9.30.14 QTWO 10Q
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 
FORM 10-Q
 
(Mark One),

ý Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the quarterly period ended September 30, 2014.   
 or
o Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Q2 Holdings, Inc.
(Exact name of Registrant as Specified in Its Charter)
Delaware
(State or Other Jurisdiction of
Incorporation or Organization)
 
001-36350
(Commission File Number)
 
20-2706637
(IRS Employer
Identification No.)

 

13785 Research Blvd, Suite 150
Austin, Texas 78750
(512) 275-0072
(Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant's Principal Executive Offices)

 

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  ý  No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  ý  No o
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.
o    Large accelerated filer
 
o    Accelerated filer
 
ý    Non-accelerated filer
 
o    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  o  No ý
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 34,218,697 shares of Common Stock, $0.0001 par value per share as of October 31, 2014.



Table of Contents

TABLE OF CONTENTS
 
 
PAGE
PART I: FINANCIAL INFORMATION
 
 
 
 
Item 1.
Financial Statements
 3
 
 
 
 
Condensed Consolidated Balance Sheets as of September 30, 2014 (unaudited) and December 31, 2013
 
 
 
 
Condensed Consolidated Statements of Operations and Comprehensive Loss for the Three and Nine Months Ended September 30, 2014 and 2013 (unaudited)
 
 
 
 
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2014 and 2013 (unaudited)
 
 
 
 
   Notes to Condensed Consolidated Financial Statements (unaudited)
 
 
 
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
 
 
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
 
 
Item 4.
Controls and Procedures
 
 
 
PART II: OTHER INFORMATION
 
 
 
 
Item 1.
Legal Proceedings
 
 
 
Item 1A.
Risk Factors
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
 
 
Item 3.
Defaults Upon Senior Securities
 
 
 
Item 4.
Mine Safety Disclosures
 
 
 
Item 5.
Other Information
 
 
 
Item 6.
Exhibits
 
 
SIGNATURES
 


2

Table of Contents

PART I - FINANCIAL INFORMATION
Item 1. Financial Statements

Q2 HOLDINGS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
 
 
September 30,
 
December 31,
 
 
2014
 
2013
 
 
(unaudited)
 
 
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
72,340

 
$
18,675

Restricted cash
 
829

 
116

Investments
 
18,028

 

Accounts receivable, net
 
6,505

 
9,063

Prepaid expenses and other current assets
 
2,321

 
1,079

Deferred solution and other costs, current portion
 
4,324

 
3,124

Deferred implementation costs, current portion
 
2,037

 
1,814

Total current assets
 
106,384

 
33,871

Property and equipment, net
 
14,251

 
14,831

Deferred solution and other costs, net of current portion
 
6,503

 
5,358

Deferred implementation costs, net of current portion
 
5,344

 
4,560

Other long-term assets
 
815

 
2,488

Total assets
 
$
133,297

 
$
61,108

Liabilities, redeemable convertible preferred stock, redeemable common stock and stockholders' equity (deficit)
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable
 
$
2,641

 
$
4,085

Accrued liabilities
 
7,089

 
11,664

Deferred revenues, current portion
 
18,031

 
12,728

Capital lease obligations, current portion
 
453

 
714

Total current liabilities
 
28,214

 
29,191

Deferred revenues, net of current portion
 
18,616

 
14,773

Capital lease obligations, net of current portion
 
259

 
575

Long-term debt, net of current portion
 
46

 
6,288

Deferred rent, net of current portion
 
4,888

 
4,444

Other long-term liabilities
 
7

 
101

Total liabilities
 
52,030

 
55,372

Commitments and contingencies (Note 6)
 

 

Redeemable convertible preferred stock and redeemable common stock:
 
 
 
 
Series A preferred stock: $0.0001 par value; no shares authorized, issued or outstanding as of September 30, 2014, and 7,908 shares authorized, issued and outstanding as of December 31, 2013
 

 
10,815

Series B preferred stock: $0.0001 par value; no shares authorized, issued or outstanding as of September 30, 2014, and 1,818 shares authorized, issued and outstanding as of December 31, 2013
 

 
10,915

Series C preferred stock: $0.0001 par value; no shares authorized, issued or outstanding as of September 30, 2014, and 2,605 shares authorized, issued and outstanding as of December 31, 2013
 

 
18,995

Common stock: $0.0001 par value; no shares outstanding as of September 30, 2014, and 3,829 shares outstanding as of December 31, 2013               
 

 
1,327

Stockholders' equity (deficit):
 
 
 
 
Junior convertible preferred stock: $0.0001 par value; no shares authorized, issued or outstanding as of September 30, 2014, and 1,251 shares authorized, issued and outstanding as of December 31, 2013
 

 
1,740

Common stock: $0.0001 par value; 150,000 shares authorized, 34,195 shares issued and outstanding as of September 30, 2014, and 35,000 shares authorized, 8,288 shares issued and outstanding as of December 31, 2013
 
3

 
1

Additional paid-in capital
 
140,890

 
6,675

Accumulated other comprehensive loss
 
(20
)
 

Accumulated deficit
 
(59,606
)
 
(44,732
)
Total stockholders' equity (deficit)
 
81,267

 
(36,316
)
Total liabilities, redeemable convertible preferred stock, redeemable common stock and stockholders' equity (deficit)
 
$
133,297

 
$
61,108

   

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

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Q2 HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(unaudited)
(in thousands, except per share data)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Revenues
 
$
20,989

 
$
14,325

 
$
56,981

 
$
41,203

Cost of revenues(1)
 
12,143

 
9,167

 
33,185

 
25,382

Gross profit
 
8,846

 
5,158

 
23,796

 
15,821

Operating expenses:
 
 
 
 
 
 
 
 
Sales and marketing(1)
 
5,642

 
4,599

 
17,183

 
11,797

Research and development(1)
 
3,155

 
2,259

 
8,678

 
6,277

General and administrative(1)
 
4,574

 
3,207

 
12,350

 
8,318

Unoccupied lease charges
 

 
88

 

 
236

Total operating expenses
 
13,371

 
10,153

 
38,211

 
26,628

Loss from operations
 
(4,525
)
 
(4,995
)
 
(14,415
)
 
(10,807
)
Other income (expense):
 
 
 
 
 
 
 
 
Interest and other income
 
25

 

 
30

 
5

Interest and other expense
 
(107
)
 
(170
)
 
(438
)
 
(342
)
Total other expense, net
 
(82
)
 
(170
)
 
(408
)
 
(337
)
Loss before income taxes
 
(4,607
)
 
(5,165
)
 
(14,823
)
 
(11,144
)
Provision for income taxes
 
(18
)
 
(14
)
 
(51
)
 
(33
)
Loss from continuing operations
 
(4,625
)
 
(5,179
)
 
(14,874
)
 
(11,177
)
Loss from discontinued operations, net of tax
 

 

 

 
(199
)
Net loss
 
$
(4,625
)
 
$
(5,179
)
 
$
(14,874
)
 
$
(11,376
)
Other comprehensive loss:
 
 
 
 
 
 
 
 
Unrealized gain (loss) on available-for-sale investments
 
(20
)
 

 
(20
)
 

Comprehensive loss
 
$
(4,645
)
 
$
(5,179
)
 
$
(14,894
)
 
$
(11,376
)
 
 
 
 
 
 
 
 
 
Net loss per common share:
 
 
 
 
 
 
 
 
Loss from continuing operations per common share, basic and diluted
 
$
(0.14
)
 
$
(0.43
)
 
$
(0.54
)
 
$
(0.95
)
Loss from discontinued operations per common share, basic and diluted
 
$

 
$

 
$

 
$
(0.01
)
Net loss per common share, basic and diluted
 
$
(0.14
)
 
$
(0.43
)
 
$
(0.54
)
 
$
(0.96
)
Weighted average common shares outstanding:
 
 
 
 
 
 
 
 
Basic and diluted
 
34,171

 
12,045

 
27,522

 
11,794

_______________________________________________________________________________

(1) 
Includes stock-based compensation expenses as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Cost of revenues
 
$
159

 
$
70

 
$
432

 
$
192

Sales and marketing
 
189

 
81

 
543

 
180

Research and development
 
131

 
64

 
360

 
189

General and administrative
 
622

 
197

 
1,752

 
561

Total stock-based compensation expenses
 
$
1,101

 
$
412

 
$
3,087

 
$
1,122

  

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

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Q2 HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)
 
 
Nine Months Ended September 30,
 
 
2014
 
2013
Cash flows from operating activities:
 
 
 
 
Net loss
 
$
(14,874
)
 
$
(11,376
)
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
 
 
 
 
Amortization of deferred implementation, solution and other costs
 
3,198

 
2,033

Depreciation and amortization
 
3,122

 
2,071

Amortization of debt issuance costs
 
72

 
44

Amortization of premiums on investments
 
24

 

Stock-based compensation expenses
 
3,087

 
1,122

Loss from discontinued operations
 

 
199

Allowance for sales credits
 
51

 
56

Loss on disposal of long-lived assets
 

 
18

Unoccupied lease charges
 

 
236

Changes in operating assets and liabilities:
 
 
 
 
Accounts receivable, net
 
2,507

 
(1,053
)
Prepaid expenses and other current assets
 
(1,241
)
 
(443
)
Deferred solution and other costs
 
(3,500
)
 
(1,947
)
Deferred implementation costs
 
(3,049
)
 
(2,550
)
Other long-term assets
 
211

 
104

Accounts payable
 
(427
)
 
(233
)
Accrued liabilities
 
(2,937
)
 
1,841

Deferred revenue
 
9,147

 
5,663

Deferred rent and other long-term liabilities
 
351

 
4,250

Net cash (used in) provided by continuing operations
 
(4,258
)
 
35

Net cash used in discontinued operating activities
 

 
(236
)
Net cash used in operating activities
 
(4,258
)
 
(201
)
Cash flows from investing activities:
 
 
 
 
Purchases of investments
 
(18,072
)
 

Purchases of property and equipment
 
(3,815
)
 
(10,058
)
Acquisitions and purchase of intangible assets
 

 
(125
)
Increase in restricted cash
 
(713
)
 

Cash included in distribution of spin-off
 

 
(46
)
Net cash used in investing activities
 
(22,600
)
 
(10,229
)
Cash flows from financing activities:
 
 
 
 
Proceeds from issuance of preferred stock, net of issuance costs
 

 
18,995

Proceeds from borrowings on line of credit
 
12,500

 
6,350

Payments on line of credit
 
(18,710
)
 
(2,682
)
Payments on capital lease obligations
 
(606
)
 
(510
)
Proceeds from the issuance of common stock, net of issuance costs
 
86,286

 

Proceeds from exercise of stock options to purchase common stock
 
1,053

 
339

Net cash provided by financing activities
 
80,523

 
22,492

Net increase in cash and cash equivalents
 
53,665

 
12,062

Cash and cash equivalents, beginning of period
 
18,675

 
9,111

Cash and cash equivalents, end of period
 
$
72,340

 
$
21,173

Supplemental disclosures of cash flow information:
 
 
 
 
Cash paid for taxes
 
$
55

 
$
164

Cash paid for interest
 
$
207

 
$
269

Supplemental disclosure of non-cash investing activities:
 
 
 
 
Equipment acquired under capital lease
 
$

 
$
975


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

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Table of Contents

Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

1. Organization and Description of Business

Q2 Holdings, Inc., or the Company, is a leading provider of secure, cloud-based virtual banking solutions. The Company enables regional and community financial institutions, or RCFIs, to deliver a robust suite of integrated virtual banking services and more effectively engage with their retail and commercial account holders who expect to bank anytime, anywhere and on any device. The Company delivers its solutions to the substantial majority of its customers using a software-as-a-service, or SaaS, model under which its RCFI customers pay subscription fees for the use of the Company's solutions.

The Company, formerly known as CBG Holdings, Inc., was incorporated in Delaware in March 2005 and is a holding company that owns 100% of the outstanding capital stock of Q2 Software, Inc. On March 1, 2013, the Company reorganized its business operations in conjunction with the private placement of its Series C redeemable convertible preferred stock. Prior to the reorganization, the Company owned 100% of the outstanding capital stock of cbanc Network Inc., or cbanc. Pursuant to the reorganization, the Company distributed all shares of cbanc to its stockholders in a spin-off, and the Company was renamed Q2 Holdings, Inc.

The Company's headquarters are located in Austin, Texas.

2. Summary of Significant Accounting Policies

Basis of Presentation and Principles of Consolidation

As used in this report, the terms "we," "us," or "our" refer to Q2 Holdings, Inc. and its wholly-owned subsidiary. These interim unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP, and Securities and Exchange Commission, or SEC, requirements for interim financial statements. The interim unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary. All intercompany accounts and transactions have been eliminated in consolidation.

In the Company's opinion, the accompanying interim unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments necessary for a fair presentation. Certain information and disclosures normally included in the notes to the annual consolidated financial statements prepared in accordance with GAAP have been omitted from these interim unaudited condensed consolidated financial statements pursuant to the rules and regulations of the SEC. Accordingly, these interim unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the accompanying notes for the fiscal year ended December 31, 2013, which are included in the Company's prospectus filed pursuant to Rule 424(b) under the Securities Act of 1933, as amended, or the Securities Act, with the SEC on March 20, 2014. The results of operations for the three and nine months ended September 30, 2014 are not necessarily indicative of the results to be expected for the year ending December 31, 2014 or for any other period.

Use of Estimates

The preparation of the accompanying interim unaudited condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the interim unaudited condensed consolidated financial statements, and the reported amounts of revenues and expenses. Significant items subject to such estimates include stock-based compensation, the useful lives of property and equipment and income taxes. In accordance with GAAP, management bases its estimates on historical experience and on various other assumptions that management believes are reasonable under the circumstances. Management regularly evaluates its estimates and assumptions using historical experience and other factors; however, actual results could differ significantly from those estimates.


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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

Cash and Cash Equivalents

The Company considers all highly liquid investments acquired with an original maturity of ninety days or less at the date of purchase to be cash equivalents. Cash equivalents are stated at cost, which approximates market value, because of the short maturity of these instruments.

Restricted Cash

Restricted cash consists of deposits held in money market accounts for leased office space.

Investments

Investments consists of primarily of U.S. government agency bonds, corporate bonds, commercial paper, certificates of deposits and money market funds. All investments are carried at fair value.

Concentration of Credit Risk

Financial instruments that potentially subject the Company to concentrations of credit risk consist of cash and cash equivalents, restricted cash and accounts receivable. The Company's cash and cash equivalents and restricted cash are placed with high credit quality financial institutions and issuers, and at times may exceed federally-insured limits. The Company has not experienced any loss relating to cash and cash equivalents or restricted cash in these accounts. The Company provides credit, in the normal course of business, to a number of its customers. The Company performs periodic credit evaluations of its customers' financial condition and generally does not require collateral. No individual customer accounted for 10% or more of revenues for each of the three and nine months ended September 30, 2014 and 2013. No individual customer accounted for 10% or more of accounts receivable, net, as of September 30, 2014 or December 31, 2013.

Accounts Receivable

Accounts receivable are stated at net realizable value, including both billed and unbilled receivables to customers. Unbilled receivable balances arise primarily when the Company earns revenues based on the number of registered users and the number of bill-pay and certain other transactions that registered users perform on the Company's virtual banking solutions in excess of the levels included in the Company's minimum subscription fee. Generally, billing for such revenues occurs one month in arrears.

The Company assesses the collectability of outstanding accounts receivable on an ongoing basis and maintains an allowance for doubtful accounts for accounts receivable deemed uncollectable. This allowance is recorded as a reduction against accounts receivable. As of September 30, 2014 and December 31, 2013, the Company did not provide for an allowance for doubtful accounts, as all amounts outstanding were deemed collectable. Historically, the Company's collection experience has not varied significantly, and bad debt expenses have been insignificant.

The Company maintains a reserve for estimated sales credits issued to customers for billing disputes or other service-related reasons. This allowance is recorded as a reduction against current period revenues and accounts receivable. In estimating this allowance, the Company analyzes prior periods to determine the amounts of sales credits issued to customers compared to the revenues in the period that related to the original customer invoice. This estimate is analyzed quarterly and adjusted as necessary. The allowance for sales credits was $0.2 million and $0.1 million as of September 30, 2014 and December 31, 2013, respectively.


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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

Deferred Implementation Costs

The Company capitalizes certain personnel and other costs, such as employee salaries, benefits and the associated payroll taxes that are direct and incremental to the implementation of its solutions. The Company analyzes implementation costs that may be capitalized to assess their recoverability, and only capitalizes costs that it anticipates to be recoverable. The Company assesses the recoverability of its deferred implementation costs by comparing the greater of the amount of the non-cancellable portion of a customer's contract and the non-refundable customer prepayments received as it relates to the specific implementation costs incurred. The Company begins amortizing the deferred implementation costs for an implementation once the revenue recognition criteria have been met, and the Company amortizes those deferred implementation costs ratably over the remaining term of the customer agreement. The portion of deferred implementation costs expected to be amortized during the succeeding twelve-month period is recorded in current assets as deferred implementation costs, current portion, and the remainder is recorded in long-term assets as deferred implementation costs, net of current portion.

Deferred Solution and Other Costs

The Company capitalizes sales commissions and other third-party costs, such as third party licenses and maintenance related to its customer agreements. The Company capitalizes sales commissions because the commission charges are so closely related to the revenues from the non-cancellable customer agreements that they should be recorded as an asset and charged to expense over the same period that the related revenue is recognized. The Company begins amortizing deferred solution and other costs for a particular customer agreement once the revenue recognition criteria are met and amortizes those deferred costs over the remaining term of the customer agreement. The Company analyzes solution and other costs that may be capitalized to assess their recoverability and only capitalizes costs that it anticipates to be recoverable. The portion of capitalized costs expected to be amortized during the succeeding twelve-month period is recorded in current assets as deferred solution and other costs, current portion, and the remainder is recorded in long-term assets as deferred solution and other costs, net of current portion. Deferred commissions were $6.3 million and $4.6 million as of September 30, 2014 and December 31, 2013, respectively.

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is calculated on a straight-line basis over the estimated useful lives of the related assets. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful lives of the related assets. Maintenance and repairs that do not extend the life of or improve an asset are expensed in the period incurred.

The estimated useful lives of property and equipment are as follows:
Computer hardware and equipment
 
3 - 5 years
Purchased software and licenses
 
3 - 5 years
Furniture and fixtures
 
7 years
Leasehold improvements
 
Lesser of estimated useful life or lease term

Deferred Revenues

Deferred revenues primarily consist of amounts that have been billed to or received from customers in advance of revenue recognition and prepayments received from customers in advance for implementation, maintenance and other services, as well as initial subscription fees. The Company recognizes deferred revenues as revenues when the services are performed and the corresponding revenue recognition criteria are met. Customer prepayments are generally applied against invoices issued to customers when services are performed and billed. Deferred revenues that are expected to be recognized as revenues during the succeeding twelve month period are recorded in current liabilities as deferred revenues, current portion and the remaining portion is recorded in long-term liabilities as deferred revenues, net of current portion.


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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

Revenues

All revenue-generating activities are directly related to the sale, implementation and support of the Company's solutions within a single operating segment. The Company derives the substantial majority of its revenues from subscription fees for the use of its solutions hosted in the Company's data centers as well as revenues for implementation and customer support services related to the Company's solutions. A small portion of the Company's customers host the Company's solutions in their own data centers under term license and maintenance agreements, and the Company recognizes the corresponding revenues ratably over the term of those customer agreements.

Revenues are recognized net of sales credits and allowances. The Company begins to recognize revenues for a customer when all of the following criteria are satisfied:

there is persuasive evidence of an arrangement;

the service has been or is being provided to the customer;

the collection of the fees is reasonably assured; and

the amount of fees to be paid by the customer is fixed or determinable.

Determining whether and when these criteria have been met can require significant judgment and estimates. In general, revenue recognition commences when the Company's solutions are implemented and made available to the customers.

The Company's software solutions are available for use in hosted application arrangements under subscription fee agreements. Subscription fees from these applications, including related customer support, are recognized ratably over the customer agreement term beginning on the date the solution is made available to the customer. Amounts that have been invoiced are recorded in accounts receivable and deferred revenues or revenues, depending on whether the Company's revenue recognition criteria have been met.

The Company considers subscription fees to be fixed or determinable unless the fees are subject to refund or adjustment or are not payable within the Company's standard payment terms. In determining whether collection of subscription fees is reasonably assured, the Company considers financial and other information about customers, such as a customer's current credit-worthiness and payment history over time. Historically bad debt expenses have not been significant.

The Company enters into arrangements with multiple-deliverables that generally include multiple subscriptions and implementation services.

For multiple-deliverable arrangements, arrangement consideration is allocated to deliverables based on their relative selling price. In order to treat deliverables in a multiple-deliverable arrangement as separate units of accounting, the deliverables must have standalone value upon delivery. If the deliverables have standalone value upon delivery, each deliverable must be accounted for separately. The Company's subscription services have standalone value as such services are often sold separately. In determining whether implementation services have standalone value apart from the subscription services, the Company considers various factors including the availability of the services from other vendors. To date, the Company has concluded that the implementation services included in multiple-deliverable arrangements do not have standalone value. As a result, when implementation services are sold in a multiple-deliverable arrangement, the Company defers any arrangement fees for implementation services and recognizes such amounts ratably over the period of performance for the initial agreement term.

When multiple-deliverables included in an arrangement are separated into different units of accounting, the arrangement consideration is allocated to the identified separate units based on a relative selling price hierarchy. The selling price for a deliverable is based on its vendor-specific objective evidence of selling price, or VSOE, if available, third-party evidence of selling price, or TPE, if VSOE is not available or best estimate of selling price, or BESP, if neither VSOE nor TPE is available. The Company has not established VSOE for its subscription services due to lack of pricing consistency, the introduction of new

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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

services and other factors. The Company has determined that TPE is not a practical alternative due to differences in its service offerings compared to other parties and the availability of relevant third-party pricing information. Accordingly, the Company uses BESP to determine the relative selling price. The amount of revenue allocated to delivered items is limited by contingent revenues.

The Company determined BESP by considering its overall pricing objectives and market conditions. Significant pricing practices taken into consideration include the Company's discounting practices, the size and volume of its transactions, customer characteristics, price lists, go-to-market strategy, historical standalone sales and agreement prices. As the Company's go-to-market strategies evolve, it may modify its pricing practices in the future, which could result in changes in relative selling prices, and include both VSOE and BESP.

Subscription Fee Revenues

The Company's solutions are available as hosted solutions under subscription fee agreements without licensing perpetual rights to the software. Subscription fees from a hosted solution are recognized monthly over the customer agreement term beginning on the date the Company's solution is made available to the customer. Additional fees for monthly usage above the levels included in the standard subscription fee, which include fees for transactions processed during the period, are recognized as revenue in the month when the usage amounts are determined and reported. Any revenues related to upfront implementation services are recognized ratably over the same customer agreement term. Amounts that have been invoiced are recorded in accounts receivable and deferred revenues or revenues, depending on whether the revenue recognition criteria have been met.

Professional Services Revenues

When professional services are not combined with subscription services or term licenses as a single unit of accounting, these professional services revenues are recognized as the services are performed. Revenues from professional services not combined with subscription services were not significant in the periods presented.

Certain out-of-pocket expenses billed to customers are recorded as revenues rather than an offset to the related expense. Revenues recorded from out-of-pocket expense reimbursements totaled approximately $0.2 million and $0.1 million during the three months ended September 30, 2014 and 2013, respectively, and were $0.5 million and $0.3 million for the nine months ended September 30, 2014 and 2013, respectively. The out-of-pocket expenses are reported in cost of revenues.

Term Licenses and Maintenance Revenues

A small portion of the Company's customers host and manage the Company's solutions on-premises or in third-party data centers under term license and maintenance agreements. Term licenses sold with maintenance, which entitles the customer to technical support and upgrades and updates to the software made available on a when-and-if-available basis, are accounted for under Accounting Standards Codification 985-605, "Software Revenue Recognition." The Company does not have VSOE of fair value for the maintenance and professional services so the entire arrangement consideration is recognized monthly over the term of the software license when all of the other revenue recognition criteria have been met. Revenues from term licenses and maintenance agreements were not significant in the periods presented.

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Table of Contents
Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)


Cost of Revenues

Cost of revenues is comprised primarily of salaries and other personnel-related costs, including employee benefits, bonuses and stock-based compensation, for employees providing services to the Company's customers. Costs associated with these services include the costs of the Company's implementation, customer support, data center and customer training personnel as well as reclassification of certain research and development expenses related to research and development personnel who perform services related to implementation and customer support. Cost of revenues also includes the direct costs of bill-pay and other third-party intellectual property included in the Company's solutions, the amortization of deferred solution and services costs, co-location facility costs and depreciation of the Company's data center assets, an allocation of general overhead costs and referral fees. Direct costs of third-party intellectual property include amounts paid for third-party licenses and related maintenance that are incorporated into the Company's software, with the costs amortized to cost of revenues over the useful lives of the purchased assets.

The amount of research and development expenses allocated to cost of revenues was $0.5 million and $0.4 million for the three months ended September 30, 2014 and 2013, respectively, and was $1.3 million and $1.2 million for the nine months ended September 30, 2014 and 2013, respectively.

The Company capitalizes certain personnel costs directly related to the implementation of its solutions to the extent those costs are considered to be recoverable from future revenues. The Company amortizes the costs for a particular implementation once revenue recognition commences, and the Company amortizes those implementation costs over the remaining term of the customer agreement. Other costs not directly recoverable from future revenues are expensed in the period incurred. The Company capitalized implementation costs in the amount of $1.2 million and $0.9 million during the three months ended September 30, 2014 and 2013, respectively, and $3.0 million and $2.6 million during the nine months ended September 30, 2014 and 2013, respectively.

Software Development Costs

Software development costs include salaries and other personnel-related costs, including employee benefits, bonuses and stock-based compensation, attributed to programmers, software engineers and quality control teams working on the Company's solutions. Costs related to software development incurred between reaching technological feasibility and the point at which the software solution is ready for general release have been insignificant through September 30, 2014, and accordingly all of the Company's software development costs have been expensed as incurred as research and development.

Research and Development Costs

Research and development costs include salaries and other personnel-related costs, including employee benefits, bonuses and stock-based compensation, third-party contractor expenses, software development tools, an allocation of facilities and depreciation expenses and other related expenses incurred in developing new solutions and upgrading and enhancing existing solutions. Research and development costs are expensed as incurred.

Advertising

All advertising costs of the Company are expensed the first time the advertising takes place. Advertising costs were $0.1 million for each of the three months ended September 30, 2014 and 2013, and were $0.4 million and $0.1 million for the nine months ended September 30, 2014 and 2013, respectively.

Sales Tax

The Company presents sales taxes and other taxes collected from customers and remitted to governmental authorities on a net basis and, as such, excludes them from revenues.


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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

Comprehensive Loss

Comprehensive loss includes net loss as well as other changes in stockholders' equity that result from transactions and economic events other than those with stockholders. Other comprehensive loss consists of net loss and unrealized gains and losses on investments.

Stock-Based Compensation

Stock options awarded to employees, directors and consultants are measured at fair value at each grant date. The Company recognizes compensation expense ratably over the requisite service period of the option award. Generally, options vest 25% on the one-year anniversary of the grant date with the balance vesting monthly over the following 36 months.

The Company values stock options using the Black-Scholes option-pricing model, which requires the input of subjective assumptions, including the risk-free interest rate, expected life, expected stock price volatility and dividend yield. The risk-free interest rate assumption is based upon observed interest rates for constant maturity U.S. Treasury securities consistent with the expected term of the Company's employee stock options. The expected life represents the period of time the stock options are expected to be outstanding and is based on the simplified method. Under the simplified method, the expected life of an option is presumed to be the mid-point between the vesting date and end of the contractual term. The Company used the simplified method due to the lack of sufficient historical exercise data to provide a reasonable basis upon which to otherwise estimate the expected life of the stock options. Expected volatility is based on historical volatilities for publicly traded stock of comparable companies over the estimated expected life of the stock options. The Company assumed no dividend yield because it does not expect to pay dividends in the near future, which is consistent with the Company's history of not paying dividends.

Income Taxes

Deferred income taxes are provided for the tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes and operating loss carryforwards and credits using enacted tax rates expected to be in effect in the years in which the differences are expected to reverse. The Company assesses the likelihood that deferred tax assets will be realized and recognizes a valuation allowance if it is more likely than not that some portion of the deferred tax assets will not be realized. This assessment requires judgment as to the likelihood and amounts of future taxable income by tax jurisdiction. To date, the Company has provided a full valuation allowance against its deferred tax assets as it believes the objective and verifiable evidence of its historical pretax net losses outweighs any positive evidence of its forecasted future results. Although the Company believes that its tax estimates are reasonable, the ultimate tax determination involves significant judgment that is subject to audit by tax authorities in the ordinary course of business. The Company will continue to monitor the positive and negative evidence, and it will adjust the valuation allowance as sufficient objective positive evidence becomes available.

The Company evaluates its uncertain tax positions based on a determination of whether and how much of a tax benefit taken by the Company in its tax filings or positions is more likely than not to be realized. Potential interest and penalties associated with any uncertain tax positions are recorded as a component of income tax expense. Through September 30, 2014, the Company has not identified any material uncertain tax positions for which liabilities would be required to be recorded.


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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

Basic and Diluted Net Loss per Common Share

The Company uses the two-class method to compute net loss per common share because the Company has issued securities, other than common stock, that contractually entitle the holders to participate in dividends and earnings of the Company. The two-class method requires earnings for the period to be allocated between common stock and participating securities based upon their respective rights to receive distributed and undistributed earnings. Holders of the Company's Series A, B and C preferred stock are entitled, on a pari passu basis, to receive dividends when, as and if declared by the board of directors, prior and in preference to any declaration or payment of any dividend on the common stock or junior convertible preferred stock until such time as the total dividends paid on each share of Series A, B and C preferred stock is equal to the original issue price of the shares. Holders of junior convertible preferred stock are entitled to receive a pro rata share of any dividend declared, based on the number of shares of common and preferred stock outstanding. As a result, all series of the Company's preferred stock are considered participating securities.

Under the two-class method, for periods with net income, basic net income per common share is computed by dividing the net income attributable to common stockholders by the weighted-average number of shares of common stock outstanding during the period. Net income attributable to common stockholders is computed by subtracting from net income the portion of current year earnings that the participating securities would have been entitled to receive pursuant to their dividend rights had all of the year's earnings been distributed. No such adjustment to earnings is made during periods with a net loss, as the holders of the participating securities have no obligation to fund losses. Diluted net loss per common share is computed under the two-class method by using the weighted-average number of shares of common stock outstanding plus, for periods with net income attributable to common stockholders, the potential dilutive effects of stock options and warrants. In addition, the Company analyzes the potential dilutive effect of the outstanding participating securities under the if-converted method when calculating diluted earnings per share, in which it is assumed that the outstanding participating securities convert into common stock at the beginning of the period. The Company reports the more dilutive of the approaches as its diluted net income per share during the period. Due to net losses for each of the three and nine months ended September 30, 2014 and 2013, basic and diluted net loss per share were the same, as the effect of all potentially dilutive securities would have been anti-dilutive.

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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

The following table sets forth the computations of loss per share for the periods listed:
 
 
Three months ended September 30,
 
Nine months ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Numerators:
 
 
 
 
 
 
 
 
Loss from continuing operations attributable to common stockholders
 
$
(4,625
)
 
$
(5,179
)
 
$
(14,874
)
 
$
(11,177
)
Loss from discontinued operations attributable to common stockholders
 

 

 

 
(199
)
Net loss attributable to common stockholders
 
$
(4,625
)
 
$
(5,179
)
 
$
(14,874
)
 
$
(11,376
)
Denominator:
 
 
 
 
 
 
 
 
Weighted-average common shares outstanding, basic and diluted
 
34,171

 
12,045

 
27,522

 
11,794

 
 
 
 
 
 
 
 
 
Loss from continuing operations per share, basic and diluted
 
$
(0.14
)
 
$
(0.43
)
 
$
(0.54
)
 
$
(0.95
)
Loss from discontinued operations per share, basic and diluted
 
$

 
$

 
$

 
$
(0.01
)
Net loss per common share, basic and diluted
 
$
(0.14
)
 
$
(0.43
)
 
$
(0.54
)
 
$
(0.96
)
Due to net losses for each of the three and nine months ended September 30, 2014 and 2013, basic and diluted loss per share were the same, as the effect of all potentially dilutive securities would have been anti-dilutive. The following table sets forth the anti-dilutive common share equivalents for the periods listed:
 
 
Three months ended September 30,
 
Nine months ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Redeemable convertible preferred stock:
 
 
 
 
 
 
 
 
Series A preferred stock
 

 
7,908

 

 
7,908

Series B preferred stock
 

 
1,818

 

 
1,818

Series C preferred stock
 

 
2,605

 

 
2,042

Junior preferred stock
 

 
1,251

 

 
1,251

Stock options
 
6,551

 
5,361

 
6,551

 
5,361

Total anti-dilutive common share equivalents
 
6,551

 
18,943

 
6,551

 
18,380

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), or ASU 2014-09, which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled to when products are transferred to customers. ASU 2014-09 will be effective for the Company beginning in its first quarter of 2017. Early adoption is not permitted. The new revenue standard may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company is currently evaluating the impact of adopting the new revenue standard on its condensed consolidated financial statements.

Subsequent Events

The Company has evaluated subsequent events through the date of filing this Form 10-Q.


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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)


3. Cash, Cash Equivalents and Investments

The Company's cash, cash equivalents and investments as of September 30, 2014 and as of December 31, 2013 consisted primarily of cash, U.S. government agency bonds, corporate bonds, commercial paper, certificates of deposits and money market funds.
The Company classifies investments as available-for-sale at the time of purchase and reevaluates such classification as of each balance sheet date. All investments are recorded at estimated fair value. Unrealized gains and losses on available-for-sale investments are included in accumulated other comprehensive loss, a component of stockholders' equity. The Company evaluates its investments to assess whether those with unrealized loss positions are other than temporarily impaired. The Company considers impairments to be other than temporary if they are related to deterioration in credit risk or if it is likely the Company will sell the investments before the recovery of their cost basis. Realized gains and losses and declines in value judged to be other than temporary are determined based on the specific identification method and are reported in other income (expense), net, in the condensed consolidated statements of operations and comprehensive loss. Interest, amortization of premiums, and accretion of discount on all investments classified as available-for-sale are also included as a component of other income (expense), net, in the condensed consolidated statements of operations and comprehensive loss.

A summary of the Company's cash, cash equivalents and investments as of September 30, 2014 is as follows:
Cash and Cash Equivalents:
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Cash
 
$
50,126

 
$

 
$

 
$
50,126

Money market funds
 
20,529

 

 

 
20,529

Certificates of deposits
 
1,685

 

 

 
1,685

 
 
$
72,340

 
$

 
$

 
$
72,340

 
 
 
 
 
 
 
 
 
Investments:
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
U.S. government agency bonds
 
$
7,002

 
$

 
$
(9
)
 
$
6,993

Corporate bonds and commercial paper
 
6,201

 

 
(11
)
 
6,190

Certificates of deposit
 
4,845

 

 

 
4,845

 
 
$
18,048

 
$

 
$
(20
)
 
$
18,028


A summary of the Company's cash and cash equivalents as of December 31, 2013 is as follows:
 
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Cash
 
$
18,675

 
$

 
$

 
$
18,675

 
 
$
18,675

 
$

 
$

 
$
18,675


The Company may sell its investments at any time, without significant penalty, for use in current operations or for other purposes, even if they have not yet reached maturity. As a result, the Company classifies its investments, including investments with maturities beyond 12 months as current assets in the accompanying condensed consolidated balance sheets.


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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

The following table summarizes the estimated fair value of the Company's investments, designated as available-for-sale and classified by the contractual maturity date of the investments as of the dates shown:

 
 
September 30, 2014
 
December 31, 2013
Due within one year or less
 
$
4,926

 
$

Due after one year through five years
 
13,102

 

Total
 
$
18,028

 
$



The Company has certain available-for-sale investments in a gross unrealized loss position, all of which have been in such position for less than 12 months. The Company reviews its debt securities classified as short-term investments on a regular basis to evaluate whether or not any security has experienced an other than temporary decline in fair value. The Company considers factors such as the length of time and extent to which the market value has been less than the cost, the financial position and near-term prospects of the issuer and its intent to sell, or whether it is more likely than not the Company will be required to sell the investment before recovery of the investment's amortized-cost basis. If the Company determines that an other than temporary decline exists in one of these investments, the respective investment would be written down to fair value. For debt securities, the portion of the write-down related to credit loss would be recognized to other income, net in the condensed consolidated statements of operations and comprehensive loss. Any portion not related to credit loss would be included in accumulated other comprehensive loss. Because the Company does not intend to sell any investments which have an unrealized loss position at this time, and it is not more likely than not that the Company will be required to sell the investment before recovery of its amortized cost basis, which may be maturity, the Company does not consider the investments with unrealized loss positions to be other than temporarily impaired as of September 30, 2014.
The following table shows the fair values and the gross unrealized losses of these available-for-sale investments aggregated by investment category as of as of September 30, 2014:
 
 
 
Fair Value
 
Gross Unrealized Loss
U.S. government agency bonds
 
$
6,993

 
$
(9
)
Corporate bonds and commercial paper
 
6,190

 
(11
)
Total
 
$
13,183

 
$
(20
)

The Company did not have any available-for-sale investments as of December 31, 2013.

4. Fair Value Measurements

The carrying values of the Company's financial instruments, principally cash equivalents, accounts receivable, restricted cash and accounts payable, approximated their fair values due to the short period of time to maturity or repayment. The carrying values of the Company's debt instruments approximated their fair value based on rates currently available to the Company.


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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

Fair value is defined as the exchange price that would be received for an asset or an exit price paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The current accounting guidance for fair value measurements defines a three-level valuation hierarchy for disclosures as follows:

Level I—Unadjusted quoted prices in active markets for identical assets or liabilities;

Level II—Inputs other than quoted prices included within Level I that are observable, unadjusted quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data; and

Level III—Unobservable inputs that are supported by little or no market activity, which requires the Company to develop its own assumptions.

The categorization of a financial instrument within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

The following table details the fair value hierarchy of the Company's financial assets measured at fair value on a recurring basis as of September 30, 2014:

 
 
 
 
Fair Value Measurements Using:
Cash Equivalents:
 
Fair Value
 
Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
Money market funds
 
$
20,529

 
$
20,529

 
$

 
$

Certificates of deposits
 
1,685

 

 
1,685

 

 
 
$
22,214

 
$
20,529

 
$
1,685

 
$

 
 
 
 
 
 
 
 
 
Investments:
 
Fair Value
 
Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
U.S. government agency bonds
 
$
6,993

 
$

 
$
6,993

 
$

Corporate bonds and commercial paper
 
6,190

 

 
6,190

 

Certificates of deposit
 
4,845

 

 
4,845

 

 
 
$
18,028

 
$

 
$
18,028

 
$


All Company assets with fair values measured on a recurring basis, which consists only of cash and cash equivalents, as of December 31, 2013, were classified as Level 1 assets.

The Company determines the fair value of its investment holdings based on pricing from our pricing vendors. The valuation techniques used to measure the fair value of financial instruments having Level 2 inputs were derived from non-binding consensus prices that are corroborated by observable market data or quoted market prices for similar instruments. Such market prices may be quoted prices in active markets for identical assets (Level 1 inputs) or pricing determined using inputs other than quoted prices that are observable either directly or indirectly (Level 2 inputs).


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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

5. Debt

In September 2008, the Company entered into a loan and security agreement with a financial institution to provide a line of credit and term loan facility. The loan and security agreement was amended periodically as the Company's operations grew, most recently in May 2012 when the line of credit was increased from $7.0 million to $10.0 million. Amounts borrowed under the line of credit which were deemed an accounts receivable advance accrued interest at an annual rate equal to the greater of the financial institution's prime rate plus 1.50%, or 5.50%. Amounts borrowed under the line of credit which were deemed a contract revenue advance accrued interest at an annual rate equal to the greater of the financial institution's prime rate plus 2.25%, or 6.25%. From January 1, 2013 through the April 2013 termination of the loan and security agreement, the Company paid interest of 5.50% on borrowings deemed accounts receivable advances, and made no borrowings deemed to be contract revenue advances. In April 2013 the Company entered into a new credit agreement with another financial institution at which time the Company paid and terminated this loan and security agreement.

In April 2013 the Company entered into a secured credit facility agreement, or Credit Facility, with Wells Fargo Bank, National Association, or Wells Fargo, which the Company and Wells Fargo subsequently amended on March 24, 2014 and again on August 11, 2014. The Credit Facility, as amended, provides for a line of credit of up to $25.0 million, with an accordion feature, or Accordion Feature, allowing the Company to increase its maximum borrowings by up to an additional $25.0 million, subject to certain conditions and limitations, including that borrowings at any time shall be limited to 75% of the Company's trailing twelve-month recurring revenues. Access to the total borrowings available under the Credit Facility is restricted based on covenants related to the Company's minimum liquidity and adjusted EBITDA. Amounts borrowed under the Credit Facility accrue interest, at the Company's election at either: (i) the per annum rate equal to the LIBOR rate plus an applicable margin; or (ii) the current base rate plus the greater of the U.S. Federal Funds rate plus one percentage point, the one-month LIBOR plus one percentage point, or the lending financial institution's prime rate. The Company pays a monthly fee based on the total unused borrowings balance, an annual administrative fee and the initial closing fee, which is paid in three equal annual installments over the first three years of the Credit Facility. The Accordion Feature expires in October 2016, at which time maximum borrowings under the Facility are reduced to $25.0 million, and the Credit Facility matures in April 2017, at which time any outstanding borrowings and accrued interest become payable. In April 2013, the Company drew an advance on the Credit Facility of $2.5 million to pay off its existing loan and security agreement with another institution. In June 2013, the Company drew an advance on the Credit Facility of $3.9 million to fund capital expenditures and secured a letter of credit for the benefit of the landlord of its new corporate headquarters in the amount of $3.0 million. On February 26, 2014, the Company drew an advance of $12.5 million on the Credit Facility, which was subsequently repaid in full on March 17, 2014.

On March 24, 2014, the Company entered into Amendment Number One to the Credit Facility in connection with, and effective upon, the closing of the Company's initial public offering of shares of its common stock, or IPO, which occurred on March 25, 2014. The amendment primarily modified the definition of "Change of Control" in the Credit Facility. On April 22, 2014, the Company paid $4.2 million on the Credit Facility.
On August 11, 2014, the Company entered into Amendment Number Two to the Credit Facility, which modified the Credit Facility to add the Accordion Feature and modified or eliminated certain of the Company's financial covenants and fees it owes under the Credit Facility. On September 5, 2014, the Company paid $2.0 million on the Credit Facility.
As of September 30, 2014, the Company had borrowings of less than $0.1 million and a secured letter of credit of $3.0 million against the Credit Facility, leaving an available balance of approximately $22.0 million, and the interest rate applicable to the Credit Facility was 4.7%. The Credit Facility is collateralized by substantially all of the Company's assets and requires that the Company maintain certain financial covenants as provided in the Credit Facility. The Company was in compliance with all financial covenants as of September 30, 2014.


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Table of Contents
Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

6. Commitments and Contingencies
Operating and Capital Lease Commitments
The Company leases office space for its corporate headquarters in Austin, Texas under a non-cancelable operating lease that expires in April 2021 and a regional sales office in Atlanta, Georgia under a non-cancelable operating lease that expires in January 2016. In addition, the Company leases office space for its previous corporate headquarters in Austin, Texas under a non-cancelable operating lease that expires in March 2015. All of the rentable space covered by this lease has been sublet to a tenant for substantially all of the remainder of the lease. Rent expense under operating leases was $0.3 million for each of the three months ended September 30, 2014 and 2013 and was $0.8 million and $1.1 million for the nine months ended September 30, 2014 and 2013, respectively. In 2013, the Company moved to its current headquarters. As a result, the Company vacated its former leased headquarters and recorded an estimated unoccupied lease charge of $0.2 million for the remaining contractual lease payments less estimated sublease income.
New Facilities Lease
On July 18, 2014, the Company entered into an office lease agreement, or the Lease, with CREF Aspen Lake Building II, LLC to lease approximately 70,000 rentable square feet, or the Premises, of an office building to be located immediately adjacent to the Company's current headquarters in order to expand the Company's headquarters. The Lease provides for phased commencement dates, with commencement of the first phase covering 55,000 rentable square feet anticipated to occur on November 1, 2015, or the Initial Commencement Date, with the remaining space becoming available nine months thereafter. The actual commencement dates are subject to timely completion of the construction of the Premises. The term of the Lease commences on the Initial Commencement Date and runs 124 months, with a five year renewal option, and the rent obligations under the Lease begin with rents of $98 per month, which escalate over the course of the Lease to $160 per month in the final four months of the Lease's term.
The Company has entered into various capital lease arrangements to obtain property and equipment for its data center and corporate operations. These agreements expire over various terms from September 2014 through May 2017 and the leases are secured by the underlying leased property and equipment.

Future minimum payments required under capital and operating leases that have initial or remaining non-cancelable lease terms in excess of one year at September 30, 2014 were as follows:

 
 
Capital Leases
 
Operating Leases
Year Ended December 31,
 
 
 
 
2014 (from October 1 to December 31)
 
$
143

 
$
504

2015
 
418

 
2,054

2016
 
164

 
3,023

2017
 
4

 
3,289

2018
 

 
3,371

Thereafter
 

 
16,899

Total minimum lease payments
 
729

 
$
29,140

Less: imputed interest
 
(17
)
 
 
Less: current portion
 
(453
)
 
 
Capital lease obligations, net of current portion
 
$
259

 
 


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Table of Contents
Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

Contractual Commitments
The Company has non-cancelable contractual commitments related to third-party products, co-location fees and other product costs. Future minimum contractual commitments that have initial or remaining non-cancelable terms in excess of one year were as follows:
 
 
Contractual Commitments
Year Ended December 31,
 
 
2014 (from October 1 to December 31)
 
$
1,340

2015
 
4,814

2016
 
4,188

2017
 
2,608

2018
 
2,019

Thereafter
 
2,955

Total commitments
 
$
17,924

Legal Proceedings
From time to time, the Company may become involved in legal proceedings arising in the ordinary course of its business. The Company is not presently a party to any legal proceedings that, if determined adversely to the Company, would have a material adverse effect on the Company.
7. Stockholder's Equity
Initial Public Offering

On March 25, 2014, the Company completed its IPO of 7,761 shares of common stock at $13.00 per share. The total shares sold in the IPO included 1,511 shares sold by selling stockholders. After deducting the payment of underwriters' discounts and commissions and offering costs, the net proceeds to the Company from the sale of shares in the offering were approximately $72.6 million.

Underwriter's Exercise Of Option to Purchase Additional Shares

On April 2, 2014, pursuant to the terms of the Company's IPO, which occurred on March 25, 2014, the underwriters exercised their option to purchase an additional 1,164 shares to cover over-allotments. After deducting the payment of underwriters' discounts and commissions and offering costs, the Company received net proceeds from the sale of shares totaling approximately $13.7 million.

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Table of Contents
Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)


Conversion of Redeemable Common and Preferred Stock

Immediately prior to the closing of the IPO, which occurred on March 25, 2014, each share of the Company's outstanding preferred, junior preferred and redeemable common stock was converted into one share of undesignated common stock. The following table presents the conversion of all classes of stock on March 25, 2014:
 
 
Prior to Conversion
 
Subsequent to Conversion
Convertible preferred stock
 
 
 
 
       Series A
 
7,908

 

       Series B
 
1,818

 

       Series C
 
2,605

 

Redeemable common stock
 
3,829

 

Junior preferred stock
 
1,251

 

Undesignated common stock
 

 
17,412


8. Stock-Based Compensation
In March 2014, the Company's board of directors approved the 2014 Equity Incentive Plan, or 2014 Plan, under which stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares and units and other cash-based or stock-based awards may be granted to employees, consultants and directors. Shares of common stock that are issued and available for issuance under the 2014 Plan consist of authorized, but unissued or reacquired shares of common stock or any combination thereof.
A total of 1,850 shares of the Company's common stock was initially authorized and reserved for issuance under the 2014 Plan. This reserve will automatically increase on January 1, 2015 and each subsequent anniversary through 2024, by an amount equal to the smaller of (a) 4.5% of the number of shares of common stock issued and outstanding on the immediately preceding December 31, or (b) an amount determined by the Company's board of directors. This reserve is automatically increased to include any outstanding shares under the Company's 2007 Stock Plan, or 2007 Plan, at the time of its termination or issuable upon expiration or termination of options granted under the Company's 2007 Plan that expire or terminate without having been exercised in full. Pursuant to the terms of the 2014 Plan, 107 shares available for future issuance under the 2007 Plan were transferred to the 2014 Plan, providing a total of 1,957 shares of common stock allocated for issuance under the 2014 Plan. In addition, 40 shares have been returned to the 2014 Plan as a result of termination of options that expired or terminated without having been exercised under the previously terminated 2007 Plan, resulting in a total of 1,997 shares available for issuance under the 2014 Plan. As of September 30, 2014, options to purchase a total of 505 shares of common stock have been granted under the 2014 Plan, 4 shares have been returned to the 2014 Plan as a result of termination of options that expired or terminated without having been exercised, and 1,496 shares of common stock remain available for future issuance under the 2014 Plan.
In July 2007, the Company adopted the 2007 Plan under which options or stock purchase rights may be granted to employees, consultants and directors. In February 2014, the board of directors, under the authority granted to it by the 2007 Plan, increased the number of shares available to be granted under the plan by 1,400 shares, and as of September 30, 2014, a total of 9,182 shares of common stock were allocated for issuance under the plan. Upon the completion of the Company's IPO in March 2014, the board of directors terminated the 2007 Plan in connection with the IPO and pursuant to the terms of the 2014 Plan, 107 shares that were available for future issuance under the 2007 Plan at such time were transferred to the 2014 Plan. No shares remain available for future issuance of awards under the 2007 Plan. The 2007 Plan will continue to govern the terms and conditions of all outstanding equity awards granted under the 2007 Plan. Shares of common stock that are issued and were available for issuance under the 2007 Plan consist of authorized, but unissued or reacquired shares of common stock or any combination thereof.

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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

The following summarizes the assumptions used for estimating the fair value of stock options granted during the periods indicated:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Risk-free interest rate
 
1.6%
 
1.3%
 
1.2 - 2.0%
 
0.7 - 1.3%
Expected life (in years)
 
4.8
 
4.8
 
3.8 - 6.3
 
4.8
Expected volatility
 
46.5%
 
46.8%
 
45.1 - 46.8%
 
46.8 - 49.4%
Dividend yield
 
 
 
 
Weighted-average grant date fair value per share          
 
$6.20
 
$3.17
 
$5.55
 
$3.09

Stock option activity during the nine months ended September 30, 2014 was as follows:
 
 
Number of
Options
 
Weighted
Average
Exercise Price
Balance as of January 1, 2014
 
5,422

 
$
2.76

Granted
 
2,258

 
9.80

Exercised
 
(1,081
)
 
0.97

Forfeited
 
(48
)
 
7.22

Balance as of September 30, 2014
 
6,551

 
$
5.45


The summary of stock options outstanding as of September 30, 2014 is as follows:
 
 
Options Outstanding
 
Options Exercisable
Range of Exercise Prices
 
Number of
Options
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual Life
(in years)
 
Number of
Options
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual Life
(in years)
$0.29 - $0.35
 
1,135

 
$
0.32

 
3.4
 
1,135

 
$
0.32

 
3.4

$0.54 - $0.84
 
592

 
0.74

 
5.3
 
586

 
0.74

 
5.3

$1.74 - $3.10
 
1,181

 
2.80

 
7.1
 
884

 
2.73

 
7.1

$4.00 - $7.82
 
1,406

 
6.88

 
5.9
 
477

 
6.20

 
5.9

$8.35
 
1,737

 
8.35

 
6.3
 

 

 

$13.00 - $15.50
 
500

 
14.82

 
6.8
 
14

 
13.00

 
6.5

 
 
6,551

 
$
5.45

 
5.8
 
3,096

 
$
2.05

 
5.2

The aggregate intrinsic value of stock options exercised during each of the three months ended September 30, 2014 and 2013 was $1.4 million and less than $0.1 million, respectively. The aggregate intrinsic value of stock options exercised during each of the nine months ended September 30, 2014 and 2013 was $9.1 million and $4.4 million, respectively. The total fair value of stock options vested during each of the three months ended September 30, 2014 and 2013 was $0.5 million and $0.5 million, respectively. The total fair value of stock options vested during each of the nine months ended September 30, 2014 and 2013 was $1.3 million and $1.1 million, respectively. As of September 30, 2014, total unrecognized stock-based compensation expense, adjusted for estimated forfeitures, related to stock options was $14.5 million, which the Company expects to recognize over the next 3.2 years.

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Q2 HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
(in thousands, except per share amounts and unless otherwise indicated)

9. Income Taxes
In accordance with applicable accounting guidance, the income tax provision for the three and nine month periods ended September 30, 2014 is based on the estimated annual effective tax rate for fiscal year 2014. The estimated effective tax rate may be subject to adjustment in subsequent quarterly periods as the estimates of pretax income for the year, along with other items that may affect the rate, change.

For each of the three and nine month periods ended September 30, 2014, the Company's provision for income taxes reflected an effective tax rate of approximately 0.3%, and for each of the three and nine month periods ended September 30, 2013 the Company's provision for income taxes reflected an effective tax rate of approximately 0.3%. For the three and nine months ended September 30, 2014 and 2013, the Company's effective tax rate was lower than the U.S. federal statutory rate primarily due to changes to its valuation allowance.

The Company has significant deferred tax assets related to its net operating loss carryforwards and tax credits and has provided a valuation allowance for the full amount of its deferred tax assets, as it is not more likely than not that any future benefit from deductible temporary differences, net operating loss carryforwards, and tax credit carryforwards will be realized. This assessment requires judgment as to the likelihood and amounts of future taxable income by tax jurisdiction.

To date, the Company has provided a full valuation allowance against its deferred tax assets as it believes the objective and verifiable evidence of its historical pretax net losses outweighs any positive evidence of its forecasted future results. Although the Company believes that its tax estimates are reasonable, the ultimate tax determination involves significant judgment that is subject to audit by tax authorities in the ordinary course of business. The Company will continue to monitor the positive and negative evidence, and it will adjust the valuation allowance as sufficient objective positive evidence becomes available.

The Company had no unrecognized tax benefits as of September 30, 2014. The Company's tax years 2010 through 2013 remain open to examination by the major taxing jurisdictions to which the Company is subject. However, the Company is not currently under examination by any taxing jurisdiction.

10. Discontinued Operations
On March 1, 2013, the Company distributed all of the shares of a subsidiary to the Company's stockholders in a spin-off. However, since all shares of the subsidiary were distributed in 2013, the Company's condensed consolidated statements of operations and comprehensive loss and statements of cash flows have been presented to show the discontinued operations of the subsidiary separately from continuing operations for all periods presented. Since the transaction was between entities under common control, the distribution of the shares of the subsidiary did not result in a gain or loss on distribution as it was recorded at historical carrying values.

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Special Note Regarding Forward-Looking Statements

This quarterly report on Form 10-Q contains forward-looking statements that are based on our management's beliefs and assumptions and on information currently available to our management. The statements contained in this quarterly report on Form 10-Q that are not purely historical are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. You can identify these statements by words such as "anticipates," "believes," "can," "continue," "could," "estimates," "expects," "intends," "may," "plans," "seeks," "should," "will," "strategy," "future," "likely," or "would" or the negative of these terms or similar expressions. These statements are not guarantees of future performance or development and involve known and unknown risks, uncertainties and other factors that are in some cases beyond our control. All of our forward-looking statements are subject to risks and uncertainties that may cause our actual results to differ materially from our expectations. Factors that may cause such differences include, but are not limited to, the risks described under "Risk Factors" in this Form 10-Q and those discussed in other documents we file with the Securities and Exchange Commission, or the 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 quarterly report on Form 10-Q. You should read this quarterly report on Form 10-Q completely and with the understanding that our actual future results may be materially different from what we expect. We hereby qualify our forward-looking statements by these cautionary statements. 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 from those anticipated in these forward-looking statements, even if new information becomes available in the future.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our interim condensed consolidated financial statements and related notes included elsewhere in this quarterly report on Form 10-Q and in our other SEC filings, including the audited consolidated financial statements included in our prospectus filed pursuant to Rule 424(b) under the Securities Act with the SEC on March 20, 2014, related to our initial public offering, or IPO.
Overview

We are a leading provider of secure, cloud-based virtual banking solutions. We enable regional and community financial institutions, or RCFIs, to deliver a robust suite of integrated virtual banking services and engage more effectively with their retail and commercial account holders who expect to bank anytime, anywhere and on any device. Our solutions are often the most frequent point of interaction between our RCFI customers and their account holders. As such, we purpose-built our solutions to deliver a compelling, consistent user experience across digital channels and drive the success of our customers by extending their local brands, enabling improved account holder retention and creating incremental sales opportunities.

The effective delivery and management of secure and advanced virtual banking solutions in the complex and heavily-regulated financial services industry require significant resources, personnel and expertise. We provide virtual banking solutions that are designed to be highly configurable, scalable and adaptable to the specific needs of our RCFI customers. Our solutions deliver to account holders a unified virtual banking experience across online, mobile, voice and tablet channels by leveraging a common platform that integrates our solutions with each other and with our customers' other internal and third-party systems. In addition, we design our solutions and our data center infrastructure to comply with stringent security and technical regulations applicable to financial institutions and to safeguard our customers and their account holders through features such as real-time risk and fraud analytics.

We deliver our solutions to the substantial majority of our customers using a software-as-a-service, or SaaS, model under which our customers pay subscription fees for the use of our solutions. A small portion of our customers host our solutions in their own data centers under term license and maintenance agreements. Our customers have numerous account holders, and those account holders can represent one or more registered users on our solutions. We price our solutions based on the number of solutions purchased by our customers and the number of registered users utilizing our solutions. We earn additional revenues based on the number of bill-pay and certain other transactions that registered users perform on our virtual banking solutions in excess of the levels included in our standard subscription fee. As a result, our revenues grow as our customers buy more

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solutions from us and increase the number of registered users utilizing our solutions and as those users increase their number of transactions on our solutions.

We have achieved significant growth since our inception. During each of the past three years, our average number of registered users per installed customer has grown, and we have been able to sell additional solutions to existing customers. Our revenues per installed customer and per registered user vary period-to-period based on the length and timing of customer implementations, changes in the average number of registered users per customer, sales of additional solutions to existing customers, changes in the number of transactions on our solutions by registered users and variations among existing customers and new customers with respect to the mix of purchased solutions and related pricing.

We believe we have a significant opportunity to continue to grow our business, and we intend to invest across our organization to increase our revenues and improve our operating efficiencies. These investments will increase our costs on an absolute dollar basis, but the timing and amount of these investments will vary based on the rate at which we expect to add new customers, the implementation and support needs of our customers, our software development plans, our technology infrastructure requirements and the internal needs of our organization. Many of these investments will occur in advance of our realizing any resultant benefit which may make it difficult to determine if we are effectively allocating our resources.

If we are successful in growing our revenues by increasing the number and scope of our customer relationships, we anticipate that greater economies of scale and increased operating leverage will improve our margins over the long term. We also anticipate that increases in the number of registered users for existing customers will improve our margins. However, we do not have any control or influence over whether account holders elect to become registered users of our customers' virtual banking services.

We sell our solutions primarily through our professional sales organization. Our target market of over 13,500 RCFIs is well-defined as a result of applicable governmental regulations. As a result, we are able to effectively concentrate our sales and marketing efforts on these readily-identifiable financial institutions. We intend to add sales representatives for both banks and credit unions across the U.S. We also expect to increase our number of sales support and marketing personnel, as well as our investment in marketing initiatives designed to increase awareness of our solutions and generate new customer opportunities.

We seek to help our RCFI customers succeed by providing advanced virtual banking solutions that allow our customers to distinguish themselves from competing financial institutions and better engage with their account holders. We believe that we successfully compete in our market due to our deep domain expertise, reputation for innovation and the quality, breadth and integration of our solutions and common platform. We have made significant investments, and intend to increase investments, in technology innovation and software development as we enhance our solutions and platform and increase or expand the number of solutions that we offer to RCFIs and their account holders.

We believe that delivery of consistent, high-quality customer support is a significant driver of RCFI purchasing and renewal decisions. To develop and maintain a reputation for high-quality service, we seek to build deep relationships with our customers through our customer service organization, which we staff with personnel who are motivated by our common mission of using technology to help RCFIs succeed and who are knowledgeable with respect to the regulated and complex nature of the financial services industry. As we grow our business, we must continue to invest in and grow our services organization to support our customers' needs and maintain our reputation.

On March 25, 2014, we completed our IPO of 7,760,870 shares of common stock at a price of $13.00 per share, before underwriting discounts and commissions, and on April 2, 2014 we completed the sale of an additional 1,164,131 shares of our common stock, at a price of $13.00 per share, before underwriting discounts and commissions, as a result of the underwriters' exercise of their over-allotment option to purchase additional shares. We sold 7,414,131 of such shares, and existing stockholders sold an aggregate of 1,510,870 of such shares. The IPO generated net proceeds to us of approximately $86.3 million, after deducting $10.1 million in underwriting discounts and commissions and offering costs, which have been recorded against the proceeds received from the IPO. We did not receive any proceeds from the sale of shares by the selling stockholders in the IPO.
There have been no material changes in the planned use of proceeds from our IPO from that described in the final prospectus filed with the SEC pursuant to Rule 424(b) on March 20, 2014. With a portion of the proceeds of the IPO, we repaid approximately $6.2 million of our outstanding indebtedness under our credit facility with Wells Fargo Bank, National Association, or Credit Facility.

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Key Operating Measures

In addition to the GAAP measures described below in "Management's Discussion and Analysis of Financial Condition and Results of Operations—Components of Operating Results," we monitor the following operating measures to evaluate growth trends, plan investments and measure the effectiveness of our sales and marketing efforts:

Installed Customers

We define installed customers as the number of customers from which we are currently recognizing revenues. The average size of our installed customers, measured in both registered users per installed customer and revenues per installed customer, has increased over time as our existing installed customers continue to add registered users and buy more solutions from us, and as we add larger RCFIs to our installed customer base. The rate at which we add installed customers varies based on our implementation capacity, the size and unique needs of our customers and the readiness of our customers to implement our solutions. We had 334, 299 and 249 installed customers as of December 31, 2013, 2012 and 2011, respectively.

Registered Users

We define a registered user as an individual related to an account holder of an installed customer who has registered to use one or more of our solutions and has current access to use those solutions as of the last day of the reporting period presented. We price our solutions based on the number of registered users, so as the number of registered users of our solutions increases, our revenues grow. Our average number of registered users per installed customer grows as our existing customers add more registered users and as we add larger RCFIs to our installed customer base. We anticipate that the number of registered users will grow at a faster rate than our number of installed customers. The rate at which our customers add registered users and the incremental revenues we recognize from new registered users vary significantly period-to-period based on the timing of our implementations of new customers and the timing of registration of new users. Our installed customers had approximately 3.1 million, 2.4 million and 1.1 million registered users as of December 31, 2013, 2012 and 2011, respectively. Registered users at September 30, 2014 were 4.1 million compared to 3.0 million at September 30, 2013.

Revenue Retention Rate

We believe that our ability to retain our installed customers and expand their use of our products and services over time is an indicator of the stability of our revenue base and the long-term value of our customer relationships. We assess our performance in this area using a metric we refer to as our revenue retention rate. We calculate our revenue retention rate as the total revenues in a calendar year from customers who were installed customers as of December 31 of the prior year, expressed as a percentage of the total revenues during the prior year from those installed customers. Our revenue retention rate provides insight into the impact on current year revenues of the number of new customers implemented during the prior year, the timing of our implementation of those new customers in the prior year, growth in the number of registered users and changes in their usage of our solutions, sales of new products and services to our existing installed customers during the current year and customer attrition. The most significant drivers of changes in our revenue retention rate each year have historically been the number of new customers in the prior year and the timing of our implementation of those new customers. The timing of our implementation of new customers in the prior year is significant because we do not start recognizing revenues from new customers until they become installed customers. If implementations are weighted more heavily in the first or second half of the prior year, our revenue retention rate will be lower or higher, respectively. Our revenue retention rate was 128%, 136% and 126% for the years ended December 31, 2013, 2012 and 2011, respectively.

Churn

We utilize churn to monitor the satisfaction of our clients and evaluate the effectiveness of our business strategies. We define churn as the amount of any monthly recurring revenue losses due to customer cancellations and downgrades, net of upgrades and additions of new solutions, during a year, divided by our monthly recurring revenue at the beginning of the year. Cancellations refer to customers that have either stopped using our services completely or remained a customer but terminated a particular service. Downgrades are a result of customers taking less of a particular service or renewing their contract for identical services at a lower price. We had annual churn of 3.5%, 3.6% and 5.4% for the years ended December 31, 2013, 2012 and 2011, respectively. Our use of churn has limitations as an analytical tool, and investors should not consider it in isolation. Other companies in our industry may calculate churn differently, which reduces its usefulness as a comparative measure.


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Adjusted EBITDA

We define adjusted EBITDA as net loss before depreciation, amortization, loss from discontinued operations, stock-based compensation, provision for income taxes, total other expense, net, unoccupied lease charges and disposal of long-lived assets. We believe that adjusted EBITDA provides useful information to investors and others in understanding and evaluating our operating results for the following reasons:

adjusted EBITDA is widely used by investors and securities analysts to measure a company's operating performance without regard to items that can vary substantially from company to company depending upon their financing, capital structures and the method by which assets were acquired;

our management uses adjusted EBITDA in conjunction with GAAP financial measures for planning purposes, in the preparation of our annual operating budget, as a measure of our operating performance, to assess the effectiveness of our business strategies and to communicate with our board of directors concerning our financial performance;

adjusted EBITDA provides more consistency and comparability with our past financial performance, facilitates period-to-period comparisons of our operations and also facilitates comparisons with other companies, many of which use similar non-GAAP financial measures to supplement their GAAP results; and

our investor and analyst presentations include adjusted EBITDA as a supplemental measure of our overall operating performance.

Adjusted EBITDA should not be considered as an alternative to net loss or any other measure of financial performance calculated and presented in accordance with GAAP. The use of adjusted EBITDA as an analytical tool has limitations such as:

depreciation and amortization are non-cash charges, and the assets being depreciated or amortized will often have to be replaced in the future and adjusted EBITDA does not reflect cash requirements for such replacements;

adjusted EBITDA may not reflect changes in, or cash requirements for, our working capital needs or contractual commitments;

adjusted EBITDA does not reflect the potentially dilutive impact of stock-based compensation;

adjusted EBITDA does not reflect interest or tax payments that could reduce cash available for use; and

other companies, including companies in our industry, might calculate adjusted EBITDA or similarly titled measures differently, which reduces their usefulness as comparative measures.

Because of these and other limitations, you should consider adjusted EBITDA together with our GAAP financial measures including cash flow from operations and net loss. The following table presents a reconciliation of net loss to adjusted EBITDA for each of the periods indicated (in thousands):
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Reconciliation of net loss to adjusted EBITDA:
 
 
 
 
 
 
 
 
Net loss
 
$
(4,625
)
 
$
(5,179
)
 
$
(14,874
)
 
$
(11,376
)
     Depreciation and amortization
 
1,092

 
809

 
3,122

 
2,071

     Stock-based compensation expense
 
1,101

 
412

 
3,087

 
1,122

     Loss from discontinued operations, net of tax
 

 

 

 
199

     Provision for income taxes
 
18

 
14

 
51

 
33

     Interest (income) expense, net
 
82

 
170

 
408

 
337

     Unoccupied lease charges
 

 
88

 

 
236

Adjusted EBITDA
 
$
(2,332
)
 
$
(3,686
)
 
$
(8,206
)
 
$
(7,378
)


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Components of Operating Results

Revenues

All of our revenue-generating activities directly relate to the sale, implementation and support of our solutions within a single operating segment. We derive the substantial majority of our revenues from subscription fees for the use of our solutions hosted in our data centers as well as revenues for implementation and customer support services related to our solutions. A small portion of our customers host our solutions in their own data centers under term license and maintenance agreements, and we recognize the corresponding revenues over the term of those customer agreements.

Subscription fees are based on the number of solutions purchased by our customers, the number of registered users and the number of bill-pay and certain other transactions those users conduct using our solutions in excess of the levels included in our standard subscription fee. Subscription fees are billed and recognized monthly over the term of our customer agreements. The initial term of our customer agreements averages over five years, although it varies by customer. We begin recognizing subscription fees on the date a solution is implemented and made available to the customer. The timing of our implementations vary period-to-period based on our implementation capacity, the number of solutions purchased by our customers, the size and unique needs of our customers and the readiness of our customers to implement our solutions. We recognize any related implementation services revenues ratably over the initial agreement term beginning on the date we commence recognizing subscription fees. Amounts that have been invoiced but not paid are recorded in accounts receivable and in revenues or deferred revenues, depending on whether our revenue recognition criteria have been met.

We consider subscription fees to be fixed or determinable unless the fees are subject to refund or adjustment or are not payable within our standard payment terms. In determining whether collection of subscription fees is reasonably assured, we consider financial and other information about customers, such as a customer's current credit-worthiness and payment history over time. Historically, our bad debt expenses have not been significant.

Cost of Revenues

Cost of revenues is comprised primarily of salaries and other personnel-related costs, including employee benefits, bonuses and stock-based compensation, for employees providing services to our customers. This includes the costs of our implementation, customer support, data center and customer training personnel as well as a reclassification of costs related to research and development personnel who perform implementation and customer support services. Cost of revenues also includes the direct costs of bill-pay and other third-party intellectual property included in our solutions, the amortization of deferred solution and services costs, co-location facility costs and depreciation of our data center assets, an allocation of general overhead costs and referral fees. We allocate general overhead expenses to all departments based on the number of employees in each department, which we consider to be a fair and representative means of allocation.

The amount of research and development costs reclassified to cost of revenues was $0.5 million and $0.4 million for the three months ended September 30, 2014 and 2013, respectively, and was $1.3 million and $1.2 million for the nine months ended September 30, 2014 and 2013, respectively.

We capitalize certain personnel costs directly related to the implementation of our solution to the extent those costs are considered to be recoverable from future revenues. We amortize the costs for a particular implementation once revenue recognition commences, and we amortize those implementation costs over the remaining term of the customer agreement. Other costs not directly recoverable from future revenues are expensed in the period incurred. We capitalized implementations costs in the amount of $1.2 million and $0.9 million for the three months ended September 30, 2014 and 2013, respectively, and $3.0 million and $2.6 million for the nine months ended September 30, 2014 and 2013, respectively.

We intend to continue to increase our investments in our implementation and customer support teams and technology infrastructure to serve our customers and support our growth. We expect cost of revenues to continue to grow in absolute dollars as we grow our business but to fluctuate as a percentage of revenues based principally on the level and timing of implementation and support activities and other related costs.


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Operating Expenses

Operating expenses consist of sales and marketing, research and development and general and administrative expenses. We intend to continue to hire new employees and make other investments to support our anticipated growth. As a result, we expect our operating expenses to increase in absolute dollars but to decrease as a percentage of revenues over the long term as we grow our business.

Sales and Marketing

Sales and marketing expenses consist primarily of salaries and other personnel-related costs, including commissions, benefits, bonuses and stock-based compensation. Additional expenses relate to advertising, lead generation, promotional event programs, corporate communications, travel and allocated overhead.

Sales and marketing expenses as a percentage of total revenues will change in any given period based on several factors including the addition of newly-hired sales professionals, the number and timing of newly-installed customers and the amount of sales commissions expense amortized related to those customers. Commissions are generally capitalized and then amortized over the life of the customer agreement.

Sales and marketing expenses are also impacted by the timing of significant marketing programs such as our annual user conference which we typically hold during the second quarter. We plan to continue investing in sales and marketing by increasing our number of sales and marketing personnel and expanding our sales and marketing activities. We believe these investments will help us build brand awareness, add new customers and expand sales to our existing customers as they continue to buy more solutions from us, the number of registered users utilizing our solutions grows and those users increase the number of transactions on our solutions.

Research and Development

We believe that continuing to improve and enhance our solutions is essential to maintaining our reputation for innovation and growing our customer base and revenues. Research and development expenses include salaries and personnel-related costs, including benefits, bonuses and stock-based compensation, third-party contractor expenses, software development costs, allocated overhead and other related expenses incurred in developing new solutions and enhancing existing solutions. Research and development expenses are expensed as incurred. To date, software development costs eligible for capitalization have not been significant. Accordingly, we have not capitalized any software development costs, and we do not anticipate capitalizing any such costs in the foreseeable future.

General and Administrative

General and administrative expenses consist primarily of salaries and other personnel-related costs, including benefits, bonuses and stock-based compensation, of our administrative, finance and accounting, information systems, legal and human resources employees. Additional expenses include consulting and professional fees, insurance and travel. We expect our general and administrative expenses to increase as a result of our operating as a newly public company. These expenses will include costs to comply with Section 404 of the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, and other regulations governing public companies, increased costs of directors' and officers' liability insurance, increased professional services expenses and costs associated with enhanced investor relations activities.

Unoccupied Lease Charges

Unoccupied lease charges include costs related to the early exit from our previous headquarters facility, partially offset by anticipated sublease income from that facility.

Total Other Expense, Net

Total other expense, net, consists primarily of interest income and expense. We earn interest income on our cash, cash equivalents and investments, and expect interest income to increase due to the increase in our cash, cash equivalents and investments as a result of our IPO. Interest expense consists primarily of the interest incurred on outstanding borrowings under our Credit Facility. We expect interest expense to decrease in future periods as we have utilized a portion of the proceeds from our IPO to pay down a portion of our Credit Facility.

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Provision for Income Taxes

As a result of our current net operating loss position, income tax expenses consist primarily of state income taxes. We incurred minimal state income taxes for each of the three and nine months ended September 30, 2014 and 2013.

Results of Operations

Condensed Consolidated Statements of Operations Data

The following table sets forth our condensed consolidated statements of operations data for each of the periods indicated (in thousands):
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Revenues
 
$
20,989

 
$
14,325

 
$
56,981

 
$
41,203

Cost of revenues(1)(2)
 
12,143

 
9,167

 
33,185

 
25,382

Gross profit
 
8,846

 
5,158

 
23,796

 
15,821

Operating expenses:
 
 
 
 
 
 
 
 
Sales and marketing(2)
 
5,642

 
4,599

 
17,183

 
11,797

Research and development(2)
 
3,155

 
2,259

 
8,678

 
6,277

General and administrative(2)
 
4,574

 
3,207

 
12,350

 
8,318

Unoccupied lease charges
 

 
88

 

 
236

Total operating expenses
 
13,371

 
10,153

 
38,211

 
26,628

Loss from operations
 
(4,525
)
 
(4,995
)
 
(14,415
)
 
(10,807
)
Total other expense, net
 
(82
)
 
(170
)
 
(408
)
 
(337
)
Loss before income taxes
 
(4,607
)
 
(5,165
)
 
(14,823
)
 
(11,144
)
Provision for income taxes
 
(18
)
 
(14
)
 
(51
)
 
(33
)
Loss from continuing operations
 
(4,625
)
 
(5,179
)
 
(14,874
)
 
(11,177
)
Loss from discontinued operations, net of tax(3)
 

 

 

 
(199
)
Net loss
 
$
(4,625
)
 
$
(5,179
)
 
$
(14,874
)
 
$
(11,376
)
_______________________________________________________________________________

(1) 
Includes reclassified costs of research and development personnel who performed certain implementation and customer support services as follows (in thousands):
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Research and development costs reclassified into cost of revenues
 
$
517

 
$
433

 
$
1,295

 
$
1,249


(2) 
Includes stock-based compensation expenses as follows (in thousands):
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Cost of revenues
 
$
159

 
$
70

 
$
432

 
$
192

Sales and marketing
 
189

 
81

 
543

 
180

Research and development
 
131

 
64

 
360

 
189

General and administrative
 
622

 
197

 
1,752

 
561

Total stock-based compensation expenses
 
$
1,101

 
$
412

 
$
3,087

 
$
1,122


(3) 
We previously had a subsidiary which we fully divested in March 2013. Loss from discontinued operations, net of tax, reflects the financial results of this divested subsidiary.

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Table of Contents


The following table sets forth our condensed consolidated statements of operations data as a percentage of revenues for each of the periods indicated:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Revenues
 
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Cost of revenues(1)(2)
 
57.9

 
64.0

 
58.2

 
61.6

Gross profit
 
42.1

 
36.0

 
41.8

 
38.4

Operating expenses:
 
 
 
 
 
 
 
 
Sales and marketing(2)
 
26.9

 
32.1

 
30.2

 
28.6

Research and development(2)
 
15.0

 
15.8

 
15.2

 
15.2

General and administrative(2)
 
21.8

 
22.4

 
21.7

 
20.2

Unoccupied lease charges
 

 
0.6

 

 
0.6

Total operating expenses
 
63.7

 
70.9

 
67.1

 
64.6

Loss from operations
 
(21.6
)
 
(34.9
)
 
(25.3
)
 
(26.2
)
Total other expense, net
 
(0.4
)
 
(1.2
)
 
(0.7
)
 
(0.8
)
Loss before income taxes
 
(22.0
)
 
(36.1
)
 
(26.0
)
 
(27.0
)
Provision for income taxes
 
(0.1
)
 
(0.1
)
 
(0.1
)
 
(0.1
)
Loss from continuing operations
 
(22.1
)
 
(36.2
)
 
(26.1
)
 
(27.1
)
Loss from discontinued operations, net of tax(3)
 

 

 

 
(0.5
)
Net loss
 
(22.1
)%
 
(36.2
)%
 
(26.1
)%
 
(27.6
)%
_______________________________________________________________________________

(1) 
Includes reclassified costs of research and development personnel who performed certain implementation and customer support services as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Research and development costs reclassified into cost of revenues
 
2.5
%
 
3.0
%
 
2.3
%
 
3.0
%

(2) 
Includes stock-based compensation expenses as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
Cost of revenues
 
0.8
%
 
0.5
%
 
0.8
%
 
0.5
%
Sales and marketing
 
0.9

 
0.6

 
1.0

 
0.4

Research and development
 
0.6

 
0.4

 
0.6

 
0.5

General and administrative
 
3.0

 
1.4

 
3.1

 
1.4

Total stock-based compensation expenses
 
5.3
%
 
2.9
%
 
5.5
%
 
2.8
%

(3) 
We previously had a subsidiary which we fully divested in March 2013. Loss from discontinued operations, net of tax reflects the financial results of this divested subsidiary.


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Table of Contents

Comparison of Three and Nine Months Ended September 30, 2014 and 2013

Revenues
    
The following table presents our revenues for each of the periods indicated (dollars in thousands):
 
 
Three Months Ended September 30,
 
Change
 
Nine Months Ended September 30,
 
Change
 
 
2014
 
2013
 
$
 
(%)
 
2014
 
2013
 
$
 
(%)
Revenues
 
$
20,989

 
$
14,325

 
$
6,664

 
46.5
%
 
$
56,981

 
$
41,203

 
$
15,778

 
38.3
%

Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013. Revenues increased by $6.7 million, or 46.5%, from $14.3 million for the three months ended September 30, 2013 to $21.0 million for the three months ended September 30, 2014. $5.5 million of this increase was generated from the growth in new registered users from existing customers and the addition of registered users from new installed customers. The remaining $1.2 million of increase was generated from increases in the number of transactions processed using our solutions. In particular, the number of registered users on our solutions increased from 3.0 million at September 30, 2013 to 4.1 million at September 30, 2014.

Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013. Revenues increased by $15.8 million, or 38.3%, from $41.2 million for the nine months ended September 30, 2013 to $57.0 million for the nine months ended September 30, 2014. $12.9 million of this increase was generated from the growth in new registered users from existing customers and the addition of registered users from new installed customers. The remaining $2.9 million of increase was generated from increases in the number of transactions processed using our solutions. In particular, the number of registered users on our solutions increased from 3.0 million at September 30, 2013 to 4.1 million at September 30, 2014.

Cost of Revenues

The following table presents our cost of revenues for each of the periods indicated (dollars in thousands):
 
 
Three Months Ended September 30,
 
Change
 
Nine Months Ended September 30,
 
Change
 
 
2014
 
2013
 
$
 
(%)
 
2014
 
2013
 
$
 
(%)
Cost of revenues
 
$
12,143

 
$
9,167

 
$
2,976

 
32.5
%
 
$
33,185

 
$
25,382

 
$
7,803

 
30.7
%
Percentage of revenues
 
57.9
%
 
64.0
%
 
 
 
 
 
58.2
%
 
61.6
%
 
 
 
 

Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013. Cost of revenues increased by $3.0 million, or 32.5%, from $9.2 million for the three months ended September 30, 2013 to $12.1 million for the three months ended September 30, 2014. This increase was attributable to a $1.1 million increase in personnel costs due to an increase in the number of personnel who provide implementation and customer support and maintain our data centers and other technical infrastructure, a $0.9 million increase in direct costs related to bill-pay transaction processing and other third-party intellectual property included in our solutions which was related to the increase in registered users from existing customers and the increase in registered users from new customers and transactions processed on our solutions, a $0.4 million increase in co-location facility costs and depreciation of our data center assets resulting from the increased infrastructure necessary to support our growing customer base, a $0.2 million increase in facilities and other overhead costs, and a $0.2 million increase in partner referral fees which was related to the increase in revenue generated by customers subject to referral agreements.

Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013. Cost of revenues increased by $7.8 million, or 30.7%, from $25.4 million for the nine months ended September 30, 2013 to $33.2 million for the nine months ended September 30, 2014. This increase was attributable to a $3.2 million increase in personnel costs due to an increase in the number of personnel who provide implementation and customer support and maintain our data centers and other technical infrastructure, a $1.9 million increase in direct costs related to bill-pay transaction processing and other third-party intellectual property included in our solutions which was related to the increase in registered users from existing customers and the increase in registered users from new customers and transactions processed on our solutions, a $1.8 million increase in co-location facility costs and depreciation of our data center assets resulting from the increased infrastructure necessary to support our growing customer base, a $0.5 million increase in partner referral fees which was related to the increase in revenue generated by customers subject to referral agreements, and a $0.3 million increase in facilities and other overhead costs.

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Table of Contents


We defer certain payroll costs directly related to the implementation of our solutions to the extent those costs are considered to be recoverable from future revenues. However, a substantial portion of our implementation costs are not eligible for deferral and, as a result, are expensed in the period incurred. Costs related to implementations that have been deferred are amortized over the same period in which the related revenue is recognized. Additionally, we invested in personnel, business processes and systems infrastructure to standardize our business processes and drive future efficiency in our implementations, customer support and data center operations. We expect these investments in capacity and process improvement to provide opportunities for future expansion of our gross margin as we begin to achieve economies of scale.

Operating Expenses

The following tables present our operating expenses for each of the periods indicated (dollars in thousands):

Sales and Marketing
 
 
Three Months Ended September 30,
 
Change
 
Nine Months Ended September 30,
 
Change
 
 
2014
 
2013
 
$
 
(%)
 
2014
 
2013
 
$
 
(%)
Sales and marketing
 
$
5,642

 
$
4,599

 
$
1,043

 
22.7
%
 
$
17,183

 
$
11,797

 
$
5,386

 
45.7
%
Percentage of revenues
 
26.9
%
 
32.1
%
 
 
 
 
 
30.2
%
 
28.6
%
 
 
 
 

Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013. Sales and marketing expenses increased by $1.0 million, or 22.7%, from $4.6 million for the three months ended September 30, 2013 to $5.6 million for the three months ended September 30, 2014. This increase was primarily attributable to a $1.0 million increase in personnel costs due to the growth of our sales and marketing organizations, and a $0.1 million increase in travel and entertainment costs due to increased employee travel to attract new customers and efforts to support our sales and marketing initiatives. These increases were offset by a $0.1 million decrease in recruiting expenses. We anticipate that sales and marketing expenses will continue to increase in absolute dollars in the future as we add personnel to support our revenue growth and as we increase discretionary marketing spend to attract new customers, retain and grow existing customers and drive brand awareness. We expect such expenses to decline as a percentage of our revenues over time as our revenues grow.

Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013. Sales and marketing expenses increased by $5.4 million, or 45.7%, from $11.8 million for the nine months ended September 30, 2013 to $17.2 million for the nine months ended September 30, 2014. This increase was primarily attributable to a $4.3 million increase in personnel costs due to the growth of our sales and marketing organizations. Travel, recruiting and other employee related expenses increased by $0.6 million due to increased employee travel to attract new customers and efforts to support our sales and marketing initiatives and our investment in hiring new sales and marketing personnel. Discretionary marketing spend increased by $0.2 million primarily due to our increased advertising efforts to drive brand awareness and our expanded marketing efforts to attract new customers and retain and grow existing customers, which included a $0.1 million increase in costs incurred as a result of the growth in our annual client conference. Sales and marketing expenses increased by $0.2 million due to an increase in facilities and other overhead costs which were allocated to the increased personnel in our sales and marketing departments.


33

Table of Contents

Research and Development
 
 
Three Months Ended September 30,
 
Change
 
Nine Months Ended September 30,
 
Change