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EX-32.1 - EXHIBIT 32.1 - Zendesk, Inc.zen_10-qxq3x2018xexhibit321.htm
EX-31.2 - EXHIBIT 31.2 - Zendesk, Inc.zen_10-qxq3x2018xexhibit312.htm
EX-31.1 - EXHIBIT 31.1 - Zendesk, Inc.zen_10-qxq3x2018xexhibit311.htm

UNITED STATES  
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
(Mark One)
 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018
OR
 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from       to       
Commission File Number: 001-36456
 
ZENDESK, INC.
(Exact Name of Registrant as Specified in its Charter)
Delaware
 
26-4411091
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
1019 Market Street
San Francisco, CA
 
94103
(Address of principal executive offices)
 
(Zip Code)
 
 
Registrant’s telephone number, including area code: (415) 418-7506
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
 x
Accelerated filer
Non-accelerated filer
(do not check if a smaller reporting company)
Smaller reporting company
 
 
Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes      No  x
As of October 31, 2018, there were 107,041,554 shares of the registrant’s common stock outstanding.



ZENDESK, INC.
TABLE OF CONTENTS
 
PART I — FINANCIAL INFORMATION
 
Item 1
 
 
 
 
 
Item 2
Item 3
Item 4
 
 
 
PART II — OTHER INFORMATION 
 
 
 
Item 1
Item 1A
Item 6

2


SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of federal securities laws, which statements involve substantial risks and uncertainties. Forward-looking statements generally relate to future events or our future financial or operating performance. In some cases, you can identify forward-looking statements because they contain words such as “may,” “will,” “should,” “might,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential,” or “continue,” or the negative of these words or other similar terms or expressions that concern our expectations, strategy, plans, or intentions. Forward-looking statements contained in this Quarterly Report on Form 10-Q include, but are not limited to, statements about:

our future financial performance, including our revenue, cost of revenue, gross profit, operating expenses, ability to generate positive cash flow, and ability to achieve and maintain profitability;
the sufficiency of our cash and cash equivalents and marketable securities to meet our liquidity needs;
our ability to attract and retain customers to use our products, and our ability to optimize the pricing for such products;
the evolution of technology affecting our products, services, and markets;
our ability to innovate and provide a superior customer experience;
our ability to successfully expand in our existing markets and into new markets;
the attraction and retention of qualified employees and key personnel;
worldwide economic conditions and their impact on information technology spending;
our ability to effectively manage our growth and future expenses;
our ability to introduce and market new products and to integrate such products into our infrastructure;
our ability to maintain, protect, and enhance our intellectual property;
our ability to comply with modified or new laws and regulations applying to our business, including privacy and data security regulations;
our ability to securely maintain customer data;
our ability to service the interest on our convertible notes and repay such notes, if required;
our ability to successfully integrate people, products, technology and services following completion of acquisitions;
our ability to maintain and enhance our brand; and
the increased expenses and administrative workload associated with being a public company.
We caution you that the foregoing list does not contain all of the forward-looking statements made in this Quarterly Report on Form 10-Q.
You should not rely upon forward-looking statements as predictions of future events. We have based the forward-looking statements contained in this Quarterly Report on Form 10-Q primarily on our current expectations and projections about future events and trends that we believe may affect our business, financial condition, operating results, and prospects. The outcome of the events described in these forward-looking statements is subject to risks, uncertainties, and other factors described in the section titled “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks and uncertainties emerge from time to time, and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements contained in this Quarterly Report on Form 10-Q. We cannot assure you that the results, events, and circumstances reflected in the forward-looking statements will be achieved or occur, and actual results, events, or circumstances could differ materially from those described in the forward-looking statements.
The forward-looking statements made in this Quarterly Report on Form 10-Q relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statements made in this Quarterly Report on Form 10-Q to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect new information or the occurrence of unanticipated events, except as required by law. We may not actually achieve the plans, intentions, or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures, or investments we may make.

3


PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
ZENDESK, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value and shares)
 
 
September 30,
2018
 
December 31,
2017
(Unaudited)
 
* As adjusted
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
157,158

 
$
109,370

Marketable securities
293,598

 
137,576

Accounts receivable, net of allowance for doubtful accounts of $2,862 and $1,252 as of September 30, 2018 and December 31, 2017, respectively
82,935

 
57,096

Deferred costs
21,183

 
15,771

Prepaid expenses and other current assets
34,287

 
24,165

Total current assets
589,161

 
343,978

Marketable securities, noncurrent
360,350

 
97,447

Property and equipment, net
72,335

 
59,157

Deferred costs, noncurrent
22,175

 
15,395

Goodwill and intangible assets, net
148,886

 
67,034

Other assets
11,157

 
8,359

Total assets
$
1,204,064

 
$
591,370

Liabilities and stockholders’ equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
29,270

 
$
5,307

Accrued liabilities
38,699

 
21,876

Accrued compensation and related benefits
39,158

 
29,017

Deferred revenue
222,936

 
173,147

Total current liabilities
330,063

 
229,347

Convertible senior notes, net
452,075

 

Deferred revenue, noncurrent
2,551

 
1,213

Other liabilities
14,598

 
6,626

Total liabilities
799,287

 
237,186

Commitments and contingencies (Note 8)

 

Stockholders’ equity:
 
 
 
Preferred stock

 

Common stock
1,066

 
1,031

Additional paid-in capital
905,386

 
753,568

Accumulated other comprehensive loss
(5,797
)
 
(2,372
)
Accumulated deficit
(495,878
)
 
(398,043
)
Total stockholders’ equity
404,777

 
354,184

Total liabilities and stockholders’ equity
$
1,204,064

 
$
591,370

* See Note 1 for a summary of adjustments.

See Notes to Condensed Consolidated Financial Statements.


4


ZENDESK, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
2018
 
2017
 
2018
 
2017
 
 
*As adjusted
 
 
*As adjusted
Revenue
$
154,828

 
$
112,265

 
$
426,501

 
$
308,249

Cost of revenue (1)
46,992

 
33,693

 
130,207

 
92,463

Gross profit
107,836

 
78,572

 
296,294

 
215,786

Operating expenses (1):
 
 
 
 
 
 
 
Research and development
40,410

 
29,358

 
115,118

 
84,512

Sales and marketing
74,270

 
54,383

 
208,778

 
151,064

General and administrative
27,357

 
21,398

 
73,809

 
59,503

Total operating expenses
142,037

 
105,139

 
397,705

 
295,079

Operating loss
(34,201
)
 
(26,567
)
 
(101,411
)
 
(79,293
)
Other income (expense), net:
 
 
 
 
 
 
 
Interest income
4,561

 
923

 
9,906

 
2,463

Interest expense
(6,375
)
 

 
(13,427
)
 

Other expense, net
(463
)
 
(304
)
 
(194
)
 
(1,118
)
Total other income (expense), net
(2,277
)
 
619

 
(3,715
)
 
1,345

Loss before benefit from income taxes
(36,478
)
 
(25,948
)
 
(105,126
)
 
(77,948
)
Benefit from income taxes
(2,334
)
 
(133
)
 
(7,291
)
 
(785
)
Net loss
$
(34,144
)
 
$
(25,815
)
 
$
(97,835
)
 
$
(77,163
)
Net loss per share, basic and diluted
$
(0.32
)
 
$
(0.26
)
 
$
(0.93
)
 
$
(0.78
)
Weighted-average shares used to compute net loss per share, basic and diluted
106,143

 
100,659

 
104,954

 
99,203

(1) Includes share-based compensation expense as follows:
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
2018
 
2017
 
2018
 
2017
 
 
* As adjusted
 
 
* As adjusted
Cost of revenue
$
3,929

 
$
2,408

 
$
10,500

 
$
6,668

Research and development
10,677

 
7,776

 
30,436

 
22,274

Sales and marketing
10,261

 
6,573

 
27,447

 
17,981

General and administrative
6,579

 
5,619

 
18,198

 
15,502

 
* See Note 1 for a summary of adjustments.

See Notes to Condensed Consolidated Financial Statements.


5


ZENDESK, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands)
(Unaudited)
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
2018
 
2017
 
2018
 
2017
 
 
* As adjusted
 
 
* As adjusted
Net loss
$
(34,144
)
 
$
(25,815
)
 
$
(97,835
)
 
$
(77,163
)
Other comprehensive gain (loss), before tax:
 
 
 
 
 
 
 
Net unrealized gain (loss) on available-for-sale investments
(50
)
 
80

 
(673
)
 
213

Foreign currency translation gain (loss)

 

 
(12
)
 
824

Net unrealized gain (loss) on derivative instruments
418

 
344

 
(3,456
)
 
3,692

Other comprehensive gain (loss), before tax
368

 
424

 
(4,141
)
 
4,729

Tax effect
(366
)
 
(156
)
 
716

 
(1,737
)
Other comprehensive gain (loss), net of tax
2

 
268

 
(3,425
)
 
2,992

Comprehensive loss
$
(34,142
)
 
$
(25,547
)
 
$
(101,260
)
 
$
(74,171
)
* See Note 1 for a summary of adjustments.

See Notes to Condensed Consolidated Financial Statements.


6


ZENDESK, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
Nine Months Ended September 30,
2018
 
2017
 
 
* As adjusted
Cash flows from operating activities
 

 
 
Net loss
$
(97,835
)
 
$
(77,163
)
Adjustments to reconcile net loss to net cash provided by operating activities
 

 
 
Depreciation and amortization
27,193

 
24,263

Share-based compensation
86,581

 
62,425

Amortization of deferred costs
15,124

 
10,332

Amortization of debt discount and issuance costs
12,665

 

Other
2,865

 
381

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
(26,721
)
 
(15,039
)
Prepaid expenses and other current assets
(10,167
)
 
(5,116
)
Deferred costs
(26,716
)
 
(15,595
)
Other assets and liabilities
(8,026
)
 
(5,323
)
Accounts payable
20,607

 
7,237

Accrued liabilities
7,073

 
6,843

Accrued compensation and related benefits
2,487

 
1,503

Deferred revenue
50,552

 
30,174

Net cash provided by operating activities
55,682

 
24,922

Cash flows from investing activities
 
 
 
Purchases of property and equipment
(27,132
)
 
(13,334
)
Internal-use software development costs
(5,550
)
 
(5,237
)
Purchases of marketable securities
(591,426
)
 
(135,279
)
Proceeds from maturities of marketable securities
131,819

 
88,960

Proceeds from sales of marketable securities
40,775

 
28,144

Cash paid for the acquisition of Outbound, net of cash acquired

 
(16,470
)
Cash paid for the acquisition of FutureSimple, net of cash acquired
(79,363
)
 

Net cash used in investing activities
(530,877
)
 
(53,216
)
Cash flows from financing activities
 
 
 
Proceeds from issuance of convertible senior notes, net of issuance costs paid of $13,561
561,439

 

Purchase of capped call related to convertible senior notes
(63,940
)
 

Proceeds from exercises of employee stock options
13,254

 
18,550

Proceeds from employee stock purchase plan
15,999

 
10,980

Other
(3,807
)
 
(2,415
)
Net cash provided by financing activities
522,945

 
27,115

Effect of exchange rate changes on cash, cash equivalents and restricted cash
(55
)
 
288

Net increase (decrease) in cash, cash equivalents and restricted cash
47,695

 
(891
)
Cash, cash equivalents and restricted cash at beginning of period
110,888

 
95,062

Cash, cash equivalents and restricted cash at end of period
$
158,583

 
$
94,171

 
 
 
 
Reconciliation of cash, cash equivalents and restricted cash to condensed consolidated balance sheets
 
 
 
Cash and cash equivalents
$
157,158

 
$
92,603

Restricted cash included in prepaid expenses and other current assets
826

 
920

Restricted cash included in other assets
599

 
648

Total cash, cash equivalents and restricted cash
$
158,583

 
$
94,171

 
 
 
 
Supplemental cash flow data
 
 
 
Cash paid for income taxes and interest
$
3,468

 
$
1,532

Non-cash investing and financing activities
 
 
 
Balance of property and equipment in accounts payable and accrued expenses
$
5,680

 
$
1,384

Property and equipment acquired through tenant improvement allowances
$
5,435

 
$
437

Share-based compensation capitalized in internal-use software development costs
$
1,986

 
$
1,984

Share-based compensation capitalized in deferred costs
$
602

 
$
380

Vesting of early exercised stock options
$

 
$
317

*See Note 1 for a summary of adjustments.
See Notes to Condensed Consolidated Financial Statements.

7


ZENDESK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
Note 1. Overview and Basis of Presentation
Company and Background
Zendesk was founded in Denmark in 2007 and reincorporated in Delaware in April 2009.
We are a software development company that provides software as a service, or SaaS, products that are intended to help organizations and their customers build better relationships. With our origins in customer service, we have evolved our offerings over time to a family of products that work together to help organizations understand their customers, improve communications, and engage where and when it’s needed most. Our product family is built upon a modern architecture that enables us and our customers to rapidly innovate, adapt our technology in novel ways, and easily integrate with other products and applications.
References to Zendesk, the “Company,” “our,” or “we” in these notes refer to Zendesk, Inc. and its subsidiaries on a consolidated basis.
Basis of Presentation
These unaudited condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles, or GAAP, and applicable rules and regulations of the Securities and Exchange Commission, or SEC, regarding interim financial reporting. Certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Therefore, these condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in our Annual Report on Form 10-K, as amended by Form 10-K/A, for the year ended December 31, 2017, filed with the SEC on November 5, 2018. There have been no changes to our significant accounting policies described in the Annual Report on Form 10-K that have had a material impact on our condensed consolidated financial statements and related notes, except as described below.
Effective January 1, 2018, we adopted the requirements of Accounting Standards Update, or ASU, 2014-09, “Revenue from Contracts with Customers” regarding Accounting Standards Codification, or ASC, Topic 606 and ASU 2016-18, “Statement of Cash Flows - Restricted Cash,” as discussed below. All amounts and disclosures set forth in this Form 10-Q have been updated to comply with the new standards, as indicated by “as adjusted.”
The unaudited consolidated balance sheet as of December 31, 2017 included herein was derived from the audited financial statements as of that date, giving effect to the adoption of ASC 606, as discussed below. The unaudited condensed consolidated financial statements reflect all normal recurring adjustments necessary to present fairly our financial position, results of operations, comprehensive loss, and cash flows for the interim periods, but are not necessarily indicative of the results of operations to be anticipated for the full year ending December 31, 2018.
Use of Estimates
The preparation of our consolidated financial statements in conformity with GAAP requires management to make certain estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenue and expenses during the reported periods.
Significant items subject to such estimates and assumptions include the fair value of share-based awards, acquired intangible assets, and goodwill as well as unrecognized tax benefits, the useful lives of acquired intangible assets and property and equipment, the capitalization and estimated useful life of capitalized costs to obtain customer contracts and capitalized internal-use software, variable consideration related to revenue recognition, and financial forecasts used in currency hedging.
These estimates are based on information available as of the date of the financial statements; therefore, actual results could differ from those estimates.

8


Concentrations of Risk
As of September 30, 2018, no customers represented 10% or greater of our total accounts receivable balance. There were no customers that individually exceeded 10% of our revenue during the three and nine months ended September 30, 2018 or 2017.
Recently Issued Accounting Pronouncements
In February 2016, the Financial Accounting Standards Board, or FASB, issued ASU 2016-02, regarding ASC Topic 842 “Leases,” including subsequent amendments. This new guidance requires lessees to recognize most leases on their balance sheets as right-of-use assets with corresponding lease liabilities and eliminates certain real estate-specific provisions. The new guidance is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period. Early adoption is permitted. We have completed our process to identify our population of lease arrangements and we are nearing the completion of applying the new guidance to each arrangement. We are also in the process of determining the incremental borrowing rate for each arrangement. We plan to adopt utilizing the modified retrospective method of transition. While the adoption remains in progress, we expect that adoption will result in the recognition of right-of-use assets and lease liabilities that were not previously recognized, which will increase total assets and liabilities on our consolidated balance sheet.
In August 2017, the FASB issued ASU 2017-12, regarding ASC Topic 815 “Derivatives and Hedging. This amendment simplifies various aspects of hedge accounting, including the measurement and presentation of hedge ineffectiveness and certain documentation and assessment requirements. The amendment also makes more hedging strategies eligible for hedge accounting. The guidance is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period. Early adoption is permitted. We are currently evaluating the effect of this standard on our consolidated financial statements.

In February 2018, the FASB issued ASU 2018-02, “Income Statement - Reporting Comprehensive Income,” which provides for the reclassification of the effect of remeasuring deferred tax balances related to items within accumulated other comprehensive income to retained earnings resulting from the Tax Cuts and Jobs Act, or Tax Act. The guidance is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period. Early adoption is permitted. We do not expect the adoption of this standard to have a material effect on our consolidated financial statements.

In June 2018, the FASB issued ASU 2018-07, regarding ASC Topic 718 “Compensation - Stock Compensation,” which largely aligns the accounting for share-based compensation for non-employees with employees. The guidance is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period. Early adoption is permitted. We do not expect the adoption of this standard to have a material effect on our consolidated financial statements.

In June 2018, the FASB issued ASU 2018-08, regarding ASC Topic 958 “Not-for-Profit Entities,” which clarified the guidance on how entities determine whether to account for a transfer of assets as an exchange transaction or a contribution. The guidance is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period. Early adoption is permitted. We do not expect the adoption of this standard to have a material effect on our consolidated financial statements.

In August 2018, the FASB issued ASU 2018-13, regarding ASC Topic 820 “Fair Value Measurement,” which modifies the disclosure requirements for fair value measurements for certain types of investments. The guidance is effective for annual reporting periods beginning after December 15, 2019, including interim periods within that reporting period. Early adoption is permitted. We do not expect the adoption of this standard to have a material effect on our consolidated financial statements.

In August 2018, the FASB issued ASU 2018-15, regarding ASC Topic 350-40 “Intangibles - Internal-Use Software,” which aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. The guidance is effective for annual reporting periods beginning after December 15, 2019, including interim periods within that reporting period. Early adoption is permitted. We are currently evaluating the effect of this standard on our consolidated financial statements.
Recently Adopted Accounting Pronouncements

9


In May 2014, the FASB issued new revenue guidance under ASU 2014-09 that provides principles for recognizing revenue when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for the promised goods or services provided to customers. ASC 606 and ASC 340-40 also require the deferral of incremental costs of obtaining contracts with customers and subsequent amortization of those costs over the period of anticipated benefit. Collectively, we refer to this guidance as “ASC 606.”
We adopted ASC 606 on January 1, 2018, utilizing the full retrospective method of transition. The adoption resulted in changes to our accounting policies for revenue recognition and incremental costs to acquire contracts, as described below. We applied ASC 606 using the following practical expedients:
consideration allocated to the remaining performance obligations and an explanation of when we expect to recognize that amount as revenue is not disclosed for comparative periods prior to the adoption date;
completed contracts that included variable consideration utilize the final transaction price rather than an estimation of variable consideration for comparative periods prior to the adoption date; and
costs of obtaining contracts with customers are expensed when the amortization period would have been one year or less.
The effect of adopting ASC 606 on our 2017 and 2016 revenues was not material. The primary effect relates to the deferral of sales commissions and other incremental costs to acquire contracts, which we historically expensed as incurred. The impact of adoption is summarized in the tables below. Under ASC 606, all incremental costs to acquire contracts are capitalized and amortized on a straight-line basis over the anticipated period of benefit, which we have determined to be three years.

In August 2016, the FASB issued ASU 2016-15, regarding ASC Topic 230 “Statement of Cash Flows.” This update addresses eight specific cash flow issues with the objective of reducing diversity in practice. The new guidance is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. We adopted this standard in the first quarter of 2018. The adoption did not have an effect on our consolidated financial statements.
In November 2016, the FASB issued ASU 2016-18, “Statement of Cash Flows - Restricted Cash,” which requires entities to show the changes in the total of cash, cash equivalents, restricted cash and restricted cash equivalents in the statement of cash flows. We adopted this standard in the first quarter of 2018 on a retrospective basis, resulting in an immaterial change to our previously reported statement of cash flows for the nine months ended September 30, 2017, which is summarized in the table below.

In January 2017, the FASB issued ASU 2017-01, “Business Combinations - Clarifying the Definition of a Business,” which clarifies the definition of a business when evaluating whether transactions should be accounted for as acquisitions or disposals of assets or businesses. We adopted this standard in the first quarter of 2018. The adoption did not have an effect on our consolidated financial statements.
In March 2018, the FASB issued ASU 2018-05, which amends ASC Topic 740 “Income Taxes” to conform with SEC Staff Accounting Bulletin 118, issued in December 2017. The guidance was issued to address the application of GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Act. The standard is effective upon issuance. We are nearing completion of our analysis of our deferred tax assets and liabilities and our historical foreign earnings as well as potential correlative adjustments. We will finalize our assessment in the fourth quarter of 2018.


10


We adjusted our condensed consolidated financial statements from amounts previously reported due to the adoption of ASC 606 and ASU 2016-18. Select unaudited condensed consolidated balance sheet line items, which reflect the adoption of ASC 606 are as follows (in thousands):
 
December 31, 2017
 
As Previously Reported
 
Adjustments
 
As Adjusted
Assets
 
 
 
 
 
Deferred costs
$

 
$
15,771

 
$
15,771

Deferred costs, noncurrent

 
15,395

 
15,395

Liabilities and stockholders’ equity
 
 
 
 
 
Deferred revenue
$
174,524

 
$
(1,377
)
 
$
173,147

Accumulated deficit
$
(430,586
)
 
$
32,543

 
$
(398,043
)
Select unaudited condensed consolidated statement of operations line items, which reflect the adoption of ASC 606 are as follows (in thousands, except per share data):
 
Three Months Ended September 30, 2017
 
As Previously Reported
 
Adjustments
 
As Adjusted
Revenue
$
112,786

 
$
(521
)
 
$
112,265

Operating expenses:
 
 
 
 
 
Sales and marketing
56,778

 
(2,395
)
 
54,383

Operating loss
(28,441
)
 
1,874

 
(26,567
)
Net loss
$
(27,689
)
 
$
1,874

 
$
(25,815
)
Net loss per share, basic and diluted
$
(0.28
)
 
$
0.02

 
$
(0.26
)
 
Nine Months Ended September 30, 2017
 
As Previously Reported
 
Adjustments
 
As Adjusted
Revenue
$
307,066

 
$
1,183

 
$
308,249

Operating expenses:
 
 
 
 
 
Sales and marketing
156,707

 
(5,643
)
 
151,064

Operating loss
(86,119
)
 
6,826

 
(79,293
)
Net loss
$
(83,988
)
 
$
6,826

 
$
(77,163
)
Net loss per share, basic and diluted
$
(0.85
)
 
$
0.07

 
$
(0.78
)

11


Select unaudited condensed consolidated statement of cash flows line items, which reflect the adoption of ASC 606 and ASU 2016-18 are as follows (in thousands):
 
Nine Months Ended September 30, 2017
 
As Previously Reported
 
Adjustments
 
As Adjusted
Cash flow from operating activities
 
 
 
 
 
Net loss
$
(83,988
)
 
$
6,826

 
$
(77,163
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
 
 
Share-based compensation
62,805

 
(380
)
 
62,425

Amortization of deferred costs

 
10,332

 
10,332

Changes in operating assets and liabilities:
 
 

 
 
Prepaid expenses and other current assets
(5,109
)
 
(7
)
 
(5,116
)
Deferred costs

 
(15,595
)
 
(15,595
)
Other assets and liabilities
(5,513
)
 
190

 
(5,323
)
Deferred revenue
31,357

 
(1,183
)
 
30,174

Net cash provided by operating activities
24,739

 
183

 
24,922

Net increase in cash, cash equivalents and restricted cash
(1,074
)
 
183

 
(891
)
Cash, cash equivalents and restricted cash at beginning of period
93,677

 
1,385

 
95,062

Cash, cash equivalents and restricted cash at end of period
$
92,603

 
$
1,568

 
$
94,171

We have also updated our significant accounting policies in connection with the adoption of ASC 606:

Revenue Recognition
We generate substantially all of our revenue from subscription services, which are comprised of subscription fees from customer accounts on Zendesk Support and, to a lesser extent, Chat, Talk, Guide, Connect, and Base. In addition, we generate revenue by providing additional features to certain of our subscription plans for a fee that is incremental to the base subscription rate for such plans. Subscription service arrangements are generally non-cancelable and do not provide for refunds to customers in the event of cancellations or any other right of return. We record revenue net of sales or excise taxes.

We also derive revenue from implementation, Talk usage, and training services, for which we recognize revenue upon completion.

Revenues are recognized when control of these services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those services.
We determine revenue recognition through the following steps:
Identification of the contract, or contracts, with a customer
Identification of the performance obligations in the contract
Determination of the transaction price
Allocation of the transaction price to the performance obligations in the contract
Recognition of revenue when, or as, the performance obligations are satisfied
Subscription revenue is recognized on a ratable basis over the contractual subscription term of the arrangement beginning on the date that our service is made available to the customer. Payments received in advance of services being rendered are recorded as deferred revenue.

12


In limited circumstances, certain customers have arrangements that provide for a maximum number of users over the subscription term, with usage measured monthly. Incremental fees are incurred when the maximum number of users is exceeded. In determining the transaction price for these arrangements, we evaluate the expected usage pattern to estimate any incremental fees that we are entitled to throughout the subscription term and recognize revenue ratably over the subscription term. In making these assessments, we constrain our estimates based on factors that could lead to a probable reversal of revenue.
Certain of our product offerings include service-level agreements warranting defined levels of uptime reliability and performance and permitting those customers to receive credits for future services in the event that we fail to meet those levels. To date, we have not accrued for any significant liabilities in our consolidated financial statements as a result of these service-level agreements.
Costs to Obtain Customer Contracts
Sales commissions and related expenses are considered incremental and recoverable costs of acquiring customer contracts. These costs are capitalized and amortized on a straight-line basis over the anticipated period of benefit, which we have estimated to be three years. We determined the period of benefit by taking into consideration the length of our customer contracts, our technology lifecycle, and other factors. Amortization expense is recorded in sales and marketing expense within our consolidated statement of operations.
Deferred Revenue
We invoice customers for subscriptions to our products in monthly, quarterly, or annual installments. Deferred revenue consists primarily of customer billings made in advance of performance obligations being satisfied and revenue being recognized, and includes an immaterial amount of billings for subscriptions with customer cancellation rights. The term between invoicing and when payment is due is not significant and we do not provide financing arrangements to customers. Deferred revenue associated with performance obligations that are anticipated to be satisfied, and thus revenue recognized, during the succeeding 12-month period is recorded as current deferred revenue and the remaining portion is recorded as noncurrent deferred revenue. Deferred revenue associated with implementation, Talk usage, and training services was immaterial as of December 31, 2017 and September 30, 2018.
We invoice customers based on billing schedules established in our contracts. Accounts receivable are recorded when the right to consideration becomes unconditional.
Accounts Receivable and Allowance for Doubtful Accounts
Accounts receivable are recorded at the invoiced amount, net of allowance for doubtful accounts. The allowance is based upon historical loss patterns, the age of each past due invoice, and an evaluation of the potential risk of loss associated with delinquent accounts. Accounts receivable deemed uncollectable are charged against the allowance for doubtful accounts when identified. The balance of accounts receivable also includes contract assets, which are recorded when revenue is recognized in advance of invoicing.
Note 2. Business Combinations
FutureSimple Inc.
On September 10, 2018, we completed the acquisition of FutureSimple Inc., or FutureSimple, the developer of Base, a sales force automation software product. We acquired FutureSimple for purchase consideration of $81.0 million in cash. We incurred transaction costs of $1.6 million in connection with the acquisition, which were included within general and administrative expenses.
The fair value of assets acquired and liabilities assumed was based on a preliminary valuation, and our estimates and assumptions are subject to change within the measurement period. The primary areas that remain preliminary relate to the fair values of certain assets and liabilities acquired and residual goodwill. The total purchase consideration was allocated to the assets acquired and liabilities assumed as set forth below (in thousands). The excess of the purchase price over the net assets acquired was recorded as goodwill. Goodwill generated from the acquisition is primarily attributable to assembled workforce and expected growth from the expansion of the scope of and market opportunity for our products. Goodwill is not deductible for income tax purposes. Goodwill will not be amortized but instead will be tested for impairment at least annually and more frequently if certain indicators of impairment are present.

13


Net tangible liabilities acquired
$
(3,371
)
Identifiable intangible assets:
 
Developed technology
19,000

Customer relationships
10,800

Backlog
1,500

Goodwill
53,094

Total purchase consideration
$
81,023


The developed technology, customer relationships, and backlog intangible assets were assigned useful lives of 6.5, 5.0, and 2.0 years, respectively.

In connection with the acquisition, we granted cash and share-based retention awards to certain employees of FutureSimple. The cash awards vest over a required service period and the share-based awards vest upon fulfillment of certain service and performance conditions. Each retention award will be recorded as expense based on the fulfillment of such service and performance conditions, as applicable, and is not included in the total purchase consideration.
From the date of the acquisition, the results of operations of FutureSimple have been included in and are immaterial to our consolidated financial statements. Pro forma revenue and results of operations have not been presented because the historical results of FutureSimple are not material to our consolidated financial statements in any period presented.
Outbound Solutions, Inc.
On April 27, 2017, we completed the acquisition of Outbound Solutions, Inc., or Outbound, a provider of software that enables companies to deliver intelligent, behavior-based messages across multiple channels. We acquired Outbound for purchase consideration of $16.6 million in cash.
The total purchase consideration was allocated to the assets acquired and liabilities assumed as set forth below (in thousands). The excess of the purchase price over the net assets acquired was recorded as goodwill. Goodwill generated from the acquisition is primarily attributable to expected growth from the expansion of the scope of and market opportunity for our products. Goodwill is not deductible for income tax purposes. Goodwill will not be amortized but instead will be tested for impairment at least annually and more frequently if certain indicators of impairment are present.
Net tangible assets acquired
$
96

Net deferred tax liability recognized
(492
)
Identifiable intangible assets:
 
Developed technology
3,200

Customer relationships
410

Goodwill
13,350

Total purchase consideration
$
16,564


The developed technology and customer relationships intangible assets were assigned useful lives of 6.5 and 3.5 years, respectively.
From the date of the acquisition, the results of operations of Outbound have been included in and are immaterial to our consolidated financial statements. Pro forma revenue and results of operations have not been presented because the historical results of Outbound are not material to our consolidated financial statements in any period presented.


14


Note 3. Financial Instruments

Investments
The following tables present information about our financial assets measured at fair value on a recurring basis based on the three-tier fair value hierarchy (in thousands):    
 
 
Fair Value Measurement at
September 30, 2018
Level 1
 
Level 2
 
Total
Description
 
 
 
 
 
Corporate bonds
$

 
$
443,934

 
$
443,934

Asset-backed securities

 
110,786

 
110,786

Money market funds
56,031

 

 
56,031

Commercial paper

 
51,730

 
51,730

U.S. treasury securities

 
50,690

 
50,690

Agency securities

 
15,489

 
15,489

Certificates of deposit

 
2,250

 
2,250

Total
$
56,031

 
$
674,879

 
$
730,910

Included in cash and cash equivalents
 
 
 
 
$
76,962

Included in marketable securities
 
 
 
 
$
653,948

 
Fair Value Measurement at
December 31, 2017
Level 1
 
Level 2
 
Total
Description
 
 
 
 
 
Corporate bonds
$

 
$
149,069

 
$
149,069

Money market funds
32,832

 

 
32,832

U.S. treasury securities

 
28,382

 
28,382

Asset-backed securities

 
27,738

 
27,738

Commercial paper

 
19,622

 
19,622

Agency securities

 
14,911

 
14,911

Total
$
32,832

 
$
239,722

 
$
272,554

Included in cash and cash equivalents
 
 
 
 
$
37,531

Included in marketable securities
 
 
 
 
$
235,023

 
As of September 30, 2018 and December 31, 2017, there were no securities within Level 3 of the fair value hierarchy. There were no transfers between fair value measurement levels during the three and nine months ended September 30, 2018. Gross unrealized gains and losses for cash equivalents and marketable securities as of September 30, 2018 and December 31, 2017 were not material. Unrealized losses for securities that have been in an unrealized loss position for more than 12 months as of September 30, 2018 and December 31, 2017 were not material.
The following table classifies our marketable securities by contractual maturity (in thousands):
 
 
September 30,
2018
 
December 31,
2017
Due in one year or less
$
293,598

 
$
137,576

Due after one year
360,350

 
97,447

Total
$
653,948

 
$
235,023

 
For our other financial instruments, including accounts receivable, accounts payable, and other current liabilities, the carrying amounts approximate their fair values due to the relatively short maturity of these balances.

15


Derivative Instruments and Hedging
Our foreign currency exposures typically arise from expenditures associated with foreign operations and sales in foreign currencies of our products. To mitigate the effect of foreign currency fluctuations on our future cash flows and earnings, we enter into foreign currency forward contracts with certain financial institutions and designate those contracts as cash flow hedges. Our foreign currency forward contracts generally have maturities of 15 months or less. As of September 30, 2018, the balance of accumulated other comprehensive loss included an unrecognized net loss of $2.5 million related to the effective portion of changes in the fair value of foreign currency forward contracts designated as cash flow hedges. We expect to reclassify a net loss of $2.7 million into earnings over the next 12 months associated with our cash flow hedges.
The following tables present information about our derivative instruments on our consolidated balance sheets (in thousands):
 
 
September 30, 2018
Asset Derivatives
 
Liability Derivatives
Derivative Instrument
Balance Sheet Location
 
Fair Value
(Level 2)
 
Balance Sheet Location
 
Fair Value
(Level 2)
Foreign currency forward contracts
Other current assets
 
$
1,731

 
Accrued liabilities
 
$
4,593

Total
 
 
$
1,731

 
 
 
$
4,593

 
December 31, 2017
Asset Derivatives
 
Liability Derivatives
Derivative Instrument
Balance Sheet Location
 
Fair Value
(Level 2)
 
Balance Sheet Location
 
Fair Value
(Level 2)
Foreign currency forward contracts
Other current assets
 
$
2,359

 
Accrued liabilities
 
$
1,220

Total
 
 
$
2,359

 
 
 
$
1,220

 
Our foreign currency forward contracts had a total notional value of $179.9 million and $139.7 million as of September 30, 2018 and December 31, 2017, respectively. We have master netting arrangements with each of our counterparties, which permit net settlement of multiple, separate derivative contracts with a single payment. We may also be required to exchange cash collateral with certain of our counterparties on a regular basis. ASC 815 permits companies to present the fair value of derivative instruments on a net basis according to master netting arrangements. We have elected to present our derivative instruments on a gross basis in our consolidated financial statements. As of September 30, 2018 and December 31, 2017, there was no cash collateral posted with counterparties.
The following table presents information about our derivative instruments on our condensed consolidated statements of operations (in thousands):
 
 
 
 
Three Months Ended September 30, 2018
 
Nine Months Ended September 30, 2018
Hedging Instrument
Location of Loss Reclassified into Earnings
 
Loss Recognized in AOCI
 
Loss Reclassified from AOCI into Earnings
 
Loss Recognized in AOCI
 
Loss Reclassified from AOCI into Earnings
Foreign currency forward contracts
Revenue, cost of revenue, operating expenses
 
$
(930
)
 
$
(1,348
)
 
$
(3,729
)
 
$
(273
)
Total
 
 
$
(930
)
 
$
(1,348
)
 
$
(3,729
)
 
$
(273
)


16


 
 
 
Three Months Ended September 30, 2017
 
Nine Months Ended September 30, 2017
Hedging Instrument
Location of Gain (Loss) Reclassified into Earnings
 
Gain Recognized in AOCI
 
Gain Reclassified from AOCI into Earnings
 
Gain Recognized in AOCI
 
Loss Reclassified from AOCI into Earnings
Foreign currency forward contracts
Revenue, cost of revenue, operating expenses
 
$
629

 
$
285

 
$
3,117

 
$
(575
)
Total
 
 
$
629

 
$
285

 
$
3,117

 
$
(575
)
All derivatives have been designated as hedging instruments. Amounts recognized in earnings related to excluded time value and hedge ineffectiveness for the three and nine months ended September 30, 2018 and 2017 were not material.
Convertible Senior Notes
As of September 30, 2018, the fair value of our convertible senior notes was $726.3 million. The fair value was determined based on the quoted price of the convertible senior notes in an inactive market on the last trading day of the reporting period and has been classified as Level 2 in the fair value hierarchy.
Note 4. Costs to Obtain Customer Contracts
The balances of deferred costs to obtain customer contracts were $43.4 million and $31.2 million as of September 30, 2018 and December 31, 2017, respectively. Amortization expense for these deferred costs was $5.6 million and $3.7 million for the three months ended September 30, 2018 and 2017, respectively, and $15.1 million and $10.3 million for the nine months ended September 30, 2018 and 2017, respectively. There were no impairment losses related to these deferred costs for the periods presented.

Note 5. Property and Equipment
Property and equipment, net consists of the following (in thousands): 
 
September 30,
2018
 
December 31,
2017
Leasehold improvements
$
51,049

 
$
28,113

Capitalized internal-use software
36,348

 
31,593

Hosting equipment
34,104

 
37,222

Computer equipment and licensed software and patents
19,949

 
16,316

Furniture and fixtures
11,136

 
9,581

Construction in progress
10,480

 
11,220

Total
163,066

 
134,045

Less: accumulated depreciation and amortization
(90,731
)
 
(74,888
)
Property and equipment, net
$
72,335

 
$
59,157

 
Depreciation expense was $5.8 million and $5.3 million for the three months ended September 30, 2018 and 2017, respectively, and $18.6 million and $15.1 million for the nine months ended September 30, 2018 and 2017, respectively.
Amortization expense of capitalized internal-use software was $1.5 million and $1.8 million for the three months ended September 30, 2018 and 2017, respectively, and $4.4 million and $6.0 million for the nine months ended September 30, 2018 and 2017, respectively. We recorded impairment losses of none and $2.0 million to construction in progress during the three and nine months ended September 30, 2018, which were included within research and development expenses on our consolidated statements of operations. The carrying value of capitalized internal-use software at September 30, 2018 and December 31, 2017 was $19.0 million and $17.7 million, respectively, including $8.7 million in construction in progress for both periods.
Note 6. Goodwill and Acquired Intangible Assets

17


The changes in the carrying amount of goodwill for the nine months ended September 30, 2018 are as follows (in thousands):
Balance as of December 31, 2017
$
59,131

Goodwill acquired
53,094

Balance as of September 30, 2018
$
112,225


Acquired intangible assets subject to amortization consist of the following (in thousands):
 
 
As of September 30, 2018
Cost
 
Accumulated
Amortization
 
Net
 
Weighted Average Remaining Useful Life
 
 
 
 
 
 
(In years)
Developed technology
$
31,000

 
$
(6,807
)
 
$
24,193

 
5.7
Customer relationships
11,710

 
(679
)
 
11,031

 
4.8
Backlog
1,500

 
$
(63
)
 
1,437

 
1.9
 
$
44,210

 
$
(7,549
)
 
$
36,661

 
 
 
 
As of December 31, 2017
Cost
 
Accumulated
Amortization
 
Foreign
Currency Translation Adjustments
 
Net
 
Weighted Average Remaining Useful Life
 
 
 
 
 
 
 
 
(In years)
Developed technology
$
17,200

 
$
(9,835
)
 
$
(93
)
 
$
7,272

 
3.7
Customer relationships
2,210

 
(1,549
)
 
(30
)
 
631

 
2.4
 
$
19,410

 
$
(11,384
)
 
$
(123
)
 
$
7,903

 
 
 
During the second quarter of 2018, we removed developed technology and customer relationships intangible assets from our consolidated balance sheet, which had become fully amortized. Amortization expense of acquired intangible assets was $1.2 million and $1.0 million for the three months ended September 30, 2018 and 2017, respectively, and $2.5 million and $3.0 million for the nine months ended September 30, 2018 and 2017, respectively.
Estimated future amortization expense as of September 30, 2018 is as follows (in thousands):
Remainder of 2018
$
2,144

2019
8,504

2020
6,682

2021
5,572

2022
5,572

2023 and after
8,187

 
$
36,661

 
Note 7. 0.25% Convertible Senior Notes and Capped Call

In March 2018, we issued $500.0 million aggregate principal amount of 0.25% convertible senior notes due March 15, 2023 in a private offering and an additional $75.0 million aggregate principal amount of such notes pursuant to the exercise in full of the over-allotment options of the initial purchasers, collectively the “Notes.” The Notes are unsecured obligations and bear interest at a fixed rate of 0.25% per annum, payable semi-annually in arrears on March 15 and September 15 of each year, commencing on September 15, 2018. The total net proceeds from the offering, after deducting initial purchase discounts and estimated debt issuance costs, are approximately $561.4 million.


18


Each $1,000 principal amount of the Notes will initially be convertible into 15.8554 shares of our common stock, the “Conversion Option,” which is equivalent to an initial conversion price of approximately $63.07 per share, subject to adjustment upon the occurrence of specified events. The Notes will be convertible at the option of the holders at any time prior to the close of business on the business day immediately preceding December 15, 2022, only under the following circumstances: (1) during any calendar quarter commencing after the calendar quarter ending on June 30, 2018 (and only during such calendar quarter), if the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day; (2) during the five business day period after any five consecutive trading day period, the “Measurement Period,” in which the trading price per $1,000 principal amount of notes for each trading day of the Measurement Period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such trading day; or (3) upon the occurrence of specified corporate events (as set forth in the indenture). On or after December 15, 2022 until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert their Notes at any time, regardless of the foregoing circumstances. Upon conversion, we will pay or deliver, as the case may be, cash, shares of our common stock or a combination of cash and shares of our common stock, at our election. If certain specified fundamental changes occur (as set forth in the indenture governing the Notes) prior to the maturity date, holders of the Notes may require us to repurchase for cash all or any portion of their notes at a repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date. In addition, if specific corporate events occur prior to the applicable maturity date, we will increase the conversion rate for a holder who elects to convert their notes in connection with such a corporate event in certain circumstances. It is our current intent and policy to settle conversions through combination settlement with a specified dollar amount of $1,000 per $1,000 principal amount of Notes. During the three and nine months ended September 30, 2018, the conditions allowing holders of the Notes to convert have not been met. The Notes are therefore not convertible during the three and nine months ended September 30, 2018 and are classified as long-term debt.

In accounting for the transaction, the Notes were separated into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar debt instrument that does not have an associated convertible feature. The carrying amount of the equity component representing the Conversion Option was $125.0 million and was determined by deducting the fair value of the liability component from the par value of the Notes. The equity component was recorded in additional paid-in capital and is not remeasured as long as it continues to meet the conditions for equity classification. The excess of the principal amount of the liability component over its carrying amount, the “Debt Discount,” is amortized to interest expense over the contractual term of the Notes at an effective interest rate of 5.26%.

In accounting for the debt issuance costs of $13.6 million related to the Notes, we allocated the total amount incurred to the liability and equity components of the Notes based on their relative values. Issuance costs attributable to the liability component were $10.6 million and will be amortized to interest expense using the effective interest method over the contractual term of the Notes. Issuance costs attributable to the equity component were netted with the equity component in additional paid-in capital.

The net carrying amount of the liability component of the Notes is as follows (in thousands):
 
September 30,
2018
 
December 31,
2017
Principal
$
575,000

 
$

Unamortized Debt Discount
(113,170
)
 

Unamortized issuance costs
(9,755
)
 

Net carrying amount
$
452,075

 
$


The net carrying amount of the equity component of the Notes is as follows (in thousands):
 
September 30,
2018
 
December 31,
2017
Debt Discount for Conversion Option
$
124,976

 
$

Issuance costs
(2,948
)
 

Net carrying amount
$
122,028

 
$


Interest expense related to the Notes is as follows (in thousands):

19


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Contractual interest expense
$
360

 
$

 
$
762

 
$

Amortization of Debt Discount
5,603

 

 
11,806

 

Amortization of issuance costs
412

 

 
859

 

Total interest expense
$
6,375

 
$

 
$
13,427

 
$


In connection with the pricing of the Notes, we entered into privately negotiated capped call transactions with certain counterparties, the “Capped Calls.” The Capped Calls each have an initial strike price of approximately $63.07 per share, subject to certain adjustments, which correspond to the initial conversion price of the Notes. The Capped Calls have initial cap prices of $95.20 per share, subject to certain adjustments. The Capped Calls cover, subject to anti-dilution adjustments, approximately 9.1 million shares of our common stock. Conditions that cause adjustments to the initial strike price of the Capped Calls mirror conditions that result in corresponding adjustments for the Notes. The Capped Calls are generally intended to reduce or offset the potential dilution to our common stock upon any conversion of the Notes with such reduction or offset, as the case may be, subject to a cap based on the cap price. For accounting purposes, the Capped Calls are separate transactions, and not part of the terms of the Notes. As these transactions meet certain accounting criteria, the Capped Calls are recorded in stockholders' equity and are not accounted for as derivatives. The cost of $63.9 million incurred in connection with the Capped Calls was recorded as a reduction to additional paid-in capital.
 
The difference between the Debt Discount and the total cost of the Capped Call, and the difference between the calculation of the book and tax allocation of debt issuance costs between the liability and equity components of the Notes, resulted in a difference between the carrying amount and tax basis of the Notes. This taxable temporary difference resulted in the recognition of a $13.8 million net deferred tax liability which was recorded as an adjustment to additional paid-in capital. The creation of the deferred tax liability represents a source of future taxable income which supports realization of a portion of the income tax benefit associated with our loss from operations. Therefore, applying the guidance in ASC 740 to interim reporting periods, we recorded a net income tax benefit of $2.5 million and $8.1 million in our consolidated statement of operations and income tax expense of $0.4 million and income tax benefit of $0.7 million in our consolidated statement of comprehensive loss for the three and nine months ended September 30, 2018, respectively. This represents applying an estimated effective tax rate resulting from the recognition of the deferred tax asset to the pre-tax loss for the quarter.
 
The net impact to our stockholders' equity, included in additional paid-in capital, of the above components of the Notes is as follows (in thousands):

Conversion Option
 
$
124,976

Purchase of Capped Calls
 
(63,940
)
Issuance costs
 
(2,948
)
Net deferred tax liability
 
(13,784
)
Total
 
$
44,304

Note 8. Commitments and Contingencies
Contractual Obligations
We lease office space under noncancelable operating leases with various expiration dates. Certain of the office space lease agreements contain rent holidays or rent escalation provisions. Rent holiday and rent escalation provisions are considered in determining the straight-line expense to be recorded over the lease term. The lease term begins on the date of initial possession of the leased property for purposes of recognizing lease expense on a straight-line basis over the term of the lease. Rent expense was $5.2 million and $2.8 million for the three months ended September 30, 2018 and 2017, respectively, and $14.0 million and $8.3 million for the nine months ended September 30, 2018 and 2017, respectively.

As of September 30, 2018, there were no material changes in our commitments under contractual obligations, as disclosed in our audited consolidated financial statements for the year ended December 31, 2017.

In October 2018, we entered into an agreement with a cloud infrastructure provider, under which we now have a total five-year minimum commitment of $255.0 million to the provider.

20



Litigation and Loss Contingencies
We accrue estimates for resolution of legal and other contingencies when losses are probable and estimable. From time to time, we may become a party to litigation and subject to claims that arise in the ordinary course of business, including intellectual property claims, labor and employment claims, threatened claims, breach of contract claims, tax, and other matters. We currently have no material pending litigation.
We are not currently aware of any litigation matters or loss contingencies that would be expected to have a material adverse effect on our business, consolidated balance sheets, results of operations, comprehensive loss, or cash flows.
Indemnifications
In the ordinary course of business, we enter into contractual arrangements under which we agree to provide indemnification of varying scope and terms to customers, business partners, and other parties with respect to certain matters, including, but not limited to, losses arising out of the breach of such agreements, intellectual property infringement claims made by third parties, and other liabilities relating to or arising from our products or our acts or omissions. In these circumstances, payment may be conditional on the other party making a claim pursuant to the procedures specified in the particular contract. Further, our obligations under these agreements may be limited in terms of time and/or amount, and in some instances, we may have recourse against third parties for certain payments. In addition, we have indemnification agreements with our directors and executive officers that require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. The terms of such obligations may vary. To date, we have not incurred any material costs, and we have not accrued any liabilities in our consolidated financial statements, as a result of these obligations.
Certain of our product offerings include service-level agreements warranting defined levels of uptime reliability and performance, which permit those customers to receive credits for future services in the event that we fail to meet those levels. To date, we have not accrued for any significant liabilities in our consolidated financial statements as a result of these service-level agreements.
Note 9. Common Stock and Stockholders’ Equity
Common Stock
As of September 30, 2018 and December 31, 2017, there were 400 million shares of common stock authorized for issuance with a par value of $0.01 per share and 106.6 million and 103.1 million shares were issued and outstanding, respectively.
Preferred Stock
As of each of September 30, 2018 and December 31, 2017, there were 10 million shares of preferred stock authorized for issuance with a par value of $0.01 per share and no shares of preferred stock were issued or outstanding.
Employee Equity Plans
Employee Stock Purchase Plan
Under our Employee Stock Purchase Plan, or ESPP, eligible employees are granted options to purchase shares of our common stock through payroll deductions. The ESPP provides for 18-month offering periods, which include three six-month purchase periods. At the end of each purchase period, employees are able to purchase shares at 85% of the lower of the fair market value of our common stock at the beginning of an offering period or the fair market value of our common stock at the end of the purchase period. For the three and nine months ended September 30, 2018, none and 0.4 million shares of common stock were purchased under the ESPP, respectively. Pursuant to the terms of the ESPP, the number of shares reserved under the ESPP increased by 1.0 million shares on January 1, 2018. As of September 30, 2018, 4.2 million shares of common stock were available for issuance under the ESPP.
Stock Option and Grant Plans
Our board of directors adopted the 2009 Stock Option and Grant Plan, or the 2009 Plan, in July 2009. The 2009 Plan was terminated in connection with our initial public offering in May 2014, and accordingly, no shares are available for issuance under this plan. The 2009 Plan continues to govern outstanding awards granted thereunder.

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Our 2014 Stock Option and Incentive Plan, or the 2014 Plan, serves as the successor to our 2009 Plan. Pursuant to the terms of the 2014 Plan, the number of shares reserved for issuance under the 2014 Plan increased by 5.2 million shares on January 1, 2018. As of September 30, 2018, we had 8.6 million shares of common stock available for future grants under the 2014 Plan.
On May 6, 2016, the compensation committee of our board of directors granted equity awards representing 1.2 million shares of common stock. These awards were granted outside of the 2014 Plan pursuant to an exemption provided for “employment inducement awards” within the meaning of Section 303A.08 of the New York Stock Exchange Listed Company Manual and accordingly did not require approval from our stockholders.
A summary of our share-based award activity for the nine months ended September 30, 2018 is as follows (in thousands, except per share information):
 
 
 
 
Options Outstanding
 
RSUs Outstanding
Shares
Available
for Grant
 
Number of
Shares
 
Weighted
Average
Exercise Price
 
Weighted
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
 
Outstanding
RSUs
 
Weighted
Average
Grant Date
Fair Value
 
 
 
 
 
 
(In years)
 
 
 
 
 
 
Outstanding — January 1, 2018
8,001

 
6,239

 
$
17.31

 
7.11
 
$
103,380

 
5,827

 
$
25.00

Increase in authorized shares
5,156

 
 
 
 
 
 
 
 
 
 
 
 
Stock options granted
(756
)
 
756

 
42.08

 
 
 
 
 
 
 
 
RSUs granted
(4,311
)
 
 
 
 
 
 
 
 
 
4,311

 
42.32

Stock options exercised
 
 
(861
)
 
15.39

 
 
 
 
 
 
 
 
RSUs vested
 
 
 
 
 
 
 
 
 
 
(2,255
)
 
26.20

Stock options forfeited or canceled
68

 
(68
)
 
28.61

 
 
 
 
 
 
 
 
RSUs forfeited or canceled
710

 
 
 
 
 
 
 
 
 
(710
)
 
29.15

RSUs forfeited or canceled and unavailable for grant
 
 
 
 
 
 
 
 
 
 
(22
)
 
23.44

PRSUs granted
(224
)
 
 
 
 
 
 
 
 
 
 
 
 
Outstanding — September 30, 2018
8,644

 
6,066

 
$
20.54

 
6.81
 
$
306,172

 
7,151

 
$
34.65

 
The restricted stock units, or RSUs, forfeited or canceled and unavailable for grant relate to our employment inducement awards. The aggregate intrinsic value for options outstanding represents the difference between the closing market price of our common stock on the last trading day of the reporting period and the exercise price of outstanding, in-the-money options.
As of September 30, 2018, we had a total of $262.7 million in future expense related to our stock options and RSUs to be recognized over a weighted average period of 2.8 years.
Performance Restricted Stock Units
During the three months ended September 30, 2018, the compensation committee of our board of directors granted performance-based restricted stock units, or PRSUs, representing 0.2 million shares of common stock, the substantial majority of which were granted in connection with the acquisition of FutureSimple. The PRSUs vest in four semi-annual tranches through March 2021. The PRSUs include a service condition and a performance condition related to the attainment of semi-annual performance targets approved and communicated in advance of each performance period. During the three months ended September 30, 2018, expense recorded related to the PRSUs was immaterial. The total future expense related to the PRSUs will be based on the fair value of the underlying shares on the grant date for each performance tranche.
    

22


Note 10. Deferred Revenue and Performance Obligations
During the three months ended September 30, 2018 and 2017, $102.4 million and $69.0 million of revenue was recognized that was included in the deferred revenue balances at the beginning of each period, respectively. During the nine months ended September 30, 2018 and 2017, $158.8 million and $111.5 million of revenue was recognized that was included in the deferred revenue balances at the beginning of each period, respectively.
The aggregate balance of unsatisfied performance obligations as of September 30, 2018 was $359.6 million. We expect to recognize $290.4 million of the balance as revenue in the next 12 months and the remainder thereafter. The aggregate balance of unsatisfied performance obligations represents contracted revenue that has not yet been recognized and does not include contract amounts which are cancelable by the customer and amounts associated with optional renewal periods.

Note 11. Net Loss Per Share
Basic net loss per share is computed by dividing net loss by the weighted-average number of shares of common stock outstanding during the period. Diluted net loss per share is computed by giving effect to all potential shares of common stock, including those related to outstanding share-based awards and our convertible senior notes, to the extent dilutive. Basic and diluted net loss per share were the same for each period presented as the inclusion of all potential common stock outstanding would have been anti-dilutive.
The following table presents the calculation of basic and diluted net loss per share for the periods presented (in thousands, except per share data):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
2018
 
2017
 
2018
 
2017
 
 
* As adjusted
 
 
* As adjusted
Net loss
$
(34,144
)
 
$
(25,815
)
 
$
(97,835
)
 
$
(77,163
)
Weighted-average shares used to compute basic and diluted net loss per share
106,143


100,659


104,954


99,203

Net loss per share, basic and diluted
$
(0.32
)
 
$
(0.26
)
 
$
(0.93
)
 
$
(0.78
)
*Adjusted to reflect the adoption of ASC 606 (see Note 1).
 
The anti-dilutive securities excluded from the shares used to calculate diluted net loss per share are as follows (in thousands):
 
As of September 30,
2018
 
2017
Shares subject to outstanding common stock options and employee stock purchase plan
6,344

 
7,488

Restricted stock units
7,151

 
6,464

Shares related to convertible senior notes
111

 

 
13,606

 
13,952

 

The shares related to convertible senior notes calculated in the table above are calculated based on the average market price of our common stock for the three months ended September 30, 2018.

We expect to settle the principal amount of the convertible senior notes in cash and therefore use the treasury stock method for calculating any potential dilutive effect of the conversion spread on diluted net income per share, if applicable. The conversion spread will have a dilutive impact on diluted net income per share when the average market price of our common stock for a given period exceeds the initial conversion price of $63.07 per share for the convertible senior notes. The convertible senior notes are not convertible as of September 30, 2018.

Note 12. Income Taxes
We reported a benefit from income taxes of $2.3 million and $7.3 million in the three and nine months ended September 30, 2018, respectively, primarily due to the recognition of net income tax benefits of $2.5 million and $8.1 million related to taxable temporary differences of the convertible senior notes and the capped call. We reported a benefit from income

23


taxes of $0.1 million and $0.8 million for the three and nine months ended September 30, 2017, respectively. The effective tax rate for each period differs from the statutory rate primarily as a result of not recognizing a deferred tax asset for U.S. losses due to having a full valuation allowance against U.S. deferred tax assets.

Note 13. Geographic Information
Our chief operating decision maker reviews the financial information presented on a consolidated basis for purposes of allocating resources and evaluating our financial performance. Accordingly, we have determined that we operate in a single reporting segment.
Revenue
The following table presents our revenue by geographic area, as determined based on the billing address of our customers (in thousands):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
2018
 
2017
 
2018
 
2017
 
 
*As adjusted
 
 
* As adjusted
United States
$
78,848

 
$
59,181

 
$
220,221

 
$
164,613

EMEA
45,927

 
32,297

 
125,564

 
87,643

APAC
18,107

 
12,770

 
48,214

 
33,514

Other
11,946

 
8,017

 
32,502

 
22,479

Total
$
154,828

 
$
112,265

 
$
426,501

 
$
308,249

*Adjusted to reflect the adoption of ASC 606 (see Note 1).
Long-Lived Assets
The following table presents our long-lived assets by geographic area (in thousands):
 
 
As of
September 30, 2018
 
As of
December 31, 2017
United States
$
27,358

 
$
23,609

EMEA:
 
 
 
Republic of Ireland
15,428

 
5,019

Other EMEA
2,816

 
5,007

  Total EMEA
18,244

 
10,026

APAC
7,714

 
7,734

Total
$
53,316

 
$
41,369

 
The carrying values of capitalized internal-use software and intangible assets are excluded from the balance of long-lived assets presented in the table above.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K, as amended by Form 10-K/A, for the year ended December 31, 2017, filed with the SEC on November 5, 2018. As discussed in the section titled “Special Note Regarding Forward-Looking Statements,” the following discussion and analysis contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk Factors” included under Part II, Item 1A below.
Overview
We are a software development company that provides SaaS products that are intended to help organizations and their customers build better experiences. Our product family is built upon a modern architecture that enables us and our customers to rapidly innovate, adapt our technology in novel ways, and easily integrate with other products and applications. With our origins in customer service, we have evolved our offerings over time to a family of products that work together to help organizations understand their customers, improve communications across all channels, and engage where and when it’s needed most.
We believe in developing products that serve organizations of all sizes and across all industries. The flagship product in our family, Zendesk Support, provides organizations with the ability to track, prioritize, and solve customer support tickets across multiple channels, bringing customer information and interactions into one place. Our other widely available products integrate with Support and include Zendesk Chat, Zendesk Talk, Zendesk Guide, and Zendesk Connect. Chat is live chat software that provides a fast and responsive way for organizations to connect with their customers. Talk is cloud-based call center software that facilitates personal and productive phone support conversations between organizations and their customers. Guide is a self-service destination that organizations can use to provide articles, interactive forums, and a community that help an organization's customers help themselves. Connect enables customer service teams to send automated and timely messages based on a customer’s past actions and preferences. Additionally, we offer Zendesk Suite, an omnichannel offering which provides Support, Chat, Talk, and Guide together for a single price, and Base, sales force automation software that complements our mission in delivering products that provide a better customer experience. We offer a range of subscription account plans for our products that vary in price based on functionality, type, and the amount of product support we offer. We also offer a range of additional features that customers can purchase and add to their subscriptions.
For the three months ended September 30, 2018 and 2017, our revenue was $154.8 million and $112.3 million, respectively, representing a 38% growth rate. For the nine months ended September 30, 2018 and 2017, our revenue was $426.5 million and $308.2 million, respectively, representing a 38% growth rate. For the three months ended September 30, 2018 and 2017, we derived $76.0 million, or 49%, and $53.1 million, or 47%, respectively, of our revenue from customers located outside of the United States. For the nine months ended September 30, 2018 and 2017, we derived $206.3 million, or 48%, and $143.6 million, or 47%, respectively, of our revenue from customers located outside of the United States. We expect that the rate of growth in our revenue will decline as our business scales, even if our revenue continues to grow in absolute terms. For the three months ended September 30, 2018 and 2017, we generated net losses of $34.1 million and $25.8 million, respectively. For the nine months ended September 30, 2018 and 2017, we generated net losses of $97.8 million and $77.2 million, respectively.
The growth of our business and our future success depend on many factors, including our ability to continue to innovate, further develop our unified omnichannel offering, build brand recognition and a scalable product for larger enterprises, maintain our leadership in the small and medium-sized business market, add new customers, generate additional revenue from our existing customer base, and increase our global customer footprint. While these areas represent significant opportunities for us, we also face significant risks and challenges that we must successfully address in order to sustain the growth of our business and improve our operating results. We anticipate that we will continue to expand our operations and headcount in the near term. The expected expenditures that we anticipate will be necessary to manage our anticipated growth, including personnel costs, expenditures relating to hosting capabilities, leasehold improvements, and related fixed assets, will make it more difficult for us to achieve profitability in the near term. Many of these investments will occur in advance of us experiencing any direct benefit and will make it difficult to determine if we are allocating our resources efficiently.

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We have focused on rapidly growing our business and plan to continue to invest for long-term growth. We expect to continue to develop our hosting capabilities primarily through expenditures for third-party managed hosting services. Additionally, we expect to incur depreciation expense and related costs associated with our self-managed colocation data centers while we transition our primary data center usage to third-party managed hosting services. The amount and timing of these disbursements will vary based on our estimates of projected growth and planned use of hosting resources. Over time, we anticipate that we will continue to gain economies of scale by efficiently utilizing our hosting and personnel resources to support the growth in our number of customers. We also expect to continue to invest in our customer experience organization, resulting in additional salary and share-based compensation expenses. In addition, we expect to incur amortization expense associated with acquired intangible assets and capitalized internal-use software. As a result, we expect our gross margin to improve in the long-term, although our gross margin may decrease in the near-term and may vary from period to period as our revenue fluctuates and as a result of the timing and amount of such costs.
We expect our operating expenses to continue to increase in absolute dollars in future periods. We have invested, and expect to continue to invest, in our software development efforts to broaden the functionality of our existing products, to further integrate these products and services, and to introduce new products. We plan to continue to expand our sales and marketing organizations, particularly in connection with our efforts to expand our customer base. We also expect to continue to incur additional general and administrative costs in order to support the growth of our business and the infrastructure required to comply with our obligations as a public company.
Key Business Metrics
We review a number of operating metrics, including the following key metrics, to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans, and make strategic decisions.
Number of Paid Customer Accounts. We believe that our ability to increase our number of paid accounts using our products is an indicator of our market penetration, the growth of our business, and our potential future business opportunities. We define the number of paid customer accounts as the sum of the number of accounts on Zendesk Support, exclusive of our legacy Starter plan, free trials, or other free services, the number of accounts on Chat, exclusive of free trials or other free services, and the number of accounts on all of our other products, exclusive of free trials and other free services, each as of the end of the period and as identified by a unique account identifier. The number of paid customer accounts does not currently include the number of customer accounts on Base. In the quarter ended June 30, 2018, we began to offer an omnichannel subscription, which provides access to multiple products through a single paid customer account, Zendesk Suite. The number of Suite paid customer accounts are included in the number of accounts on products other than Support and Chat, and are not included in the number of paid customer accounts using Support or Chat. Other than usage of our products through our omnichannel subscription offering, the use of Support, Chat, and our other products requires separate subscriptions and each of these accounts are treated as a separate paid customer account. Existing customers may also expand their utilization of our products by adding new accounts and a single consolidated organization or customer may have multiple accounts across each of our products to service separate subsidiaries, divisions, or work processes. Other than usage of our products through our omnichannel subscription offering, each of these accounts is also treated as a separate paid customer account. Other than paid accounts for Zendesk Connect, an increase in the number of paid customer accounts generally correlates to an increase in the number of authorized agents licensed to use our products, which directly affects our revenue and results of operations. We view growth in this metric as a measure of our success in converting new sales opportunities. We had approximately 133,700 paid customer accounts as of September 30, 2018, including approximately 72,100 paid customer accounts on Support, approximately 46,800 paid customer accounts on Chat, and approximately 14,800 paid customer accounts on our other products. As the total number of paid customer accounts increases, we expect the rate of growth in the number of paid customer accounts to decline.
Dollar-Based Net Expansion Rate. Our ability to generate revenue is dependent upon our ability to maintain our relationships with our customers and to increase their utilization of our products. We believe we can achieve this by focusing on delivering value and functionality that retains our existing customers, expands the number of authorized agents associated with an existing paid customer account, and results in upgrades to higher-priced subscription plans and the purchase of additional products. Maintaining customer relationships allows us to sustain and increase revenue to the extent customers maintain or increase the number of authorized agents licensed to use our products. We assess our performance in this area by measuring our dollar-based net expansion rate. Our dollar-based net expansion rate provides a measurement of our ability to increase revenue across our existing customer base through expansion of authorized agents associated with paid customer accounts, upgrades in subscription plans, and the purchase of additional products as offset by churn, contraction in authorized agents associated with paid customer accounts, and downgrades in subscription plans. We do not currently incorporate operating metrics associated with our analytics product, our Connect product, or our Base product into our measurement of dollar-based net expansion rate.

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Our dollar-based net expansion rate is based upon our monthly recurring revenue for a set of paid customer accounts on our products. Monthly recurring revenue for a paid customer account is a legal and contractual determination made by assessing the contractual terms of each paid customer account, as of the date of determination, as to the revenue we expect to generate in the next monthly period for that paid customer account, assuming no changes to the subscription and without taking into account any one-time discounts or any usage above the subscription base, if any, that may be applicable to such subscription. Monthly recurring revenue is not determined by reference to historical revenue, deferred revenue, or any other United States generally accepted accounting principles, or GAAP, financial measure over any period. It is forward-looking and contractually derived as of the date of determination.
We calculate our dollar-based net expansion rate by dividing our retained revenue net of contraction and churn by our base revenue. We define our base revenue as the aggregate monthly recurring revenue across our products from the paid customer accounts on Support and Chat as of the date one year prior to the date of calculation. We define our retained revenue net of contraction and churn as the aggregate monthly recurring revenue across our products from the same customer base included in our measure of base revenue at the end of the annual period being measured. Our dollar-based net expansion rate is also adjusted to eliminate the effect of certain activities that we identify involving the transfer of agents between paid customer accounts, consolidation of customer accounts, or the split of a single paid customer account into multiple paid customer accounts. In addition, our dollar-based net expansion rate is adjusted to include paid customer accounts in the customer base used to determine retained revenue net of contraction and churn that share common corporate information with customers in the customer base that is used to determine our base revenue. Giving effect to this consolidation results in our dollar-based net expansion rate being calculated across approximately 108,500 customers, as compared to the approximately 133,700 total paid customer accounts as of September 30, 2018. To the extent that we can determine that the underlying customers do not share common corporate information, we do not aggregate paid customer accounts associated with reseller and other similar channel arrangements for the purposes of determining our dollar-based net expansion rate. While not material, we believe the failure to account for these activities would otherwise skew our dollar-based net expansion metrics associated with customers that maintain multiple paid customer accounts across their products, and paid customer accounts associated with reseller and other similar channel arrangements.
Our dollar-based net expansion rate was 118% as of September 30, 2018. We expect that, among other factors, our continued focus on adding larger paid customer accounts at the time of addition and the growth in our revenue will result in an overall decline in our dollar-based net expansion rate over time as our aggregate monthly recurring revenue grows.
Components of Results of Operations
Revenue
We derive substantially all of our revenue from subscription services, which are comprised of subscription fees from customer accounts on Support and, to a lesser extent, Chat, Talk, Guide, Connect, and Base. Each subscription may have multiple authorized users, and we refer to each user as an “agent.” The number of agents ranges from one to thousands for various customer accounts. Our pricing is generally established on a per agent basis. We offer a range of subscription account plans for our products that vary in price based on functionality, type, and, for Support and Chat, the amount of product support we offer. We also offer a range of additional features that customers can purchase and add to their subscriptions. Certain arrangements provide for incremental fees above a fixed maximum number of monthly agents during the subscription term. We sell subscription services under contractual agreements that vary in length, ranging between one month and multiple years, with the majority of subscriptions having a term of either one month or one year.
Subscription fees are generally non-refundable regardless of the actual use of the service. Subscription revenue is typically affected by the number of customer accounts, number of agents, and the type of plan purchased by our customers, and is recognized ratably over the term of the arrangement beginning on the date that our services are made available to our customers. Subscription services purchased online are typically paid for via a credit card on the date of purchase while subscription services purchased through our internal sales organization are generally billed with monthly, quarterly, or annual payment frequencies. Due to our mixed contract lengths and billing frequencies, the annualized value of the arrangements we enter into with our customers may not be fully reflected in deferred revenue at any single point in time. Accordingly, we do not believe that the change in deferred revenue for any period is an accurate indicator of future revenue for a given period of time. Additionally, because of the mix of contract lengths, customer purchasing patterns, and renewal patterns for our products, we do not believe that the amount of unsatisfied performance obligations, or any backlog calculated therefrom, measured as of any particular determination date, or period-over-period changes in such amounts, are accurate predictors of our future revenue for any future period, and we caution you not to rely on such amounts for that purpose.


27


We also derive revenue from implementation, Talk usage, and training services, for which we recognize revenue upon completion.
Cost of Revenue, Gross Margin, and Operating Expenses
Cost of Revenue. Cost of revenue consists primarily of personnel costs (including salaries, share-based compensation, and benefits) for employees associated with our infrastructure, product support, and professional service organizations, and expenses for hosting capabilities, including third-party managed hosting services and depreciation from our self-managed colocation data centers. Cost of revenue also includes third-party license fees, payment processing fees, amortization expense associated with capitalized internal-use software, amortization expense associated with acquired intangible assets, and allocated shared costs. We allocate shared costs such as facilities, information technology, and security costs to all departments based on headcount. As such, allocated shared costs are reflected in cost of revenue and each operating expense category.
We currently operate out of four self-managed colocation data centers, in which we manage our own network equipment and systems, located in California, Virginia, Ireland, and Germany. In addition, we utilize third-party managed hosting facilities located in North America, Europe, Asia, and Australia to host our services, support our infrastructure, and support certain research and development functions. We currently intend to continue to operate our self-managed colocation data centers and incur expenditures for third-party managed hosting services over time while we transition our primary data center usage to third-party managed hosting services.
We intend to continue to invest additional resources in our infrastructure, product support, and professional service organizations, organically and through acquisitions. We expect that recent and future business acquisitions will result in increased amortization expense of intangible assets such as acquired technology. As we continue to invest in technology innovation, we expect to continue to incur capitalized internal-use software costs and related amortization. We expect these investments in technology to not only expand the capabilities of our products but also to increase the efficiency of how we deliver these services, enabling us to improve our gross margin over time, although our gross margin may decrease in the near-term and may vary from period to period as our revenue fluctuates and as a result of the timing and amount of these investments. To the extent that we continue to rely on third-party technology to provide certain functionality within our products or for certain subscription plans or integrations, we expect third-party license fees for technology that is incorporated in such products and subscription plans to remain significant over time.
Gross Margin. Gross margin is gross profit expressed as a percentage of revenue. Our gross margin may fluctuate from period to period as our revenue fluctuates and as a result of the timing and amount of investments to expand our product support and professional services teams, investments in additional personnel, hosting equipment, and third-party managed hosting facilities to support our infrastructure, increased share-based compensation expense, as well as the amortization of certain acquired intangible assets, costs associated with capitalized internal-use software, and third-party license fees.
Research and Development. Research and development expenses consist primarily of personnel costs (including salaries, share-based compensation, and benefits) for employees associated with our research and development organization and allocated shared costs.
We focus our research and development efforts on the continued development of our products, including the development and deployment of new features and functionality and enhancements to our software architecture and integration across our products. We expect that, in the future, research and development expenses will increase in absolute dollars. However, we expect our research and development expenses to decrease modestly as a percentage of our revenue in the long-term, although this may fluctuate from period to period depending on fluctuations in revenue and the timing and the extent of our research and development expenses.
Sales and Marketing. Sales and marketing expenses consist of personnel costs (including salaries, share-based compensation, sales commissions, and benefits) for employees associated with our sales and marketing organizations, costs of marketing activities, and allocated shared costs. Marketing activities include both online and offline marketing initiatives, including digital advertising such as search engine, paid social, e-mail and product marketing, content marketing, user events, conferences, corporate communications, web marketing and optimization, and outbound list generation. Sales commissions are considered incremental costs of obtaining customer contracts and are capitalized and amortized on a straight-line basis over the anticipated period of benefit, which we have determined to be three years.

28


We focus our sales and marketing efforts on generating awareness of our products, establishing and promoting our brand, and cultivating a community of successful and vocal customers. We plan to continue investing in sales and marketing by increasing the number of sales employees, developing our marketing teams, building brand awareness, and sponsoring additional marketing events, which we believe will enable us to add new customers and increase penetration within our existing customer base. Because we do not have a long history of undertaking or growing many of these activities, we cannot predict whether, or to what extent, our revenue will increase as we invest in these strategies. We expect our sales and marketing expenses to continue to increase in absolute dollars and continue to be our largest operating expense category for the foreseeable future. Our sales and marketing expenses as a percentage of our revenue over time may fluctuate from period to period depending on fluctuations in revenue and the timing and extent of our sales and marketing expenses.
General and Administrative. General and administrative expenses consist primarily of personnel costs (including salaries, share-based compensation, and benefits) for our executive, finance, legal, human resources, and other administrative employees. In addition, general and administrative expenses include fees for third-party professional services, including legal, accounting, and tax related services, other corporate expenses, and allocated shared costs.
We expect to incur incremental costs associated with supporting the growth of our business, both in terms of size and geographic expansion, and the infrastructure required to be a public company. Such costs include increases in our finance, legal, and human resources personnel, additional legal, accounting, tax, and compliance-related services fees, insurance costs, and costs of executing significant transactions, including business acquisitions, and other costs associated with being a public company. As a result, we expect our general and administrative expenses to continue to increase in absolute dollars for the foreseeable future. However, we expect our general and administrative expenses to decrease modestly as a percentage of our revenue in the long-term, although this may fluctuate from period to period depending on fluctuations in revenue and the timing and extent of our general and administrative expenses.
Other Income (Expense), Net
Other income (expense), net consists primarily of interest income from marketable securities, foreign currency gains and losses, and interest expense from our convertible senior notes. Interest expense includes amortization of the debt discount, amortization of issuance costs, and contractual interest expense.
Provision for (Benefit from) Income Taxes
Provision for (benefit from) income taxes consists of federal and state income taxes in the United States and income taxes in certain foreign jurisdictions.
Results of Operations
The following tables set forth our results of operations for the periods presented in dollars and as a percentage of our revenue:
 

29


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
2018
 
2017
 
2018
 
2017
 
 
* As adjusted
 
 
* As adjusted
Revenue
$
154,828

 
$
112,265

 
$
426,501

 
$
308,249

Cost of revenue (1)
46,992

 
33,693

 
130,207

 
92,463

Gross profit
107,836


78,572

 
296,294

 
215,786

Operating expenses (1):
 

 
 

 
 
 
 
Research and development
40,410

 
29,358

 
115,118

 
84,512

Sales and marketing
74,270

 
54,383

 
208,778

 
151,064

General and administrative
27,357

 
21,398

 
73,809

 
59,503

Total operating expenses
142,037


105,139

 
397,705

 
295,079

Operating loss
(34,201
)
 
(26,567
)
 
(101,411
)
 
(79,293
)
Other income (expense), net:
 
 
 
 
 
 
 
Interest income
4,561

 
923

 
9,906

 
2,463

Interest expense
(6,375
)
 

 
(13,427
)
 

Other expense, net
(463
)
 
(304
)
 
(194
)
 
(1,118
)
Total other income (expense), net
(2,277
)
 
619

 
(3,715
)
 
1,345

Loss before benefit from income taxes
(36,478
)

(25,948
)
 
(105,126
)
 
(77,948
)
Benefit from income taxes
(2,334
)
 
(133
)
 
(7,291
)
 
(785
)
Net loss
$
(34,144
)

$
(25,815
)
 
$
(97,835
)
 
$
(77,163
)
______________
(1) Includes share-based compensation expense as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
2018
 
2017
 
2018
 
2017
 
 
* As adjusted
 
 
* As adjusted
Cost of revenue
$
3,929

 
$
2,408

 
$
10,500

 
$
6,668

Research and development
10,677

 
7,776

 
30,436

 
22,274

Sales and marketing
10,261

 
6,573

 
27,447

 
17,981

General and administrative
6,579

 
5,619

 
18,198

 
15,502

 

30


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
2018

2017
 
2018
 
2017
 
 
* As adjusted
 
 
* As adjusted
Revenue
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Cost of revenue (2)
30.4

 
30.0

 
30.5

 
30.0

Gross profit
69.6


70.0

 
69.5

 
70.0

Operating expenses (2):
 

 
 

 
 
 
 
Research and development
26.1

 
26.2

 
27.0

 
27.4

Sales and marketing
48.0

 
48.4

 
49.0

 
49.0

General and administrative
17.7

 
19.1

 
17.3

 
19.3

Total operating expenses
91.8

 
93.7

 
93.3

 
95.7

Operating loss
(22.2
)
 
(23.7
)
 
(23.8
)
 
(25.7
)
Other income (expense), net:
 
 
 
 
 
 
 
Interest income
2.9

 
0.8

 
2.3

 
0.8

Interest expense
(4.1
)
 

 
(3.1
)
 

Other expense, net
(0.3
)
 
(0.3
)
 

 
(0.4
)
Total other income (expense), net
(1.5
)
 
0.5

 
(0.8
)
 
0.4

Loss before benefit from income taxes

(23.7
)
 
(23.2
)
 
(24.6
)
 
(25.3
)
Benefit from income taxes
(1.5
)
 
(0.1
)
 
(1.7
)
 
(0.3
)
Net loss
(22.2
)%
 
(23.1
)%
 
(22.9
)%
 
(25.0
)%
______________
(2) Includes share-based compensation expense as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
2018
 
2017
 
2018
 
2017
 
 
* As adjusted
 
 
* As adjusted
Cost of revenue
2.5
%
 
2.1
%
 
2.5
%
 
2.2
%
Research and development
6.9

 
6.9

 
7.1

 
7.2

Sales and marketing
6.6

 
5.9

 
6.4

 
5.8

General and administrative
4.2

 
5.0

 
4.3

 
5.0

*Adjusted to reflect the adoption of ASC 606. See Note 1 of the notes to our condensed consolidated financial statements.
Revenue
 
 
Three Months Ended September 30,
 
 
 
Nine Months Ended September 30,
 
 
2018
 
2017
 
% Change
 
2018
 
2017
 
% Change
 
* As adjusted
 
 
 
 
* As adjusted
 
 
(In thousands, except percentages)
Revenue
$
154,828

 
$
112,265

 
38
%
 
$
426,501

 
$
308,249

 
38
%
Revenue increased $42.6 million, or 38%, in the three months ended September 30, 2018 compared to the same period in 2017. Of the total increase in revenue, $17.5 million, or 41%, was attributable to revenue from new customer accounts acquired from October 1, 2017 through September 30, 2018, net of churn and contraction, and $25.1 million, or 59%, was attributable to revenue from accounts existing on or before September 30, 2017, net of churn and contraction. Revenue increased $118.3 million, or 38%, in the nine months ended September 30, 2018 compared to the same period in 2017 due to the addition of new customer accounts and the continued expansion of existing customer accounts.

31


Cost of Revenue and Gross Margin
 
 
Three Months Ended September 30,
 
 
 
Nine Months Ended September 30,