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Table of Contents

 

 

 

UNITED STATES
SECURITIES AND

EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

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

 

FOR THE QUARTERLY PERIOD ENDED March 31, 2015

 

OR

 

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

 

For the transition period from               to              

 

Commission File Number 001-33197

 


 

GUIDANCE SOFTWARE, INC.

(Exact name of registrant as specified in its charter)

 


 

Delaware

 

95-4661210

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

 

 

1055 E. Colorado Blvd.

 

 

Pasadena, California 91106

 

(626) 229-9191

(Address of principal executive offices)

 

Registrant’s telephone number, including area code

 

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

Common Stock, $0.001 par value per share.

 

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

None.

 


 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  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 x  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.

 

Large accelerated filer o

 

Accelerated filer x

 

 

 

Non- accelerated filer o

 

Smaller reporting company o

 

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

 

As of May 5, 2015, there were approximately 30,257,000 shares of the registrant’s Common Stock outstanding.

 

 

 



Table of Contents

 

GUIDANCE SOFTWARE, INC.

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED March 31, 2015

 

Table of Contents

 

 

Page

 

 

PART I. FINANCIAL INFORMATION

3

 

 

 

Item 1.

Financial Statements

3

 

Condensed Consolidated Balance Sheets at March 31, 2015 and December 31, 2014

3

 

Condensed Consolidated Statements of Operations for the three months ended March 31, 2015 and 2014

4

 

Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2015 and 2014

5

 

Notes to the Condensed Consolidated Financial Statements

6

Item 2.

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

19

Item 3.

Quantitative and Qualitative Disclosure about Market Risk

27

Item 4.

Controls and Procedures

27

 

 

 

PART II. OTHER INFORMATION

28

 

 

 

Item 1.

Legal Proceedings

28

Item 1A.

Risk Factors

29

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

29

Item 3.

Defaults upon Senior Securities

29

Item 4.

Removed and Reserved

29

Item 5.

Other Information

29

Item 6.

Exhibits

29

 

 

 

SIGNATURE

30

 

2



Table of Contents

 

PART I. FINANCIAL INFORMATION

 

Item 1.                                  Financial Statements

 

GUIDANCE SOFTWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

(Unaudited)

 

 

 

March 31,
2015

 

December 31,
2014

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

24,430

 

$

18,355

 

Restricted cash

 

 

153

 

Trade receivables, net of allowance for doubtful accounts of $602 and $634, respectively

 

16,949

 

20,255

 

Inventory

 

2,550

 

2,684

 

Prepaid expenses and other current assets

 

4,959

 

5,054

 

Total current assets

 

48,888

 

46,501

 

 

 

 

 

 

 

Long-term assets:

 

 

 

 

 

Property and equipment, net

 

14,420

 

14,558

 

Intangible assets, net

 

7,317

 

7,766

 

Goodwill

 

14,632

 

14,632

 

Other assets

 

2,252

 

2,370

 

Total long-term assets

 

38,621

 

39,326

 

 

 

 

 

 

 

Total assets

 

$

87,509

 

$

85,827

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

3,579

 

$

5,919

 

Accrued liabilities

 

9,961

 

8,407

 

Capital lease obligations

 

73

 

67

 

Deferred revenues

 

42,571

 

39,128

 

Total current liabilities

 

56,184

 

53,521

 

 

 

 

 

 

 

Long-term liabilities:

 

 

 

 

 

Deferred rent

 

7,516

 

7,661

 

Other long-term liabilities

 

659

 

645

 

Deferred revenues

 

6,743

 

6,232

 

Deferred tax liabilities

 

607

 

584

 

Total long-term liabilities

 

15,525

 

15,122

 

 

 

 

 

 

 

Commitments and contingencies (Note 10)

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, $0.001 par value: 10,000,000 shares authorized; no shares issued or outstanding

 

 

 

Common stock, $0.001 par value; 100,000,000 shares authorized; 31,749,000 and 31,155,000 shares issued, respectively; and 29,969,000 and 29,376,000 shares outstanding, respectively

 

26

 

25

 

Additional paid-in capital

 

112,693

 

110,265

 

Treasury stock, at cost, 1,779,000 and 1,779,000 shares, respectively

 

(11,479

)

(11,479

)

Accumulated deficit

 

(85,440

)

(81,627

)

Total stockholders’ equity

 

15,800

 

17,184

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

87,509

 

$

85,827

 

 

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

 

3



Table of Contents

 

GUIDANCE SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(Unaudited)

 

 

 

Three Months Ended
March 31,

 

 

 

2015

 

2014

 

Revenues:

 

 

 

 

 

Product revenue

 

$

7,054

 

$

6,861

 

Subscription revenue

 

1,553

 

2,377

 

Services and maintenance revenues

 

16,397

 

16,143

 

Total revenues

 

25,004

 

25,381

 

 

 

 

 

 

 

Cost of revenues (excluding amortization and depreciation, shown below):

 

 

 

 

 

Cost of product revenue

 

1,743

 

1,750

 

Cost of subscription revenue

 

1,022

 

1,133

 

Cost of services and maintenance revenues

 

5,684

 

5,808

 

Total cost of revenues (excluding amortization and depreciation, shown below)

 

8,449

 

8,691

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

Selling and marketing

 

8,944

 

10,065

 

Research and development

 

5,165

 

6,472

 

General and administrative

 

4,555

 

4,262

 

Depreciation and amortization

 

1,641

 

1,974

 

Total operating expenses

 

20,305

 

22,773

 

 

 

 

 

 

 

Operating loss

 

(3,750

)

(6,083

)

 

 

 

 

 

 

Other income and expense:

 

 

 

 

 

Interest income

 

2

 

1

 

Interest expense

 

(2

)

(4

)

Other income, net

 

8

 

20

 

Total other income and expense

 

8

 

17

 

Loss before income taxes

 

(3,742

)

(6,066

)

Income tax provision

 

71

 

78

 

Net loss

 

$

(3,813

)

$

(6,144

)

 

 

 

 

 

 

Net loss per share calculation:

 

 

 

 

 

Basic

 

$

(0.14

)

$

(0.23

)

Diluted

 

$

(0.14

)

$

(0.23

)

 

 

 

 

 

 

Weighted average number of shares used in per share calculation:

 

 

 

 

 

Basic

 

27,523

 

26,425

 

Diluted

 

27,523

 

26,425

 

 

4



Table of Contents

 

GUIDANCE SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

 

 

 

Three Months Ended
March 31,

 

 

 

2015

 

2014

 

Operating Activities:

 

 

 

 

 

Net loss

 

$

(3,813

)

$

(6,144

)

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

 

 

 

 

 

Depreciation and amortization

 

1,641

 

1,974

 

Share-based compensation

 

1,666

 

1,730

 

Deferred taxes

 

23

 

23

 

Loss on disposal of assets

 

12

 

 

Changes in operating assets and liabilities:

 

 

 

 

 

Restricted cash

 

153

 

 

Trade receivables

 

3,306

 

5,125

 

Inventory

 

134

 

79

 

Prepaid expenses and other assets

 

213

 

(793

)

Accounts payable

 

(2,913

)

(1,290

)

Accrued liabilities

 

1,409

 

(844

)

Deferred revenues

 

3,954

 

1,845

 

Net cash provided by operating activities

 

5,785

 

1,705

 

 

 

 

 

 

 

Investing Activities:

 

 

 

 

 

Purchase of property and equipment

 

(452

)

(930

)

Net cash used in investing activities

 

(452

)

(930

)

 

 

 

 

 

 

Financing Activities:

 

 

 

 

 

Proceeds from the exercise of stock options

 

764

 

645

 

Principal payments on capital lease obligations and other obligations

 

(22

)

(76

)

Net cash provided by financing activities

 

742

 

569

 

Net increase in cash and cash equivalents

 

6,075

 

1,344

 

Cash and cash equivalents, beginning of period

 

18,355

 

19,919

 

Cash and cash equivalents, end of period

 

$

24,430

 

$

21,263

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

 

 

 

 

 

 

Non-cash investing and financing activities:

 

 

 

 

 

Purchase of equipment included in accounts payable and accrued expenses

 

$

854

 

$

177

 

Capital lease obligations incurred to acquire assets

 

$

42

 

$

11

 

 

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

 

5



Table of Contents

 

GUIDANCE SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Note 1. Description of the Business

 

General

 

Guidance Software, Inc. was incorporated in the state of California in 1997 and reincorporated in Delaware on December 11, 2006.  Guidance and its subsidiaries are collectively referred to herein as “Guidance,” “we,” “our,” or the “Company.”  Headquartered in Pasadena, California, Guidance is the leading global provider of digital investigative solutions.  Our EnCase® platform provides an investigative infrastructure that enables our customers to search, collect and analyze electronically stored information in order to address human resources matters, litigation matters, allegations of fraud, suspicious network endpoint activity and to defend and secure their organization’s data assets.

 

Our main products and services are:

 

EnCase® Enterprise, a comprehensive, network-enabled digital investigative solution that enables corporations and government agencies to search, collect, preserve and analyze data across all of the servers, desktops and laptops that comprise their entire network from a single location.  It also serves as a platform on which more powerful electronic discovery and cybersecurity products, as described below, are built;

 

EnCase® Cybersecurity, which provides the ability to identify and analyze undiscovered threats, such as polymorphic or metamorphic malware, and other advanced hacking techniques that evade traditional network or host-based defenses and includes investigative capabilities that target confidential or sensitive data and perform risk mitigation by wiping sensitive data from unauthorized locations;

 

EnCase® Analytics, a security intelligence product designed to derive insights from the data generated by endpoint activity.  EnCase Analytics leverages kernel-level access for endpoint data collection providing a repository of the most reliable data for insights into undetected risks and threats.  Through its interactive visual interface, EnCase Analytics exposes suspicious patterns, commonalities, and anomalies, to proactively identify threats and minimize damage;

 

EnCase® eDiscovery, which automates the search, collection, preservation and processing of electronically stored information for litigation and compliance purposes;

 

EnCase® eDiscovery Review, a cloud-based document review and production software-as-a-service (“SaaS”) for corporations and law firms;

 

EnCase® Forensic, a desktop-based product primarily used by law enforcement, government agencies and consultancies for collecting, preserving, analyzing and authenticating electronic computer forensic data for use in criminal and civil court proceedings;

 

EnCase® Portable, a triage and collection solution, delivered on a USB device, that allows forensic professionals and non-experts to quickly and easily triage and collect digital evidence in a forensically sound and court proven manner;

 

EnCase® App Central, an online marketplace that allows development and investigation professionals the opportunity to share and discover the latest apps that complement the Company’s EnCase solutions; and

 

Tableau ™, a family of data acquisition forensic hardware products, including forensic duplicators, multiple write blockers and other hardware.

 

In addition, we complement these offerings with a comprehensive array of professional and training services including technical support and maintenance services to help our customers implement our solutions, conduct investigations and train their IT and legal professionals to effectively and efficiently use our products.

 

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Table of Contents

 

Note 2. Summary of Significant Accounting Policies

 

Basis of Presentation

 

The accompanying condensed consolidated balance sheets as of March 31, 2015 and the condensed consolidated statements of operations for the three months ended March 31, 2015 and 2014 and cash flows for the three months ended March 31, 2015 and 2014 are unaudited.  These statements should be read in conjunction with the audited consolidated financial statements and related notes, together with management’s discussion and analysis of financial position and results of operations, contained in our Annual Report on Form 10-K for the year ended December 31, 2014, filed with the U.S. Securities and Exchange Commission (the “SEC”) on February 24, 2015.

 

The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or (“GAAP”), and pursuant to the rules and regulations of the SEC for interim financial reporting.  In the opinion of our management, the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2014 and include all normal and recurring adjustments necessary for the fair presentation of our financial position as of March 31, 2015 and our results of operations for the three months ended March 31, 2015 and 2014 and our cash flows for the three months ended March 31, 2015 and 2014.  The condensed consolidated balance sheet as of December 31, 2014 has been derived from the December 31, 2014 audited financial statements.  The operating results for the three month period ended March 31, 2015 are not necessarily indicative of the results that will be achieved for the full fiscal year or for future periods.

 

The condensed consolidated financial statements include the accounts of Guidance and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

 

Use of Estimates and Assumptions

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures.  On an ongoing basis, we evaluate these estimates, including those related to revenue recognition, share-based compensation, bad debts, income taxes, contingent consideration, commitments, impairment considerations, contingencies and litigation.  We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances.  Actual results may differ from these estimates.

 

Cash and Cash Equivalents

 

We invest excess cash in money market funds and highly liquid debt instruments of the US government and its agencies. Highly liquid investments with stated maturities of three months or less from the date of purchase are classified as cash and cash equivalents.

 

Fair Value of Financial Instruments

 

The carrying amounts of cash equivalents, accounts receivable and accounts payable approximate fair value because of the short-term maturities of these instruments.  Based on borrowing rates currently available to us for borrowings with similar terms, the carrying values of our capital lease obligations also approximate fair value.

 

Trade Receivables

 

Trade receivables are carried at original invoice amount less an allowance for doubtful accounts.  The allowance is established through a provision for bad debt expense, which is included in general and administrative expenses.  We determine the adequacy of this allowance by evaluating individual customer accounts receivable, through consideration of the customer’s financial condition and credit history, and taking into account current economic conditions.  In addition, we analyze our historical credit loss history and apply these loss rates to our current accounts receivable balances to verify the reasonableness of our allowance.  Trade receivables are written off when deemed uncollectible.  A trade receivable is generally considered past due if any portion of the receivable balance is outstanding for more than 30 days unless alternate terms are provided.

 

7



Table of Contents

 

Inventory

 

Inventory is comprised of hardware components, packaged software components and finished goods and is valued at the lower of cost or market, using the weighted average cost method.  We conduct quarterly inventory reviews for obsolescence, and inventory considered unlikely to be sold is adjusted to net realizable value.

 

Amortization of Intangible Assets with Finite Lives

 

Intangible assets with finite lives are recorded at their fair value at the time of acquisition.  With the exception of our customer relationships intangible asset, which is amortized on a double-declining basis, the acquisition date fair values of such assets are amortized on a straight-line basis over the estimated useful lives.

 

Goodwill and Indefinite-Lived Intangibles

 

We account for our goodwill and indefinite-lived intangible assets in accordance with Intangibles — Goodwill and Other (ASC 350).  Goodwill represents the excess of purchase price over fair value of net assets acquired and is assigned to a reporting unit at the date the goodwill is initially recorded.  Goodwill and indefinite-lived intangible assets are not amortized but evaluated for impairment annually, or whenever events or changes in circumstances indicate that the value may not be recoverable.  Commencing on January 1, 2013, the Company adopted the ASU 2011-08 issued by the Financial Accounting Standards Board (“FASB”) for the revised guidance on “Testing of Goodwill for Impairment.”  Under this guidance, the Company has the option to choose whether it will apply the qualitative assessment first before the quantitative assessment.  We performed a quantitative assessment for our goodwill and indefinite-lived assets as of October 1, 2014, and determined they were not impaired.

 

Concentrations of Credit Risk

 

Financial instruments that potentially subject us to significant concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable.  We restrict our investments in cash and cash equivalents to financial institutions, US government or federal agency instruments and obligations of corporations with high credit ratings.  At March 31, 2015, the majority of our cash balances were held at financial institutions located in California in accounts that are insured by the Federal Deposit Insurance Corporation for up to $250,000. Uninsured balances aggregate approximately $23.9 million as of March 31, 2015.  At March 31, 2015 all of our cash equivalents consisted of financial institution obligations.  We periodically perform credit evaluations of our customers and maintain reserves for potential losses on our accounts receivable.  We do not believe we are subject to concentrations of credit risk with respect to such receivables.

 

Revenue Recognition

 

We generate revenues principally from the sale of our EnCase® Enterprise and EnCase® Forensic software products.  Our Enterprise products include perpetual licenses and are related to our EnCase® Enterprise, EnCase® Cybersecurity, and eDiscovery products.  Our Forensic products include revenues related to EnCase® Forensic, EnCase® Portable, and forensic hardware sales.  Revenue associated with the sale of software licenses and revenue associated with forensic hardware sales are referred to as product revenue.  Revenue associated with cloud-based document review and production software-as-a-service which is referred to as subscription revenue.  Revenues are also generated from training courses, implementation services and consulting services in which we assist customers with the performance of digital investigations and train their IT and legal professionals in the use of our software products, which we collectively refer to as services revenues.  Our proprietary products are generally sold with one to three years of maintenance, which can be renewed at a stated renewal rate and is referred to as maintenance revenues.

 

We recognize revenue in accordance with Accounting Standards Update (“ASU”) 2009-13, Multiple-Deliverable Revenue Arrangements, (amendment to Accounting Standards Codification (“ASC”) Topic 605, Revenue Recognition), Revenue Recognition - Software topic (ASC 985-605) and Revenue Recognition (ASC 605).  While the standards govern the basis for revenue recognition, significant judgment and the use of estimates are required in connection with the allocation of revenue between product, subscription, services and maintenance revenues, as well as the amount of deferred revenue to be recognized in each accounting period.

 

Revenue Recognition Criteria: In general, we recognize revenue when the following criteria have been met:

 

·                          Persuasive evidence of an arrangement: If we either enter into contracts or receive written purchase orders issued by a customer that legally bind us and the customer, we consider that as persuasive evidence of an arrangement.

 

·                          Delivery: We deem delivery of products to have occurred when the title and risk of ownership have passed to the buyer. Services revenues are considered delivered as they are performed.

 

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Table of Contents

 

·                          Fixed or determinable fee: We consider the fee to be fixed or determinable if the fee is not subject to refund or adjustment and the payment terms are within normal established practices.  If the fee is not fixed or determinable, we recognize revenues as amounts become due and payable with respect to transactions with extended payment terms, or as refund rights lapse with respect to transactions containing such provisions, provided all other revenue recognition criteria have been met.

 

·                          Collection is deemed probable: We conduct a credit review for all significant transactions at the time of the arrangement to determine the credit-worthiness of the customer.  Collection is deemed probable if we have a reasonable basis to expect that the customer will pay amounts under the arrangement as payments become due.

 

Revenue Recognition for Software Products and Software-Related Services (Software Elements)

 

Software product revenue.  The timing of software product revenue recognition is dependent on the nature of the product sold or the structure of the license.

 

EnCase® Enterprise Solutions and EnCase® Forensic Solutions: Revenue associated with these arrangements, exclusive of amounts allocated to maintenance and other undelivered elements, for which we have vendor-specific objective evidence of fair value (“VSOE”), is recognized upon delivery, provided that all other criteria for revenue recognition have been met.  Revenue associated with term licenses are recognized ratably over the term of the license because we have not established VSOE for post-contract customer support in term license arrangements.

 

Services and maintenance revenues. The majority of our consulting and implementation services are performed under per hour, or fixed fee arrangements.  Revenues from such services are recognized as the services are provided or upon expiration of the contractual service period.

 

Training revenue is either recognized on a per-class basis upon a participant’s attendance or, for those customers who have subscribed to our Annual Training Passport program, revenue is recognized ratably over the annual period.

 

Maintenance revenue includes technical support and software updates on a when-and-if-available basis.  We recognize maintenance revenue ratably over the applicable maintenance period.  We determine the amount of maintenance revenue to be allocated through reference to substantive maintenance renewal provisions contained in multiple element arrangements.  We consider substantive maintenance provisions to be provisions where the cost of the maintenance renewal, stated in the contract with our customer as a percentage of the product fee.

 

Revenue Recognition for Multiple-Element Arrangements — Software Products and Software-Related Services (Software Arrangements)

 

We often enter into arrangements with customers that purchase both software products and software-related services from us at the same time, or within close proximity of one another (referred to as software-related multiple-element arrangements).  Such software-related multiple-element arrangements may include the sale of our software products, software maintenance services, which include license updates and product support, consulting/implementation services and training whereby the software license delivery is followed by the subsequent delivery of the other elements.  For those software-related multiple-element arrangements, we have applied the residual method to determine the amount of software license revenues to be recognized pursuant to ASC 985-605.  Under the residual method, if VSOE exists for the undelivered elements, this amount is deferred with the remaining, or residual, portion of the arrangement consideration recognized upon delivery of the software license, provided all other revenue recognition criteria are met.

 

Revenue Recognition for Hardware and Subscription Revenues (Nonsoftware Elements)

 

Hardware product revenue. Revenue associated with the sale of forensic hardware is recognized upon shipment to the customers, which include certain resellers, provided that all other criteria for revenue recognition have been met.

 

Subscription revenue.  Customers pay subscription fees to access our cloud-based document review and production software; however, they may not take possession of the software at any time during the term of the agreement.  In general, we recognize revenue for subscription fees on a straight-line basis over the contract period commencing on the date the subscription is made available to the customer.  Usage-based fees, which are determined monthly, are recognized when incurred.

 

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Table of Contents

 

Revenue Recognition for Multiple-Element Arrangements — Hardware, SaaS and Nonsoftware-Related Services (Nonsoftware Arrangements)

 

We enter into arrangements with customers that purchase both nonsoftware-related SaaS subscription and nonsoftware-related services, such as consulting services, at the same time or within close proximity of one another (referred to as nonsoftware multiple-element arrangements).  Each element within a nonsoftware multiple-element arrangement is accounted for as a separate unit of accounting provided the following criteria are met: the delivered products or services have value to the customer on a standalone basis; and for an arrangement that includes a general right of return relative to the delivered products or services, delivery or performance of the undelivered product or service is considered probable and is substantially controlled by us.  We consider a deliverable to have standalone value if the product or service is sold separately by us or another vendor, or could be resold by the customer.  Further, our revenue arrangements generally do not include a general right of return relative to the delivered products. Where the aforementioned criteria for a separate unit of accounting are not met, the deliverable is combined with the undelivered element and treated as a single unit of accounting for the purposes of allocation of the arrangement consideration and revenue recognition.  For those units of accounting that include more than one deliverable but are treated as a single unit of accounting, we generally recognize revenues ratably over the delivery period.  For the purposes of revenue classification of the elements that are accounted for as a single unit of accounting, we allocate revenue to the respective revenue line items within our consolidated statements of operations based on a rational and consistent methodology utilizing our best estimate of relative selling prices of such elements.

 

For our nonsoftware multiple-element arrangements, we allocate revenue to each element based on a selling price hierarchy at the arrangement’s inception.  The selling price for each element is based upon the following selling price hierarchy: VSOE, if available; third party evidence (“TPE”) if VSOE is not available; or best estimate of selling price (“BESP”) if neither VSOE nor TPE are available.  A description as to how we determine VSOE, TPE and BESP is provided below:

 

· VSOE. VSOE is determined based on its historical pricing and discounting practices for the specific product or service when sold separately.  In determining VSOE, we require that a substantial majority of the selling prices for these services fall within a reasonably narrow pricing range.

 

· TPE. When VSOE cannot be established for deliverables in a multiple element arrangement, judgment is applied with respect to whether we can establish a selling price based on TPE.  TPE is determined based on competitor prices for similar deliverables when sold separately.  Generally, our go-to-market strategy differs from that of our peers and our offerings contain a significant level of differentiation such that comparable pricing of services with similar functionality has not been obtained.  Furthermore, we have been unable to reliably determine selling prices of similar competitive services on a stand-alone basis.  As a result, we have not been able to establish selling prices based on TPE.

 

· BESP. When VSOE or TPE cannot be established, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the service were sold on a stand-alone basis.  We determine BESP for deliverables by considering multiple factors including but not limited to prices we charge for similar offerings, market conditions, competitive landscape and pricing practices.

 

Revenue Recognition for Multiple-Element Arrangements — Arrangements with Software and Nonsoftware Elements

 

We also enter into multiple-element arrangements that may include a combination of our various software-related and nonsoftware-related products and services.  In such arrangements, we first allocate the total arrangement consideration based on the relative selling prices to the software group of elements as a whole and to the nonsoftware group of elements.  We then further allocate consideration allocated to the software group and nonsoftware group to the respective elements within that group following the guidance in ASC 985-605, ASC 605-25, and our policies described above.  After the arrangement consideration has been allocated to the elements, we recognize revenue for each respective element in the arrangement as described above.

 

Recently Issued Accounting Pronouncements

 

In May 2014, the FASB and IASB jointly issued ASU No. 2014-09, Revenue from Contracts with Customers, which supercedes the revenue recognition requirements in ASC 605 Revenue Recognition.  ASU 2014-09 is a comprehensive new revenue recognition standard that will supercede nearly all existing revenue recognition guidance under US GAAP.  The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services.  In doing so, companies will need to use more judgment and make more estimates than under current authoritative guidance.  These may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation.  The standard is effective beginning after December 15, 2016, and early adoption is not permitted under US GAAP.  On April 1, 2015, the FASB voted to propose to defer the effective date of ASU 2014-09 by one year.  We are currently evaluating the financial statement impact of the new revenue recognition standard.

 

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In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40), Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. This standard sets forth management’s responsibility to evaluate, each reporting period, whether there is substantial doubt about our ability to continue as a going concern, and if so, to provide related footnote disclosures. The standard is effective for annual and interim reporting periods ending after December 15, 2016.  We are currently evaluating this new standard and expect it to have no impact on our financial position and results of operations.

 

Note 3. Net Loss Per Share

 

Earnings Per Share (ASC 260) defines unvested share-based payment awards that contain non-forfeitable rights to dividends as participating securities that should be included in computing EPS using the two-class method.  The Company’s nonvested restricted stock awards qualify as participating securities.

 

Basic net loss per common share is calculated by dividing net loss allocated to common stockholders by the weighted average number of common shares outstanding during the reporting period. Diluted net loss allocated to common stockholders per share is calculated based on the weighted average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares consist of the shares issuable upon the exercise of stock options and upon the vesting of restricted stock awards under the treasury stock method. In net loss periods, basic net loss per share and diluted net loss per share are identical since the effect of potential common shares is anti-dilutive and therefore excluded.

 

The following table sets forth the computation of basic and diluted net loss allocated to common stockholders per share (in thousands, except per share amounts):

 

 

 

Three Months Ended
March 31,

 

 

 

2015

 

2014

 

Basic loss per common share:

 

 

 

 

 

Numerator:

 

 

 

 

 

Net loss

 

$

(3,813

)

$

(6,144

)

Net income allocated to participating securities

 

 

 

Net loss allocated to common stockholders

 

$

(3,813

)

$

(6,144

)

Denominator:

 

 

 

 

 

Basic weighted average shares outstanding

 

27,523

 

26,425

 

Net loss per basic common share

 

$

(0.14

)

$

(0.23

)

 

 

 

 

 

 

Diluted loss per common share:

 

 

 

 

 

Numerator:

 

 

 

 

 

Net loss

 

$

(3,813

)

$

(6,144

)

Net income allocated to participating securities

 

 

 

Net loss allocated to common stockholders

 

$

(3,813

)

$

(6,144

)

Denominator:

 

 

 

 

 

Basic weighted average shares outstanding

 

27,523

 

26,425

 

Effect of dilutive share-based awards

 

 

 

Diluted weighted average shares outstanding

 

27,523

 

26,425

 

Net loss per diluted common share

 

$

(0.14

)

$

(0.23

)

 

Antidilutive securities, which consist of stock options and restricted stock awards that are not included in the diluted net loss per share calculation, consisted of an aggregate of approximately 2,398,000 shares for the three months ended March 31, 2015, and 1,800,000 shares for the three months ended March 31, 2014.

 

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Note 4. Inventory

 

Inventory is comprised of hardware components, packaged software components and finished goods and is valued at the lower of cost or market, using the weighted average cost method.  The following table sets forth, by major classes, inventory as of March 31, 2015 and December 31, 2014 (in thousands):

 

 

 

March 31,
2015

 

December 31,
2014

 

Inventory:

 

 

 

 

 

Components

 

$

1,191

 

$

1,121

 

Finished goods

 

1,359

 

1,563

 

Total inventory

 

$

2,550

 

$

2,684

 

 

Note 5. Goodwill and Other Intangibles

 

We evaluate goodwill and indefinite-lived intangible assets for impairment on an annual basis, or more frequently if circumstances indicate impairment may have occurred, and there have been no impairment charges related to such assets through March 31, 2015.  We expect the balance of goodwill assigned to our products segment to be deductible for tax purposes while the balance of goodwill assigned to our subscription and services segments will not be deductible for tax purposes.

 

Intangible assets are amortized on a straight-line basis over their estimated useful lives, with the exception of customer relationships, which are amortized on a double-declining basis. Amortization expense for intangible assets with finite lives was $0.4 million and $0.6 million for the three months ended March 31, 2015, and 2014, respectively. The following table summarizes cumulative amortization expense related to intangible assets subject to amortization as of March 31, 2015 and December 31, 2014 (in thousands):

 

 

 

March 31, 2015

 

December 31, 2014

 

 

 

Gross Costs

 

Accumulated
Amortization

 

Net

 

Gross Costs

 

Accumulated
Amortization

 

Net

 

Core technology

 

$

5,800

 

$

(2,625

)

$

3,175

 

$

5,800

 

$

(2,430

)

$

3,370

 

Existing and developed technology

 

2,300

 

(2,300

)

 

2,300

 

(2,300

)

 

Customer relationships

 

6,475

 

(3,327

)

3,148

 

6,475

 

(3,143

)

3,332

 

Trade names

 

2,100

 

(1,182

)

918

 

2,100

 

(1,122

)

978

 

Covenant not-to-compete

 

200

 

(124

)

76

 

200

 

(114

)

86

 

Total

 

$

16,875

 

$

(9,558

)

$

7,317

 

$

16,875

 

$

(9,109

)

$

7,766

 

 

The following table summarizes the estimated remaining amortization expense through 2019 and thereafter (in thousands):

 

Year ending

 

Amortization
Expense

 

2015

 

$

1,203

 

2016

 

1,499

 

2017

 

1,399

 

2018

 

1,392

 

2019

 

816

 

Thereafter

 

1,008

 

Total amortization expense

 

$

7,317

 

 

Note 6. Debt Obligations

 

On August 29, 2014, we entered into a three year, Senior Secured Revolving Line of Credit (“Revolver”) with a bank.  The maximum principal amount that may be outstanding at any given time under the Revolver, which includes up to $3.0 million of standby letters of credit, is $10.0 million.  Any borrowings under the Revolver would be secured by substantially all of our assets, as well as pledges of capital stock.  The Revolver requires that, if we suffer an event of default or have borrowed more than 75% of the maximum principal amount permitted to be outstanding, we maintain an Adjusted Quick Ratio of at least 1.15 to 1.0.  If the Adjusted Quick Ratio falls below 1.5 to 1.0, any collections received by the bank on behalf of the Company will be applied to outstanding loan balances before being remitted to the Company’s operating account.  The Adjusted Quick Ratio is calculated by dividing Quick Assets (cash less restricted cash plus accounts receivable) by current liabilities (current liabilities plus outstanding standby letter of credit less the current portion of deferred revenue).  Borrowings under the Revolver bear interest at a floating rate ranging from 1.25% to 3.25% above the Prime Rate depending on the Company’s Adjusted Quick Ratio.  We are obligated to pay a commitment fee of $0.2 million over the three year term of the Revolver. All principal, interest and any other fees will be due and payable in full on or prior to August 29, 2017.

 

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On February 25, 2015, we entered into an amendment (“Amendment”) to the Revolver.  The Amendment allows for advances (each, an “Equipment Advance”) from the bank to be used solely for eligible equipment purchases.  Eligible equipment includes (a) general purpose equipment, computer equipment, office equipment, furnishings, subject to certain limitations, (b) computer software and transferable software licenses, and (c) other equipment.  The maximum advance (“Equipment Line”) equals $2.2 million and an Equipment Advance must be paid over a period of thirty-six months after it has been issued.  The principal amount outstanding for each Equipment Advance shall accrue interest at an annual rate, based on the Adjusted Quick Ratio, ranging from 1.25% - 3.25% above the Prime Rate, and shall be paid monthly. Amount drawn on the Equipment Line reduces the available amount under the Revolver. To date we have not drawn on the Equipment Line.

 

As of March 31, 2015, we were in compliance with all the covenants of the Revolver.  We had letters of credit outstanding against the Revolver in the amount of $1.3 million, resulting in the maximum available borrowing under the Revolver to be $8.5 million.  Availability is calculated as 80% of eligible accounts receivable, with a maximum of $10.0 million.  To date we have not borrowed under the Revolver.

 

Note 7. Employee Benefit Plans

 

At March 31, 2015, approximately 1,149,000 shares were available for grant as options or nonvested share awards under the Guidance Software, Inc. Second Amended and Restated 2004 Equity Incentive Plan (the “Plan”).

 

Stock Options

 

The terms of the options granted under the Plan are determined at the time of grant, and generally vest 25% annually over a four-year service period and typically must be exercised within 10 years from the date of grant.  A summary of stock option activity follows:

 

 

 

Number of
Options

 

Weighted
Average
Exercise
Price

 

Weighted Average
Remaining
Contractual Term
(in years)

 

Aggregate
Intrinsic Value

 

Outstanding, December 31, 2014

 

1,415,000

 

$

8.36

 

2.8

 

$

1,589,000

 

Granted

 

148,000

 

6.09

 

 

 

 

 

Exercised

 

(169,000

)

4.52

 

 

 

 

 

Forfeited or expired

 

(48,000

)

11.70

 

 

 

 

 

Outstanding, March 31, 2015

 

1,346,000

 

$

8.47

 

3.68

 

$

249,000

 

 

 

 

 

 

 

 

 

 

 

Exercisable, March 31, 2015

 

1,048,000

 

$

9.18

 

1.95

 

$

 249,000

 

 

We define in-the-money options at March 31, 2015 as options that had exercise prices that were lower than the $5.41 fair market value of our common stock at that date.  The aggregate intrinsic value of options outstanding at March 31, 2015 is calculated as the difference between the exercise price of the underlying options and the fair market value of our common stock for the 308,000 shares that were in-the-money at that date, all of which were exercisable.

 

Restricted Stock Awards

 

We issue restricted stock awards to certain directors, officers and employees. Compensation expense for such awards, based on the fair market value of the awards on the grant date, is recorded during the vesting period. Restricted stock awards generally vest 25% annually over a four-year service period. A summary of restricted stock awards activity follows:

 

 

 

Number of
Shares

 

Weighted Average
Fair Value

 

Outstanding, December 31, 2014

 

2,059,000

 

$

8.60

 

Granted

 

550,000

 

5.89

 

Vested

 

(185,000

)

9.40

 

Forfeited

 

(126,000

)

8.80

 

Outstanding, March 31, 2015

 

2,298,000

 

$

7.88

 

 

The total grant date fair value of shares vested under such grants during the three months ended March 31, 2015 was $1,739,000.

 

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Share-Based Compensation

 

We account for share-based compensation in accordance with Compensation-Stock Compensation (ASC 718).   Compensation expense for stock options is recognized using the Black-Scholes option pricing model to determine the grant date fair value of share-based payments and recognize that cost, net of an estimated forfeiture rate, as compensation expense on a straight-line basis over the vesting period. Stock awards generally vest 25% annually over a four-year service period.  The determination of the grant date fair value of share-based awards using that model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include the estimated number of years that we expect employees to hold their stock options (the option “expected term”) and our expected stock price volatility, risk-free interest rates and dividends to be paid on our stock over that term.

 

The fair values of stock options granted under the Second Amended and Restated Plan were estimated at the date of grant using the Black-Scholes option pricing model and the following weighted average assumptions:

 

 

 

March 31,
2015

 

March 31,
2014

 

Risk-free interest rate

 

1.7

%

%

Dividend yield

 

%

%

Expected life (years)

 

5.85

 

 

Volatility

 

43.90

%

%

Weighted average grant date fair value

 

$

2.60

 

$

 

 

When historical data is available and relevant, the expected term of options granted is determined by calculating the average term from historical stock option exercise experience.  The volatility of our common stock is estimated at the date of grant based on the volatility of our publicly traded common stock over the expected term of the options granted.  The volatility is calculated based on the adjusted close price each day from a composite index. The risk-free interest rate used in option valuation is based on the implied yield in effect at the time of each option grant, based on US Treasury zero-coupon issues with equivalent expected terms. We use a dividend yield of zero in the Black-Scholes model, as we have no expectation we will pay any cash dividends on our common stock in the foreseeable future. Compensation-Stock Compensation (ASC 718) also requires that we estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. Quarterly changes in the estimated forfeiture rate can potentially have a significant effect on reported share-based compensation, as the cumulative effect of adjusting the forfeiture rate for all expense amortization after the grant date is recognized in the period the forfeiture estimate is changed.

 

The following table summarizes the share-based compensation expense we recorded (in thousands):

 

 

 

Three Months Ended
March 31,

 

 

 

2015

 

2014

 

Stock option awards

 

$

39

 

$

18

 

Restricted stock awards

 

1,627

 

1,712

 

Share-based compensation expense

 

$

1,666

 

$

1,730

 

 

As of March 31, 2015, approximately $0.8 million of total unrecognized share-based compensation related to stock options is expected to be recognized over a weighted-average period of 3.8 years.  Approximately $14.6 million of total unrecognized share-based compensation cost related to restricted stock awards is expected to be recognized over a weighted-average period of 2.7 years.  For awards outstanding at March 31, 2015, we expect to record approximately $0.2 million and $4.9 million in share-based compensation for the remainder of fiscal year 2015 related to stock options and restricted stock awards, respectively.

 

Note 8. Income Taxes

 

We account for income taxes in accordance with Income Taxes (ASC 740).  Deferred income taxes are recorded for the expected tax consequences of temporary differences between the tax bases of assets and liabilities for financial reporting purposes and amounts recognized for income tax purposes.  We record a valuation allowance to reduce our deferred tax assets to the amount of future tax benefit that is more likely than not to be realized.  As of March 31, 2015, we have recorded a valuation allowance against our net deferred tax assets resulting in a carrying value of zero.

 

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Management’s judgment is required in assessing the realizability of future deferred tax assets.  We consider all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance.  If we later determine that it is more likely than not that the net deferred tax assets would be realized, we would reverse the applicable portion of the previously provided valuation allowance.  Likewise, in the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to earnings in the period in which we make such a determination.

 

We file income tax returns with the Internal Revenue Service and the taxing authorities of various state and foreign jurisdictions.  We periodically perform a review of our uncertain tax positions.  An uncertain tax position represents our expected treatment of a tax position taken in a filed tax return, or planned to be taken in a future tax return, that has not been reflected in measuring income tax expense for financial reporting purposes.  At March 31, 2015, our liability for uncertain tax positions was $1.0 million.  We do not expect there to be any material changes to the estimated amount of liability associated with our uncertain tax positions over the next twelve months.  Due to the net operating loss carryforwards, the Company’s U.S. federal and state returns are generally open to examination by the Internal Revenue Service and state jurisdictions when such net operating losses are utilized.  Most foreign jurisdictions have statute of limitations that range from three to six years.

 

We recorded an income tax provision for the three months ended March 31, 2015 of $71,000 as compared to $78,000 for the same period in 2014.  Our income tax provision for the three months ended March 31, 2015 and 2014 differs from the U.S. statutory rate of 34% primarily due to state taxes, foreign taxes, the tax impact of certain share-based compensation charges, and the impact of providing a valuation allowance against research and development credits and deferred tax assets.

 

Note 9. Fair Value Measurements

 

In accordance with Fair Value Measurements and Disclosures (ASC 820), we measure our financial assets and liabilities at fair value on a recurring basis.  ASC 820 requires disclosure that establishes a framework for measuring fair value and expands disclosure about fair value measurements.  Under this standard, fair value is defined as the price that would be received in exchange for selling an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date.  ASC 820 establishes a hierarchy for inputs used in measuring fair value that minimizes the use of unobservable inputs by requiring the use of observable market data when available.  Observable inputs are inputs that market participants would use in pricing the asset or liability based on active market data.  Unobservable inputs would be inputs that reflect our assumptions about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances.  The statement requires fair value measurements be classified and disclosed in one of the following three categories:

 

Level 1:                                 Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets and liabilities.

Level 2:                                 Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly, and corroborated by market data.

Level 3:                                 Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.

 

The following table sets forth, by level within the fair value hierarchy, financial assets and liabilities that are accounted for at fair value on a recurring basis as of March 31, 2015 and December 31, 2014 (in thousands):

 

 

 

Fair Value Measurements at March 31, 2015

 

 

 

Total

 

Level 1

 

Level 2

 

Level 3

 

Assets:

 

 

 

 

 

 

 

 

 

U.S. Treasury Securities

 

$

2,006

 

$

2,006

 

$

 

$

 

Money market accounts

 

4,282

 

4,282

 

 

 

Total assets

 

$

6,288

 

$

6,288

 

$

 

$

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair Value Measurements at December 31, 2014

 

 

 

Total

 

Level 1

 

Level 2

 

Level 3

 

Assets:

 

 

 

 

 

 

 

 

 

U.S. Treasury Securities

 

$

2,006

 

$

2,006

 

$

 

$

 

Money market accounts

 

4,280

 

4,280

 

 

 

Total assets

 

$

6,286

 

$

6,286

 

$

 

$

 

 

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CaseCentral Contingent Consideration

 

The Company had obligations, to be paid in cash, to the former shareholders of CaseCentral if certain SaaS and EnCase® eDiscovery revenue thresholds were achieved during the three 12-month periods that ended on March 31, 2015.  The revenue thresholds for those periods were not met and consequently no contingent consideration was due.  The fair value of this contingent consideration is determined using a present value calculation.  Expected cash flows are determined using the probability-weighted average of possible outcomes that would occur should certain revenue metrics be reached.  There is no market data available to use in valuing the contingent consideration; therefore, we developed our own assumptions related to the future financial performance of the businesses to evaluate the fair value of these liabilities.

 

In connection with estimating the fair value of the contingent consideration, we developed various scenarios (base case, downside case, and upside case) and weighted each case according to the probability of occurrence.  The probabilities ranged from 20 percent to 50 percent, with the most significant weighting given to the base case at 50 percent.  These scenarios were developed based on the expected financial performance of CaseCentral, with SaaS revenue growth rates being a primary input in the calculation.  An increase or decrease in the probability of achievement of any of the scenarios could result in a significant increase or decrease to the estimated fair value.

 

The fair value was reviewed quarterly based on the financial performance of the most recently completed fiscal quarter. An analysis was performed at the end of each fiscal quarter to compare actual results to forecasted financial performance.  If performance deviated from projected levels, the valuation was updated for the latest information available.

 

The significant assumptions noted in the items above that may materially affect fair value are developed in conjunction with the guidance of our senior management to ensure that the most accurate and latest financial projections are used and compared with the most recent financial results in the fair value measurement.

 

Note 10. Commitments and Contingencies

 

Office Leases

 

On March 31, 2015, we amended our Office Lease Agreement (the “Pasadena Lease”) dated July 26, 2012 to expand our headquarters by approximately 3,600 rentable square feet.  The amendment commences on June 1, 2016 and the Pasadena Lease expires on May 31, 2024.  The expansion increases the base rent from a range of approximately $110,000 for the first year to approximately $140,000 for the final year.

 

On July 3, 2014, we entered into an Office Lease Agreement (the “San Francisco Lease”) to lease approximately 6,000 rentable square feet of an office building located in San Francisco, California.  The office building is the new location of our San Francisco office.  The San Francisco Lease commenced on December 1, 2014 and expires in December 31, 2019.  The total annual rent under the San Francisco Lease ranges from approximately $295,000 for the first year to approximately $332,000 for the final year.

 

Data Center Lease

 

Effective April 1, 2014, we entered into a Colocation Lease Agreement (the “Colocation Lease”) to rent space in a building located in Chandler, Arizona.  The Colocation Lease expires on June 30, 2018.  The Colocation Lease will serve as our new data center, replacing our former San Francisco location obtained in the Case Central acquisition.  Rent is based on power allocation and ranges from approximately $236,000 for the first year to approximately $265,000 for the final year.

 

Third-party Software Licenses

 

During the year ended December 31, 2014, the Company entered into a $1.5 million third-party software license agreement authorizing the Company to integrate software as a component of its products through March 2018.  The agreement also provides for maintenance and support over a three-year period, which may be renewed by the Company at the expiration of the three-year period ending March 2018.  The $1.5 million is payable in three annual installments of $492,000, with the final installment being paid in November 2016.  The license, maintenance and remaining liability have been recorded on the accompanying Consolidated Balance Sheets.

 

Legal Matters

 

On May 20, 2011, MyKey Technology Inc. (“MyKey”) filed a complaint against us and certain other parties for patent infringement in the United States District Court for the District of Delaware.  With respect to the Company, the complaint alleged that certain of the data acquisition forensic hardware products that we acquired through the acquisition of certain assets of Tableau, LLC (“Tableau”) infringe three of MyKey’s patents relating to write blocking, duplication and data removal technologies.  The complaint sought a declaration of infringement, a finding of willful infringement, compensatory damages, treble damages, injunctive relief, interest, expenses, costs and attorneys’ fees.

 

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On July 22, 2011, MyKey also filed a complaint with the United States International Trade Commission (the “ITC”), alleging infringement by the Company and certain other parties of the three patents discussed in the preceding paragraph and requesting that the ITC commence an investigation pursuant to Section 337 of the Tariff Act of 1930.  The complaint sought injunctive relief barring the Company from the importation of products that allegedly infringed the MyKey patents.  On August 24, 2011, the ITC commenced an investigation of the Company and certain other parties related to the complaint by MyKey.  On August 31, 2011 the proceeding in the District Court was stayed pending the resolution of the ITC matter.  On August 1, 2012, MyKey amended its ITC complaint to remove allegations that its duplication patent had been infringed by the Company and to reduce the number of claims alleging the Company infringed MyKey’s data removal patent.  In August 2012, the parties completed a trial on the remaining patent claims at issue.

 

On December 28, 2012, the ITC released a final determination and Order holding that no violation of Section 337 of the Tariff Act of 1930 occurred as a result of the Company’s importation into the United States and sale of the products at issue.  This Order effectively ended the ITC proceeding in the Company’s favor.

 

On February 20, 2013, the U.S. District Court of Delaware lifted the stay of the proceedings in the MyKey matter.  Effective April 8, 2013, the parties stipulated to a transfer of the matter to the U.S. District Court for the Central District of California.  On April 16, 2013, the Company filed its Answer and Counterclaim.  MyKey filed a petition to consolidate a number of related cases, including the case against the Company in the Central District of California, into a Multi-District Litigation (“MDL”) proceeding.  On August 16, 2013, the MDL panel approved the petition and assigned the MDL consolidated cases to the judge who is also presiding over the individual case against the Company.  The MDL case will dispose of certain issues common to the consolidated cases, such as the validity of patents being asserted against the joint defendants.  On May 23, 2014, the parties completed a Markman hearing related to claim construction of the patents at issue.

 

On March 26, 2014, MyKey also filed a complaint against the United States of America alleging that the United States has infringed U.S. Patents No. 6,813,682, 7,159,086 and 7,228,379 by or through its acceptance, receipt and/or use of write blocker products, data duplication products and data removal products.  The complaint alleges that such products were supplied to the government by the Company and certain of its co-defendants in the MDL proceeding.  No damages amount is stated in the complaint.  The government could assert a claim for indemnification against the Company but has not done so yet.  Although a financial loss is reasonably possible, the Company is unable to estimate the range of potential loss at this time.

 

On October 16, 2014, MyKey filed a Notice of Status on Claim Construction Issues in the MDL action in which it acknowledged that MyKey will not be able to prove that the Company’s data duplication products infringed U.S. Patent 7,159,086.  In the same filing, MyKey acknowledged that certain claims of United States Patent 6,813,682 are invalid and therefore cannot be infringed by any product.

 

We intend to defend the remaining MyKey matters vigorously.  While a financial loss is reasonably possible, at this time we are unable to estimate what, if any, liability we may have in connection with these matters.  We are unable to estimate a range of reasonably possible financial losses for various reasons, including, among others, that (1) certain of the proceedings are at an early stage, (2) there is uncertainty as to the outcome of pending appeals, motions, or settlements, (3) there are significant factual issues to be resolved, (4) there are unresolved negotiations with certain indemnitors or indemnitees of the Company, related to the actions, and (5) we have meritorious defenses that we intend to assert.

 

From time to time, we may become involved in various other lawsuits and legal proceedings that arise in the ordinary course of business.  Litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business.  We are not currently aware of any such other legal proceedings or claims that are likely to have a material impact on our business.

 

Indemnifications

 

We have agreed to indemnify our directors and executive officers for costs associated with any fees, expenses, judgments, fines and settlement amounts incurred by them in any action or proceeding to which any of them is, or is threatened to be, made a party by reason of his or her services in their role as a director or officer.

 

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Note 11. Segment Information

 

In accordance with ASC 280, Segment Reporting, our segmentation is based on our internal organization and reporting of revenue and other performance measures. Our segments are designed to allocate resources internally and provide a framework to determine management responsibility.  Operating segments are defined as components of an enterprise about which discrete financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance.  Our chief operating decision maker is our Chief Executive Officer.  We have five operating segments, as summarized below:

 

·                  Products segment—Includes EnCase® Enterprise, EnCase® Cybersecurity, EnCase® Analytics, EnCase® eDiscovery, EnCase® Forensic, EnCase® Portable, Premium License Support Program and hardware sales.

 

·                  Subscription segment—Includes subscription services for cloud-based document review and production software.  The subscription segment is new as of February 2012 due to our acquisition of CaseCentral.

 

·                  Professional services segment—Performs consulting services and implementations.

 

·                  Training segment—Provides training classes by which we train our customers to effectively and efficiently use our software products.

 

·                  Maintenance segment—Includes maintenance related services.

 

We present the revenues generated by our services and maintenance segments collectively.  Currently, we do not separately allocate operating expenses to these segments, nor do we allocate specific assets, with the exception of goodwill, to these segments. Therefore, the segment information reported includes only revenues, cost of revenues and segment profit.  The following tables present the results of operations for each operating segment (in thousands):

 

 

 

Three Months Ended March 31, 2015

 

 

 

Products

 

Subscription

 

Professional
services

 

Training

 

Maintenance

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

$

7,054

 

$

1,553

 

$

4,460

 

$

2,168

 

$

9,769

 

$

25,004

 

Cost of revenues

 

1,743

 

1,022

 

3,776

 

1,418

 

490

 

8,449

 

Segment profit

 

$

5,311

 

$

531

 

$

684

 

$

750

 

$

9,279

 

16,555

 

Total operating expenses

 

 

 

 

 

 

 

 

 

 

 

20,305

 

Operating loss

 

 

 

 

 

 

 

 

 

 

 

$

(3,750

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended March 31, 2014

 

 

 

Products

 

Subscription

 

Professional
services

 

Training

 

Maintenance

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

$

6,861

 

$

2,377

 

$

4,652

 

$

1,931

 

$

9,560

 

$

25,381

 

Cost of revenues

 

1,750

 

1,133

 

3,721

 

1,574

 

513

 

8,691

 

Segment profit

 

$

5,111

 

$

1,244

 

$

931

 

$

357

 

$

9,047

 

16,690

 

Total operating expenses

 

 

 

 

 

 

 

 

 

 

 

22,773

 

Operating loss

 

 

 

 

 

 

 

 

 

 

 

$

(6,083

)

 

Revenues, classified by the major geographic areas in which we operate, are as follows (in thousands):

 

 

 

Three Months Ended
March 31,

 

 

 

2015

 

2014

 

Revenues

 

 

 

 

 

United States

 

$

19,047

 

$

19,671

 

Europe

 

3,511

 

3,563

 

Asia

 

1,175

 

988

 

Other

 

1,271

 

1,159

 

 

 

$

25,004

 

$

25,381

 

 

Note 12. Subsequent Events

 

On April 14, 2015, we announced the appointment of Patrick Dennis as President and Chief Executive Officer, effective May 1, 2015.  Interim Chief Executive Officer and Chief Financial Officer, Barry Plaga, will remain with the Company in the role of Chief Financial Officer.

 

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Table of Contents

 

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

 

The following discussion of our financial condition and results of operations should be read together with the financial statements and related notes that are included elsewhere in this Quarterly Report. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in this Quarterly Report under “Risk Factors,” in our Annual Report on Form 10-K for the year ended December 31, 2014 under “Risk Factors” and in other parts of this Quarterly Report.

 

Overview

 

We were incorporated and commenced operations in 1997.  From 1997 through 2002, we generated a substantial portion of our revenues from the sale of our EnCase® Forensic products and related services.  We experienced increases in our revenue as a result of the release of our EnCase® Enterprise product in late 2002, which expanded our customer base into corporate enterprises and federal government agencies.  In addition, the releases of our EnCase® eDiscovery solution in late 2005 and EnCase® Information Assurance solution in late 2006 (which was replaced by our EnCase® Cybersecurity solution in 2009) have increased our revenues.  In May 2010, we added a family of data acquisition forensic hardware products, including forensic duplicators, multiple write blockers and other hardware through our acquisition of Tableau, LLC (“Tableau”).  In February 2012, we added cloud-based document review and production software-as-a-service for corporations and law firms through our acquisition of CaseCentral, Inc. (“CaseCentral”).  In September 2013, we introduced EnCase® Analytics, a security intelligence solution that exposes threats that evade detection using insights from endpoint data.  We anticipate that sales of our EnCase Enterprise products and related services, in particular our EnCase Cybersecurity and EnCase eDiscovery solutions, sales of our forensic hardware products and sales of subscriptions for cloud-based document review and production SaaS will comprise a substantial portion of our future revenues.

 

Factors Affecting Our Results of Operations

 

There are a number of trends that may affect our business and our industry. Some of these trends or other factors include:

 

·                  Legislative and regulatory developments. Our digital investigation solutions allow law enforcement agencies, government organizations and corporations to conduct investigations within the legal and regulatory framework.  Historically, the implementation of new laws and regulations surrounding digital investigations has helped create demand for our products. Future changes in applicable laws or regulations could enhance or detract from the desirability of our products.

 

·                  Information technology budgets. Deployment of our solutions may require substantial capital expenditures by our customers. Budgets for information technology-related capital expenditures at corporations and all levels of government organizations are typically cyclical in nature, with generally higher budgets in times of improving economic conditions and lower budgets in times of economic slowdowns.

 

·                  Law enforcement agency budgets. We sell our EnCase® Forensic products and training services primarily to law enforcement agencies.  Because of the limited nature of law enforcement budgets, funds are typically initially allocated toward solving issues perceived to be the most pressing.  Sales of our products could be impacted by changes in the budgets of law enforcement agencies or in the relative priority assigned to digital law enforcement investigations.

 

·                  Prevalence and impact of hacking incidents and spread of malicious software. The increasing sophistication of hacking attacks on government and private networks and the global spread of malicious software, such as viruses, worms and rootkits, have increased the focus of corporations and large government organizations on digital investigations and other aspects of network security, which has, in turn, increased demand for our products.  Future changes in the number and severity of such attacks or the spread of malicious software could have an effect on the demand for our products.

 

·                  Unpredictability of revenues. We experience unpredictability in our revenues, primarily from our customers’ budgeting cycles. The federal government’s budget year ends in the third calendar quarter of the year and a majority of corporate budget years end in the fourth calendar quarter of the year.  In addition, our customers also tend to make software purchases near the end of a particular quarter, which tends to make our revenues for a particular quarter unpredictable for a significant portion of that quarter.  We expect that this unpredictability in our revenues within particular quarterly periods will continue for the foreseeable future.

 

·                  Amount of commercial litigation. Because commercial litigation often involves eDiscovery, an increase in commercial litigation could increase demand for our products and services, while a decrease in commercial litigation could decrease demand.

 

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Critical Accounting Policies and Estimates

 

In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our net revenue, operating income or loss and net income or loss, as well as on the value of certain assets and liabilities on our balance sheet.  We believe that the estimates, assumptions and judgments involved in the accounting policies described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2014 have the greatest potential impact on our financial statements, so we consider them to be our critical accounting policies and estimates.

 

In May 2014, the FASB and IASB jointly issued ASU No. 2014-09, Revenue from Contracts with Customers, which supercedes the revenue recognition requirements in ASC 605 Revenue Recognition.  ASU 2014-09 is a comprehensive new revenue recognition standard that will supercede nearly all existing revenue recognition guidance under US GAAP.  The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services.  In doing so, companies will need to use more judgment and make more estimates than under current authoritative guidance.  These may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation.  The standard is effective beginning after December 15, 2016, and early adoption is not permitted under US GAAP.  On April 1, 2015, the FASB voted to propose to defer the effective date of ASU 2014-09 by one year.  We are currently evaluating the financial statement impact of the new revenue recognition standard.

 

In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40), Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. This standard sets forth management’s responsibility to evaluate, each reporting period, whether there is substantial doubt about our ability to continue as a going concern, and if so, to provide related footnote disclosures. The standard is effective for annual and interim reporting periods ending after December 15, 2016.  We are currently evaluating this new standard and expect it to have no impact on our financial position and results of operations.

 

Results of Operations

 

The following table sets forth our results of operations for the three months ended March 31, 2015 and 2014, respectively, expressed as a percentage of total revenues:

 

 

 

Three Months Ended
March 31,

 

 

 

 

2015

 

2014

 

Revenues:

 

 

 

 

 

Product revenues

 

28.2

%

27.0

%

Subscription revenues

 

6.2

 

9.4

 

Services and maintenance revenues

 

65.6

 

63.6

 

Total revenues

 

100.0

 

100.0

 

 

 

 

 

 

 

Cost of revenues:

 

 

 

 

 

Cost of product revenues

 

7.0

 

6.9

 

Cost of subscription revenues

 

4.1

 

4.4

 

Cost of services and maintenance revenues

 

22.7

 

22.9

 

Total cost of revenues

 

33.8

 

34.2

 

Gross profit

 

66.2

 

65.8

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

Selling and marketing

 

35.8

 

39.7

 

Research and development

 

20.7

 

25.5

 

General and administrative

 

18.2

 

16.8

 

Depreciation and amortization

 

6.6

 

7.8

 

Total operating expenses

 

81.3

 

89.8

 

Operating loss

 

(15.1

)

(24.0

)

 

 

 

 

 

 

Other income and expense:

 

 

 

 

 

Interest income

 

 

 

Interest expense

 

 

 

Other income, net

 

 

 

Total other income and expense

 

 

 

Loss before income taxes

 

(15.1

)

(24.0

)

Income tax provision

 

0.3

 

0.3

 

Net loss

 

(15.4

)%

(24.3

)%

 

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Table of Contents

 

The following table sets forth share-based compensation expense recorded in each of the respective periods (in thousands):

 

 

 

Three Months Ended
March 31,

 

 

 

2015

 

2014

 

Non-cash Share-Based Compensation Data (1):

 

 

 

 

 

Cost of product revenues

 

$

32

 

$

39

 

Cost of subscription revenues

 

12

 

52

 

Cost of services and maintenance revenues

 

317

 

317

 

Selling and marketing

 

355

 

393

 

Research and development

 

438

 

462

 

General and administrative

 

512

 

467

 

Total non-cash share-based compensation

 

$

1,666

 

$

1,730

 

 


(1)                  Non-cash share-based compensation recorded in the three month period ended March 31, 2015 and 2014 relates to stock options and restricted share awards granted to employees measured under the fair value method.  See Note 7 to the condensed consolidated financial statements.

 

Comparison of Results of Operations for the Three Months Ended March 31, 2015 and 2014

 

Sources of Revenues

 

Our software product sales transactions typically include the following elements: (i) a software license fee paid for the use of our products under a perpetual license term, or for a specific term; (ii) an arrangement for first-year support and maintenance, which includes unspecified software updates, upgrades and post-contract support; and (iii) professional services for installation, implementation, consulting and training.  We also generate revenues from cloud-based document review and production software sold as subscription services.  We derive the majority of our revenues from sales of our software products.  We sell our software products and services primarily through our direct sales force and in some cases we utilize resellers.  We sell our hardware products primarily through resellers.

 

 

 

Three Months Ended
March 31,

 

(Dollars in thousands)

 

2015

 

Change
%

 

2014

 

Product revenues

 

$

7,054

 

3%

 

$

6,861

 

Subscription revenues

 

1,553

 

(35)%

 

2,377

 

 

 

 

 

 

 

 

 

Services and maintenance revenues:

 

 

 

 

 

 

 

Professional services

 

4,460

 

(4)%

 

4,652

 

Training

 

2,168

 

12%

 

1,931

 

Maintenance

 

9,769

 

2%

 

9,560

 

Total services and maintenance revenues

 

16,397

 

2%

 

16,143

 

Total revenues

 

$

25,004

 

(2)%

 

$

25,381

 

 

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Table of Contents

 

Product Revenues

 

We generate product revenue principally from two product categories: Enterprise and Forensic products.  Our Enterprise products include perpetual licenses and are related to our EnCase® Enterprise, Cybersecurity, Analytics and eDiscovery products. Our Forensic products include revenues related to EnCase® Forensic, EnCase® Portable, and forensic hardware sales.  During the first two quarters of each fiscal year, we typically experience our lowest levels of product sales due to the seasonal budgetary cycles of our customers.

 

Product revenues increased by $0.2 million, or 3%, from $6.9 million to $7.1 million for the three months ended March 31, 2015, as compared to the same period in 2014.  The increase in product revenues was primarily a result of $0.7 million increase in Enterprise product revenues, partially offset by $0.5 million decrease in forensic product revenues.  The increase in Enterprise revenue was primarily due to higher average deal sizes as compared to the comparable period in the prior year.  Forensic revenue decreased primarily due to continued weakness in government spending.  During the three months ended March 31, 2015, we added 120 new EnCase® Enterprise customers, compared to 161 for the comparable period in the prior year.

 

Subscription Revenues

 

Subscription service customers have the right to access our cloud-based document review and production software; however, they may not take possession of the software at any time during the term of the agreement.  We generate subscription revenue principally from two types of customers: corporate or large enterprise customers who typically use our cloud-based software to host multiple legal cases on an ongoing basis, and law firm customers, who typically use our cloud-based software to host single cases.  In general, we recognize revenues for subscriptions on a straight-line basis over the contract period commencing on the date the subscription is made available to the customer.  Usage-based fees, which are determined monthly, are recognized when earned.

 

Subscription revenues decreased $0.8 million, or 35%, from $2.4 million to $1.6 million for the three months ended March 31, 2015, as compared with the same period in 2014.  The decrease was primarily due to downward pricing pressures in the eDiscovery sector and reduced revenue as a result of single-use law firm customers transitioning their cases from production to archive status.  Our business model focuses on enterprise customers who typically use our product for multiple legal cases on an ongoing basis.

 

Services and Maintenance Revenues

 

Services and maintenance revenues increased by $0.3 million, or 2%, from $16.1 million to $16.4 million for the three months ended March 31, 2015, as compared to the same period in 2014.  The increase was due to an increase in training revenues of $0.2 million related to increased demand for our training services due to our overall higher customer count, an increase in our maintenance revenues of $0.2 million due to sustained increases in our installed product base and renewals, partially offset by a $0.2 million decrease in professional services revenue related to lower demand from our cloud-based subscription customers.  In 2014, our installed product base increased primarily through the addition of 568 new EnCase Enterprise customers and sales of 157 new EnCase Cybersecurity, 99 new EnCase Analytics, and 137 new EnCase eDiscovery modules to EnCase Enterprise customers.  In addition, in the first quarter of 2015, we added 120 new EnCase Enterprise customers and sales of 31 new EnCase Cybersecurity, 12 new EnCase Analytics, and 23 new EnCase eDiscovery modules to EnCase Enterprise customers.

 

Cost of Revenues

 

 

 

Three Months Ended
March 31,

 

(Dollars in thousands)

 

2015

 

Change %

 

2014

 

Cost of product revenues

 

$

1,743

 

(1)%

 

$

1,750

 

Cost of subscription revenues

 

1,022

 

(10)%

 

1,133

 

 

 

 

 

 

 

 

 

Cost of services and maintenance revenues:

 

 

 

 

 

 

 

Professional services revenues

 

3,776

 

2%

 

3,721

 

Training

 

1,418

 

(10)%

 

1,574

 

Maintenance revenues

 

490

 

(5)%

 

513

 

Total cost of services and maintenance revenues

 

5,684

 

(2)%

 

5,808

 

Total cost of revenues

 

$

8,449

 

(3)%

 

$

8,691

 

 

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Table of Contents

 

Share-based compensation included above:

 

Cost of product revenues

 

$

32

 

 

 

$

39

 

Cost of subscription revenues

 

$

12

 

 

 

$

52

 

Cost of services and maintenance revenues

 

$

317

 

 

 

$

317

 

 

 

 

 

 

 

 

 

Gross Margin Percentage

 

 

 

 

 

 

 

Products

 

75.3

%

 

 

74.5

%

Subscriptions

 

34.2

%

 

 

52.3

%

Services and maintenance

 

65.3

%

 

 

64.0

%

Total

 

66.2

%

 

 

65.8

%

 

Cost of Product Revenues

 

Cost of product revenue consists principally of the cost of producing our software products, including third party software royalties, the cost of manufacturing our hardware products and product distribution costs, including the cost of packaging, shipping, customs duties, and, to a lesser extent, compensation and related overhead expenses.  While these costs are primarily variable with respect to sales volumes, they remain low in relation to the revenues generated and result in higher gross margins than our services and training businesses.  Our gross margins can be affected by product mix, as our enterprise products are generally higher margin products than our forensic products, which include software and hardware.

 

Cost of product revenue decreased $0.1 million, or 1%, from $1.8 million to $1.7 million for the three months ended March 31, 2015, as compared to the same period in 2014.  The decrease was due to a reduction of $0.2 million in various costs of goods sold, partially offset by a $0.1 million increase in cost of hardware.

 

Cost of Subscription Revenues

 

The cost of subscription revenues consists principally of employee compensation costs, including share-based compensation and related overhead, software maintenance paid to third party vendors, and SaaS hosting infrastructure costs.  The cost of subscription revenues decreased $0.1 million, or 10%, from $1.1 million to $1.0 million for the three months ended March 31, 2015, compared with the same period in 2014.  The decrease was primarily due to a reduction in compensation and employee-related costs associated with a reduction in headcount that occurred during the second quarter of 2014.

 

Cost of Services and Maintenance Revenues

 

The cost of services and maintenance revenues is largely comprised of employee compensation costs, including share-based compensation, and related overhead, travel and facilities costs.  The cost of maintenance revenues is primarily outsourced, but also includes employee compensation cost for customer technical support and related overhead costs.

 

Total cost of services and maintenance revenues decreased $0.1 million, or 2%, from $5.8 million to $5.7 million for the three months ended March 31, 2015, as compared with the same periods in 2014.  The decrease was primarily due to realignment expense associated with our headcount reduction in 2014.

 

Operating Expenses

 

 

 

Three Months Ended
March 31,

 

(Dollars in thousands) 

 

2015

 

Change %

 

2014

 

Selling and marketing expenses

 

$

8,944

 

(11)%

 

$

10,065

 

Research and development expenses

 

$

5,165

 

(20)%

 

$

6,472

 

General and administrative expenses

 

$

4,555

 

7%

 

$

4,262

 

Depreciation and amortization expenses

 

$

1,641

 

(17)%

 

$

1,974

 

 

 

 

 

 

 

 

 

Share-based compensation included above:

 

 

 

 

 

 

 

Selling and marketing expenses

 

$

355

 

 

 

$

393

 

Research and development expenses

 

$

438

 

 

 

$

462

 

General and administrative expenses

 

$

512

 

 

 

$

467

 

 

 

 

 

 

 

 

 

As a percentage of revenues:

 

 

 

 

 

 

 

Selling and marketing expenses

 

35.8

%

 

 

39.7

%

Research and development expenses

 

20.7

%

 

 

25.5

%

General and administrative expenses

 

18.2

%

 

 

16.8

%

Depreciation and amortization expenses

 

6.6

%

 

 

7.8

%

 

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Table of Contents

 

Selling and Marketing Expenses

 

Selling and marketing expenses consist primarily of personnel costs and costs related to our sales force and marketing staff. Selling and marketing expenses also include expenses relating to advertising, brand building, marketing promotions and trade show events (net of amounts received from sponsors and participants), product management, and travel and allocated overhead.

 

Selling and marketing expenses decreased $1.1 million, or 11%, from $10.1 million to $8.9 million for the three months ended March 31, 2015, as compared with the same period in 2014.  The decrease was primarily due to $0.5 million of realignment expense in 2014 related to our headcount reduction, a $0.5 million decrease in compensation and other employee-related costs due to lower headcount, and a $0.1 million decrease in sales commissions.

 

Research and Development Expenses

 

Research and development expenses consist primarily of compensation, including share-based compensation and related overhead expenses.  Research and development expenses decreased $1.3 million, or 20%, from $6.5 million to $5.2 million for the three months ended March 31, 2015, as compared to the same period in 2014.  The decrease was primarily due to a $1.0 million decrease in compensation and other employee-related costs due to lower headcount and a decrease of $0.3 million of realignment expense related to the reduction in headcount in 2014.

 

General and Administrative Expenses

 

General and administrative expenses consist of personnel and related costs for accounting, legal, information systems, human resources and other administrative functions.  In addition, general and administrative expenses include professional service fees, bad debt expense, and other corporate expenses and related overhead.

 

General and administrative expenses increased $0.3 million, or 7%, from $4.3 million to $4.6 million for the three months ended March 31, 2015, as compared with the same period in 2014.  The increase was due to a $0.2 million increase in variable compensation expense due to higher expected achievements for 2015 than in the prior year quarter, and a $0.2 million increase in recruiting fees associated with the search for our new CEO, partially offset by a $0.1 million decrease in realignment expense related to our headcount reduction in 2014.

 

Depreciation and Amortization Expenses

 

Depreciation and amortization expenses consist of depreciation and amortization of our leasehold improvements, furniture, computer hardware and software, and intangible assets.  Depreciation and amortization expenses decreased $0.3 million, or 17%, from $2.0 million to $1.6 million for the three months ended March 31, 2015, as compared with the same period in 2014.  The decrease was due to a $0.2 million reduction in fixed asset purchases and assets being full depreciated, as well as a $0.1 million decrease due to the review of the viability of certain acquired technology in the first quarter of 2014, which resulted in the acceleration of the amortized life of some of our acquired technology.

 

Other Income and Expense

 

Total other income and expense consists of interest earned on cash balances, interest expense paid and other miscellaneous income and expense items.  Other income decreased $8,000, or 47%, from $17,000 to $9,000 for the three months ended March 31, 2015, compared to the same period in 2014.

 

Income Tax Provision

 

We recorded an income tax provision for the three months ended March 31, 2015 of $71,000 as compared to $78,000 for the same period in 2014. Our income tax provision for the three months ended March 31, 2015 and 2014 differs from the U.S. statutory rate of 34% primarily due to state taxes, foreign taxes, the tax impact of certain share-based compensation charges, and the impact of providing a valuation allowance against research & development credits and deferred tax assets.

 

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Liquidity and Capital Resources

 

Since inception, we have largely financed our operations from the cash flow generated from the sale of our products and services. As of March 31, 2015, we had $24.4 million in cash and cash equivalents.  We believe that our cash flow from operations and our cash and cash equivalents are sufficient to fund our working capital and capital expenditure requirements for at least the next 12 months.

 

Changes in Cash Flow

 

We generate cash from operating activities primarily from cash collections related to the sale of our products and services. Net cash provided by operating activities was $5.8 million for the three months ended March 31, 2015, as compared to $1.7 million for the same period in 2014.  The increase in cash provided by operating activities was primarily a result of a decrease in our net loss to $3.8 million for the three months ended March 31, 2015, compared to the net loss of $6.1 million for the same period in 2014, an increase in accrued liabilities of $1.4 million for the three months ended March 31, 2015, compared to a decrease of $0.8 million for the same period in 2014, an increase of deferred revenues of $4.0 million for the three months ended March 31, 2015, compared to an increase of $1.8 million for the same period in 2014, partially offset by a decrease of $3.3 million in trade receivables for the three months ended March 31, 2015, compared to $5.1 million for the same period in 2014, and a $2.9 million decrease in accounts payable for the three months ended March 31, 2015, compared to a $1.3 million decrease for the same period in 2014.

 

Net cash used in investing activities was $0.5 million for the three months ended March 31, 2015, compared to $0.9 million for the same period in 2014.  The decrease in cash used in investing activities was primarily due to assets being fully depreciated and lower fixed asset purchases in the first quarter of 2015, compared to the same period in 2014.

 

Net cash provided by financing activities was $0.7 million for the three months ended March 31, 2015, compared to net cash used in financing activities of $0.6 million for the same period in 2014.  The increase in cash provided by financing activities was primarily due to $0.8 million in proceeds from the exercise of stock options for the three months ended March 31, 2015, compared to $0.6 million for the same period in 2014, partially offset by $22,000 in principal payments made on capital leases and other obligations for the three months ended March 31, 2015, compared to $76,000 for the same period in 2014.

 

On August 29, 2014, we entered into a three year, Senior Secured Revolving Line of Credit (“Revolver”) with a bank.  The maximum principal amount that may be outstanding at any given time under the Revolver, which includes up to $3.0 million of standby letters of credit, is $10.0 million.  Any borrowings under the Revolver would be collateralized by substantially all of our assets, as well as pledges of capital stock.  The Revolver requires that, if we suffer an event of default or have borrowed more than 75% of the maximum principal amount permitted to be outstanding, we maintain an Adjusted Quick Ratio of at least 1.15 to 1.0.  If the Adjusted Quick Ratio falls below 1.5 to 1.0, any collections received by the bank on behalf of the Company will be applied to outstanding loan balances before being remitted to the Company’s operating account.  The Adjusted Quick Ratio is calculated by dividing Quick Assets (cash less restricted cash plus accounts receivable) by current liabilities (current liabilities plus outstanding standby letter of credit less the current portion of deferred revenue).  Borrowings under the Revolver bear interest at a floating rate ranging from 1.25% to 3.25% above the Prime Rate depending on the Company’s Adjusted Quick Ratio.  We are obligated to pay a commitment fee of $0.2 million over the three year term of the Revolver. All principal, interest and any other fees will be due and payable in full on or prior to August 29, 2017.

 

As of March 31, 2015, we were in compliance with all the covenants of the Revolver.  We had letters of credit outstanding against the Revolver in the amount of $1.3 million, resulting in the maximum available borrowing under the Revolver to be $8.5 million.  Availability is calculated as 80% of eligible accounts receivable, with a maximum of $10.0 million.  To date we have not borrowed under the Revolver.

 

On February 25, 2015, we entered into an amendment (“Amendment”) to the Senior Secured Revolving Line of Credit (“Revolver.”)  The Amendment is for advances (each, an “Equipment Advance”) from the bank to be used solely for eligible equipment purchases.  Eligible equipment includes (a) general purpose equipment, computer equipment, office equipment, furnishings, subject to certain limitations, (b) computer software and transferable software licenses, and (c) other equipment.  The maximum advance (“Equipment Line”) equals $2.2 million an Equipment Advance and must be paid thirty-six months after it has been issued.  The principal amount outstanding for each Equipment Advance shall accrue interest at an annual rate, based on the Adjusted Quick Ratio, ranging from 1.25% - 3.25% above the Prime Rate, and shall be paid monthly. Amount drawn on the Equipment Line reduces the available amount under the Revolver. To date we have not drawn on the Equipment Line.

 

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Contractual Obligations and Commitments

 

The Company had obligations, to be paid in cash, to the former shareholders of CaseCentral if certain SaaS and EnCase® eDiscovery revenue thresholds were achieved during the three 12-month periods that ended on March 31, 2015.  The revenue thresholds for those periods were not met and consequently no contingent consideration was due.  The fair value of this contingent consideration is determined using a present value calculation.  Expected cash flows are determined using the probability-weighted average of possible outcomes that would occur should certain revenue metrics be reached.  There is no market data available to use in valuing the contingent consideration; therefore, we developed our own assumptions related to the future financial performance of the businesses to evaluate the fair value of these liabilities.

 

In connection with estimating the fair value of the contingent consideration, we developed various scenarios (base case, downside case, and upside case) and weighted each case according to the probability of occurrence.  The probabilities ranged from 20 percent to 50 percent, with the most significant weighting given to the base case at 50 percent.  These scenarios were developed based on the expected financial performance of CaseCentral, with SaaS revenue growth rates being a primary input in the calculation.  An increase or decrease in the probability of achievement of any of the scenarios could result in a significant increase or decrease to the estimated fair value.

 

The fair value was reviewed quarterly based on the financial performance of the most recently completed fiscal quarter. An analysis was performed at the end of each fiscal quarter to compare actual results to forecasted financial performance.  If performance deviated from projected levels, the valuation was updated for the latest information available.

 

The significant assumptions noted in the items above that may materially affect fair value are developed in conjunction with the guidance of our senior management to ensure that the most accurate and latest financial projections are used and compared with the most recent financial results in the fair value measurement.

 

On March 31, 2015, we amended our Office Lease Agreement (the “Pasadena Lease”) dated July 26, 2012 to expand our headquarters by approximately 3,600 rentable square feet.  The amendment commences on June 1, 2016 and the Pasadena Lease expires on May 31, 2024.  The expansion increases the base rent from a range of approximately $110,000 for the first year to approximately $140,000 for the final year.

 

On July 3, 2014, we entered into an Office Lease Agreement (the “San Francisco Lease”) to lease approximately 6,000 rentable square feet of an office building located in San Francisco, California.  The office building is the new location of our San Francisco office.  The San Francisco Lease commenced on December 1, 2014 and expires in December 31, 2019.  The total annual rent under the San Francisco Lease ranges from approximately $295,000 for the first year to approximately $332,000 for the final year.

 

Effective April 1, 2014, we entered into a Colocation Lease Agreement (the “Colocation Lease”) to rent space in a building located in Chandler, Arizona.  The Colocation Lease expires on June 30, 2018.  The Colocation Lease will serve as our new data center, replacing our former San Francisco location obtained in the Case Central acquisition.  Rent is based on power allocation and ranges from approximately $236,000 for the first year to approximately $265,000 for the final year.

 

During the year ended December 31, 2014, the Company entered into a $1.5 million third-party software license agreement authorizing the Company to integrate software as a component of its products through March 2018.  The agreement also provides for maintenance and support over a three-year period, which may be renewed by the Company at the expiration of the three-year period ending March 2018.  The $1.5 million is payable in three annual installments of $492,000, with the final installment being paid in November 2016.  The license, maintenance and remaining liability have been recorded on the accompanying Consolidated Balance Sheets.

 

At March 31, 2015, other than the CaseCentral contingent consideration, our outstanding contractual cash commitments were largely limited to our non-cancellable lease obligations, primarily relating to office facilities. In “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2014, we reported that our contractual obligation for these non-cancellable lease obligations as of December 31, 2014 was approximately $32.6 million, of which $4.6 million is due during 2015.  Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our selling and marketing activities, the timing and extent of research and development spending to support product development and enhancement efforts, costs associated with expansion into new territories or markets, the timing of the introduction of new products and services, the enhancement of existing products and the continuing market acceptance of our products and services.  To the extent that our existing cash, cash from operations or the availability of cash under our line of credit are insufficient to fund our future activities and planned growth, we may need to raise additional funds through public or private equity or debt financings.  Additional funds may not be available on terms favorable to us or at all.  Furthermore, although we cannot accurately anticipate the effect of inflation or foreign exchange markets on our operations, we do not believe these external economic forces have had, or are likely in the foreseeable future to have, a material impact on our results of operations.

 

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Other than the items stated above, we currently have no other material cash commitments, except our normal recurring trade payables, expense accruals, leases and license obligations, all of which are currently expected to be funded through existing working capital and future cash flows from operations.

 

Off-Balance Sheet Arrangements

 

At March 31, 2015, we had no off-balance sheet arrangements as defined in Item 303(a)(4) of the SEC’s Regulation S-K.  We do not have material relationships or transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties except as disclosed in this report.

 

Item 3.                                   Quantitative and Qualitative Disclosure about Market Risk

 

Market Risk. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates.  Our market risk exposure is primarily a result of fluctuations in foreign exchange rates, interest rates and credit risk.  We do not hold or issue financial instruments for trading purposes.

 

Foreign Currency Risk. To date, substantially all of our international sales have been denominated in US dollars, and therefore, the majority of our revenues are not subject to foreign currency risk.  Our operating expenses and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, but such changes have historically had relatively little impact on our operating results and cash flows.  A strengthening of the dollar could make our products and services less competitive in foreign markets and therefore could reduce our revenues. In the future, an increased portion of our revenues and costs may be denominated in foreign currencies.  We do not enter into derivative instrument transactions for trading or speculative purposes.

 

Interest Rate Risk.  Our investment portfolio, consisting of highly liquid debt instruments of the US government at March 31, 2015, is subject to interest rate risk.  The fair value of our investment portfolio would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due mainly to the short-term nature of our investment portfolio.

 

Item 4.                                  Controls and Procedures

 

Management, with the participation of the President and Chief Executive Officer and Chief Financial Officer, has performed an evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934).  This evaluation includes consideration of the controls, processes and procedures that are designed to ensure that information required to be disclosed by us in the reports we file under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our President and Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Based on such evaluation, our President and Chief Executive Officer and Chief Financial Officer concluded that, as of March 31, 2015, our disclosure controls and procedures were effective.

 

Changes in Internal Control Over Financial Reporting

 

There have been no changes in our internal control over financial reporting during the three months ended March 31, 2015 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

 

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PART II. OTHER INFORMATION

 

Item 1.                                  Legal Proceedings

 

On May 20, 2011, MyKey Technology Inc. (“MyKey”) filed a complaint against us and certain other parties for patent infringement in the United States District Court for the District of Delaware.  With respect to the Company, the complaint alleged that certain of the data acquisition forensic hardware products that we acquired through the acquisition of certain assets of Tableau, LLC (“Tableau”) infringe three of MyKey’s patents relating to write blocking, duplication and data removal technologies.  The complaint sought a declaration of infringement, a finding of willful infringement, compensatory damages, treble damages, injunctive relief, interest, expenses, costs and attorneys’ fees.

 

On July 22, 2011, MyKey also filed a complaint with the United States International Trade Commission (the “ITC”), alleging infringement by the Company and certain other parties of the three patents discussed in the preceding paragraph and requesting that the ITC commence an investigation pursuant to Section 337 of the Tariff Act of 1930.  The complaint sought injunctive relief barring the Company from the importation of products that allegedly infringed the MyKey patents.  On August 24, 2011, the ITC commenced an investigation of the Company and certain other parties related to the complaint by MyKey.  On August 31, 2011 the proceeding in the District Court was stayed pending the resolution of the ITC matter.  On August 1, 2012, MyKey amended its ITC complaint to remove allegations that its duplication patent had been infringed by the Company and to reduce the number of claims alleging the Company infringed MyKey’s data removal patent.  In August 2012, the parties completed a trial on the remaining patent claims at issue.

 

On December 28, 2012, the ITC released a final determination and Order holding that no violation of Section 337 of the Tariff Act of 1930 occurred as a result of the Company’s importation into the United States and sale of the products at issue.  This Order effectively ended the ITC proceeding in the Company’s favor.

 

On February 20, 2013, the U.S. District Court of Delaware lifted the stay of the proceedings in the MyKey matter.  Effective April 8, 2013, the parties stipulated to a transfer of the matter to the U.S. District Court for the Central District of California.  On April 16, 2013, the Company filed its Answer and Counterclaim.  MyKey filed a petition to consolidate a number of related cases, including the case against the Company in the Central District of California, into a Multi-District Litigation (“MDL”) proceeding.  On August 16, 2013, the MDL panel approved the petition and assigned the MDL consolidated cases to the judge who is also presiding over the individual case against the Company.  The MDL case will dispose of certain issues common to the consolidated cases, such as the validity of patents being asserted against the joint defendants.  On May 23, 2014, the parties completed a Markman hearing related to claim construction of the patents at issue.

 

On March 26, 2014, MyKey also filed a complaint against the United States of America alleging that the United States has infringed U.S. Patents No. 6,813,682, 7,159,086 and 7,228,379 by or through its acceptance, receipt and/or use of write blocker products, data duplication products and data removal products.  The complaint alleges that such products were supplied to the government by the Company and certain of its co-defendants in the MDL proceeding.  No damages amount is stated in the complaint.  The government could assert a claim for indemnification against the Company but has not done so yet.  Although a financial loss is reasonably possible, the Company is unable to estimate the range of potential loss at this time.

 

On October 16, 2014, MyKey filed a Notice of Status on Claim Construction Issues in the MDL action in which it acknowledged that MyKey will not be able to prove that the Company’s data duplication products infringed U.S. Patent 7,159,086.  In the same filing, MyKey acknowledged that certain claims of United States Patent 6,813,682 are invalid and therefore cannot be infringed by any product.

 

We intend to defend the remaining MyKey matters vigorously.  While a financial loss is reasonably possible, at this time we are unable to estimate what, if any, liability we may have in connection with these matters.  We are unable to estimate a range of reasonably possible financial losses for various reasons, including, among others, that (1) certain of the proceedings are at an early stage, (2) there is uncertainty as to the outcome of pending appeals, motions, or settlements, (3) there are significant factual issues to be resolved, (4) there are unresolved negotiations with certain indemnitors or indemnitees of the Company, related to the actions, and (5) we have meritorious defenses that we intend to assert.

 

From time to time, we may become involved in various other lawsuits and legal proceedings that arise in the ordinary course of business.  Litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business.  We are not currently aware of any such other legal proceedings or claims that are likely to have a material impact on our business.

 

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Item 1A.                          Risk Factors

 

There have been no material changes to the risk factors as presented in our Annual Report on Form 10-K for the year ended December 31, 2014, filed with the U.S. Securities and Exchange Commission on February 24, 2015.

 

Item 2.                                 Unregistered Sales of Equity Securities and Use of Proceeds

 

There have been no material changes to the Unregistered Sales of Equity Securities and Use of Processed as presented in our Annual Report on Form 10-K for the year ended December 31, 2014, filed with the U.S. Securities and Exchange Commission on February 24, 2015.

 

Item 3.                                  Defaults upon Senior Securities

 

No information is required in response to this item.

 

Item 4.                                  [Removed and Reserved]

 

No information is required in response to this item.

 

Item 5.                                  Other Information

 

No information is required in response to this item.

 

Item 6.         Exhibits

 

Exhibit
Number

 

Description of Documents

10.37

 

Second Amendment to Pasadena Lease, dated March 31, 2015, by and among Guidance Software, Inc., 1055 E Pasadena, CA L.P.

10.38*

 

Appointment of Certain Officers, Press Release of Guidance Software, Inc., dated April 14, 2015

31.1

 

Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2

 

Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1†

 

Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2†

 

Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101.INS

 

XBRL Instance Document

101.SCH

 

XBRL Taxonomy Extension Schema Document

101.CAL

 

XBRL Taxonomy Extension Calculation Linkbase Document

101.DEF

 

XBRL Taxonomy Extension Definition Linkbase Document

101.LAB

 

XBRL Taxonomy Extension Label Linkbase Document

101.PRE

 

XBRL Taxonomy Extension Presentation Linkbase Document

 


*                          Incorporated by reference to Guidance Software, Inc.’s Current Report on Form 8-K filed on April 15, 2015.

                          These certifications are being furnished solely to accompany this Quarterly Report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934 and are not to be incorporated by reference into any filing of Guidance Software, Inc., whether made before or after the date hereof, regardless of any general incorporation language in such filing.

 

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SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

Guidance Software, Inc.

 

 

 

By:

/s/ Barry J. Plaga

 

 

Barry J. Plaga

 

 

Chief Financial Officer

 

 

(Principal Financial Officer)

 

Dated: May 8, 2015

 

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