricing for our maintenance renewals since we generally charge list prices for our maintenance renewals.

Maintenance and Other Revenue. We derive maintenance revenue from fees for software maintenance services. We recognize maintenance revenue ratably on a daily basis over the contract period. Customers with maintenance agreements are entitled to receive unspecified upgrades or enhancements to new versions of their software products on a when-and-if-available basis. Other revenue consists primarily of subscription revenue which is recognized ratably on a daily basis over the contract period. Other revenue for the years ended December 31, 2012, 2011 and 2010 was insignificant.

Deferred Revenue

Deferred revenue consists of billings or payments received in advance of revenue recognition from maintenance fees and training services. We generally bill maintenance agreements annually in advance for services to be performed over a 12-month period. Customers have the option to purchase maintenance renewals for periods other than 12 months. We initially record the amounts to be paid under maintenance agreements as deferred revenue and recognize these amounts ratably on a daily basis over the term of the maintenance agreement. We record deferred revenue that will be recognized during the succeeding 12-month period as current deferred revenue and the remaining portion is recorded as long-term deferred revenue.

 

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Table of Contents

SolarWinds, Inc.

Notes to Consolidated Financial Statements—(Continued)

 

Cost of Revenue

Cost of License Revenue. Cost of license revenue consists primarily of amortization of acquired developed product technologies and third party software license royalties. Third party software license royalties are amortized based on the number of units issued. Amortization of acquired developed product technologies and third party software license royalties included in cost of license revenue was as follows:

 

     Year Ended December 31,  
(in thousands)    2012      2011      2010  

Acquired developed product technologies

   $ 7,300       $ 3,652       $ 1,730   

Third party software licenses

     791         438         187   

Cost of Maintenance and Other Revenue. Cost of maintenance and other revenue consists of compensation and benefits related to personnel providing customer support and an allocation of facilities and other overhead costs, including depreciation.

Advertising

We expense advertising costs as incurred. Advertising expense is included in sales and marketing expenses in our consolidated statements of income.

 

     Year Ended December 31,  
(in thousands)    2012      2011      2010  

Advertising expense

   $ 3,360       $ 2,704       $ 3,798   

Leases

We lease facilities worldwide and certain equipment under non-cancelable lease agreements. The terms of some of our lease agreements provide for rental payments on a graduated basis. We recognize rent expense on a straight-line basis over the lease period and accrue rent expense incurred but not paid.

Income Taxes

We use the liability method of accounting for income taxes as set forth in the authoritative guidance for accounting for income taxes. Under this method, we recognize deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the respective carrying amounts and tax basis of our assets and liabilities.

The guidance on accounting for uncertainty in income taxes prescribes a recognition threshold and measurement attribute for financial statement disclosure of tax positions taken or expected to be taken on a tax return. We accrue interest and penalties related to unrecognized tax benefits as a component of income tax expense. There was an insignificant amount accrued for interest and penalties related to unrecognized tax benefits as of December 31, 2012 and 2011.

We establish valuation allowances when necessary to reduce deferred tax assets to the amounts expected to be realized. On a quarterly basis, we evaluate the need for, and the adequacy of, valuation allowances based on the expected realization of our deferred tax assets. The factors used to assess the likelihood of realization include our latest forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets.

 

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Table of Contents

SolarWinds, Inc.

Notes to Consolidated Financial Statements—(Continued)

 

We intend either to invest our non-U.S. earnings permanently in foreign operations or to remit these earnings to our U.S. entities in a tax-free manner. For this reason, we do not record federal income taxes on the undistributed earnings of our foreign subsidiaries.

Stock-Based Compensation

We have granted our employees and directors stock-based incentive awards. These awards are in the form of stock options, restricted stock and restricted stock units. We measure stock-based compensation expense for all share-based awards granted based on the estimated fair value of those awards on the date of grant. The fair values of stock option awards are estimated using a Black-Scholes valuation model. The fair value of restricted stock and restricted stock unit awards is determined using the fair market value of our common stock based on the quoted market price on the date of grant, or intrinsic value.

We estimated the fair value for options at the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:

 

     Year Ended December 31,  
     2012     2011     2010  

Expected dividend yield

     0.0     0.0     0.0

Volatility

     54.2     54.8     59.4

Risk-free rate of return

     0.8-1.4     1.1-2.7     1.5-2.9

Expected life

     6.14 years        6.00 years        6.02 years   

We have not paid and do not anticipate paying cash dividends on our common stock; therefore, we assume the expected dividend yield to be zero. Since we were a private entity prior to our IPO in May 2009 with no historical data regarding the volatility of our own common stock price, we based the expected volatility on the historical and implied volatility of comparable companies from a representative industry peer group. We determined expected volatility of options granted using an average of the historical volatility measures of this peer group of companies. We based the risk-free rate of return on the average U.S. treasury yield curve for five- and seven-year terms for the years ended December 31, 2012, 2011 and 2010. As allowed under current guidance, we have elected to apply the “simplified method” in developing our estimate of expected life for “plain vanilla” stock options by using the midpoint between the vesting date and contractual termination date since we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term due to the limited period of time our common stock has been publicly traded. For all dates, we granted employees options at exercise prices equal to the fair value of the underlying common stock on the date of grant, which is the closing price of our common stock as reported by the NYSE.

The reduction in income before income taxes due to stock-based compensation expense and the related income tax benefits were as follows:

 

     Year Ended December 31,  
(in thousands)    2012      2011      2010  

Reduction in income before income taxes due to stock-based compensation

   $ 15,264       $ 10,690       $ 10,880   

Income tax benefit related to stock-based compensation

     4,197        2,557         2,722   

An excess tax benefit arises when the tax deduction related to a stock option award is greater than the award’s original grant date fair value pursuant to the authoritative guidance. For financial reporting purposes, this excess tax benefit is not recorded as a tax benefit in our consolidated statements of income and is instead treated as additional paid-in capital in our consolidated balance sheets.

 

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Table of Contents

SolarWinds, Inc.

Notes to Consolidated Financial Statements—(Continued)

 

Tax benefits and excess tax benefits from the exercise of stock option awards were as follows:

 

     Year Ended December 31,  
(in thousands)    2012      2011      2010  

Tax benefit from the exercise of stock option awards

   $ 12,051       $ 8,429       $ 32,060   

Excess tax benefit from the exercise of stock option awards

     10,486         6,359         26,748   

These excess tax benefits are a reduction to our cash payments related to income taxes and must be reported as cash flows from financing activities in our consolidated statements of cash flows.

Earnings Per Share

We computed basic earnings per share available to common stockholders by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the reporting period. We computed diluted earnings per share similarly to basic earnings per share except that it reflects the potential dilution that could occur if dilutive securities or other obligations to issue common stock were exercised or converted into common stock.

Concentrations of Risks

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash and cash equivalents, short-term and long-term investments and accounts receivable. We consider all highly liquid investments with original maturities of three months or less to be cash equivalents. Our cash and cash equivalents consisted of the following:

 

     December 31,  
(in thousands)    2012      2011  

Demand deposit accounts

   $ 82,195       $ 30,371   

Money market funds

     97,507         92,336   
  

 

 

    </